What is a Variable Annuity

A variable annuity is a long-term investment product sold by an insurance company. It differs significantly from other investment products because an annuity is a contract between the purchaser of the annuity, who is the annuitant, and the insurance company.  The annuitant agrees to purchase the annuity for a defined dollar amount in exchange for future payments. Unlike other investment vehicles such as mutual funds, stocks or bonds, that can be sold without penalty at any time (provided they are not part of a tax-deferred account) an annuity is not a liquid investment. The contractual aspect of an annuity locks in the payment amount for a set number of years, but also provides for surrender charges should the annuitant wish to cancel the contract.

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Variable Annuities as Retirement

Variable annuities were designed as an additional way for individual investors to save money for retirement. The underlying investments in which the annuity is invested, whether stock or bond mutual funds, money market funds or a combination of the three, grow tax-deferred. This provides a significant advantage for retirement asset accumulation, as gains in appreciation and the interest earned are not taxed until the money is withdrawn after the retirement age of 59 1/2.

However, unlike a traditional Individual Retirement Account, the money that is put into a variable annuity, either as one lump sum or as monthly contributions, is not tax deductible on either the federal or state level. While an investor in a variable annuity does not see a tax advantage in the year the money is deposited, he or she can invest as much money as he or she chooses in the annuity.

Several types of investors, each with different retirement needs and financial concerns can benefit from a variable annuity, including:

  • An investor who feels he or she is at risk of outliving his or her savings
  • A professional, such as a doctor, who needs to shield assets from potential lawsuits
  • An investor who is currently contributing the maximum amount allowed by law to his or her tax-deferred accounts

The Value of a Variable Annuity Can Appreciate with the Market

A variable annuity has underlying financial instruments from which it derives its value. Therefore, the value of a variable annuity can fluctuate up or down with the market. The insurance company that issued the annuity invests the money it receives from the annuitant in an attempt to take advantage of market gains and increase the value of the annuity. Because the underlying investments can either increase or decrease in value, the rate paid on a variable annuity is set by current market conditions.

But, because volatile downward market fluctuations can impact the value of a variable annuity in a negative way, many insurance companies now provide a guarantee of the principle of the annuity. Even if the underlying financial instruments suffer losses and the amount paid to the annuitant decreases, the entire value of the variable annuity is guaranteed never to decrease. This is one of the most appealing features of a variable annuity if you can find it. It is one of only a few retirement investment products for which the principle may be guaranteed.

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Guaranteed Death Benefit

In addition to guaranteeing the principle, many insurance companies also now offer a guaranteed death benefit on a variable rate annuity, much like that on a traditional life insurance policy. The death benefit ensures that any portion of the principle not yet paid to the annuitant at the time of his or her death will be paid to the beneficiary. For example, if an annuitant purchased a $200,000 variable annuity and had only received monthly income payments totaling $50,00 at the time of his or her death, the beneficiary would receive $150,000. The death benefit guarantees that the beneficiary receives the guaranteed account value, or the amount the original annuitant paid in minus the amount that has been paid out.

Upon Retirement

The insurance portion of a variable annuity functions to guarantee income once an investor has retired. To “annuitize” means to tell the insurance company that payments should begin arriving at the required intervals. Variable rate annuity investors can typically choose among several options for not only receiving payments but for how long. A “lifetime” payout will pay the annuitant until he or she dies, even if the total payout is more than the original principle.  For example, if an annuitant purchases a $200,000 variable annuity, he or she will be paid for life, even if the total amount paid out over his or her lifetime exceeds $200,000. The investor can also choose a “joint and last survivor” option.  This option is also known as “period certain” and pays the beneficiary until his or her death if the original annuitant dies.

A variable annuity can provide the peace of mind and comfort of knowing that guaranteed income is always available, even if market conditions deteriorate. While the principle value of a retiree’s other investments may decline, the principle of the variable annuity can be guaranteed. However, before purchasing an annuity, it’s important for each investor to clearly define his or her financial goals in order to understand the role each investment will play in the overall financial plan. While the risk of investing in a variable annuity may be greater for one investor than another, it’s also possible that the return will be greater. It is also advised that investors determine that the insurance company selling the annuity is a top rated insurance company (at least A) by Standard and Poor’s, Moody’s or A.M. Best for financial strength, security, and stability.

Because it can offer income for life, a protection of principle, and a death benefit, a variable annuity functions both as a financial and an insurance product. And, while it may seem complicated, a variable annuity may very well be worth looking into for those concerned about outliving their savings, those who are already contributing the maximum amount allowed to the tax-deferred plans and those looking to protect additional assets.

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