Variable annuities are a type of investment company product (regulated by the Investment Company Act of 1940) that can provide lifetime income in retirement. These products allow unlimited contributions and can make payments that fluctuate based on investment performance, potentially lasting until the owner’s death. You can think of an annuity as a “self-made pension”: you contribute money now and may later choose to receive payments for life.
Contributions (sometimes called premium payments) to variable annuities can be made as periodic payments or as a lump sum. Variable annuities are generally considered non-qualified retirement plans*, so contributions are not tax-deductible (there’s no tax benefit just for contributing). There are two general types of annuities - immediate and deferred. The key difference is how long the investor spends contributing during the accumulation phase.
*You should assume variable annuities are generally non-qualified, but rolling over qualified funds into an annuity is possible. In turn, this creates a qualified annuity. We’ll learn more about this below.
If someone reaches retirement with a large sum of money, they can start annuity payments right away without a long accumulation period. This is an immediate annuity: the insurance company begins retirement income soon after it accepts the lump sum.
If the lump sum is made in one payment, it may be called a single premium immediate annuity. For example, an investor deposits $1 million into an immediate variable annuity and begins receiving monthly payments starting at $2,500. Those payments fluctuate based on the investment performance of the separate account (discussed below).
As with most financial choices, there are trade-offs:
Immediate annuity benefits
Immediate annuity risks
*The inaccessibility of the lump sum only becomes a problem if the investor needs more money than they receive in their annuity payments.
**An annuity typically stops making payments once the account owner dies. For example, assume an investor deposits $1 million into an immediate annuity in return for average monthly payments starting at $2,500. If they were to pass away after one year, the investor would’ve only received roughly $30,000 in total payments ($2,500 x 12 months). Exchanging $1 million for $30,000 of payments represents an extraordinary $970,000 loss. This is one of the primary risks investors face with annuities.
Deferred annuities take time to build assets before income begins. For example, assume an investor contributes $2,000 per month to a deferred variable annuity starting at age 40. By age 60, they would’ve contributed $480,000 ($2,000 x 12 months x 20 years). Because contributions are invested, the account could grow beyond $480,000 - say, to $1 million.
In retirement, the investor may annuitize the account, which means giving up control of the $1 million to the insurance company in exchange for monthly payments for life.
Deferred annuity benefits
Deferred annuity risks
*Deferred annuities are not required to be annuitized. We’ll learn more about this below.
Regardless of annuity type, there are two general phases:
The accumulation phase is when money is contributed and invested to build the annuity’s value. This phase could last a day (immediate annuity) or several decades (deferred annuity).
During the accumulation phase, contributions go into a separate account. It’s called “separate” because it’s kept separate from the insurance company’s own assets and capital. When a contribution is placed into the separate account, the investor purchases accumulation units. Like shares, accumulation units measure the investor’s interest in the account and help track their basis (the amount invested). Additional contributions buy additional accumulation units. In general, the more accumulation units an investor owns, the larger their interest in the separate account.
The investor controls the separate account and chooses how the money is invested. The available choices are typically diversified portfolios of stocks, bonds, and other products that are very similar to mutual funds. The investor’s choices determine risk exposure, which affects return potential.
The assets in the separate account grow tax-deferred, similar to other retirement plans. Investors generally don’t pay taxes on dividends or realized capital gains inside the annuity; taxes apply when a distribution (withdrawal) is taken (often in retirement). Investment income received in the separate account must be reinvested.
Variable annuities are also subject to the same early-withdrawal rules as many retirement plans: investors generally must wait until age 59 ½ to withdraw funds, and withdrawals taken earlier are typically subject to a 10% penalty.
Variable annuities typically provide a death benefit that applies only during the accumulation phase. This benefit applies if the account owner dies before annuitizing the contract (electing lifetime payments). For example, assume a 30-year-old contributes $500 monthly and plans to continue until age 60. They pass away unexpectedly at age 50 after contributing $120,000 over 20 years ($500 per month x 12 months x 20 years). The death benefit guarantees payment to the listed beneficiary. Specifically, the beneficiary receives the GREATER of the account owner’s basis or the current account value.
Continuing the example, assume the separate account performed poorly and the balance is $100,000 at death. The beneficiary would receive $120,000 (the basis). The death benefit ensures that, if the owner dies before taking distributions, at least the original amount contributed is returned - regardless of investment performance.
If the investments performed well, the beneficiary receives the current account value. Using the same $120,000 basis, assume the account grew to $200,000. Upon the owner’s death, the beneficiary would receive $200,000.
When an investor is ready to take money from a variable annuity, they enter the distribution phase and have several choices. They can withdraw the entire value of the separate account as a lump sum. They can also take random or systematic withdrawals - for example, requesting $2,000 per month until the account is exhausted.
When distributions are taken, only the growth is taxable. Contributions (basis) are made after-tax and aren’t taxed again. For example, if an investor contributed $50,000 and the account grew to $75,000, they would owe ordinary income taxes only on the $25,000 of growth.
If a lump sum or periodic withdrawal is taken from a deferred annuity*, the investor is not guaranteed income for life. If enough money is withdrawn, the separate account will eventually be depleted. Investors who are concerned about outliving their assets generally avoid these payout options.
*We are not discussing this option with an immediate annuity because they are almost always annuitized (payments for life). Otherwise, an investor with a large lump sum would be better off placing those funds in a brokerage account, investing what they didn’t need, and taking distributions as needed.
If an investor wants guaranteed income for life, they annuitize the contract. Annuitization means giving ownership of the separate account to the insurance company in exchange for payments for life. When an investor annuitizes, their accumulation units convert into a fixed number of annuity units. The value of those annuity units depends on the performance of the separate account, which directly affects future payouts.
Annuity payments are typically made monthly. The first payout is predetermined based on the annuitization structure (discussed later in this section). After the first payout, future payments depend on the performance of the separate account.
When an investor annuitizes, they’re given an assumed interest rate (AIR). The AIR is a conservative estimate of the projected growth of the separate account.
The separate account’s performance is continually compared to the AIR. Assume the AIR is 3% (annualized). The investor’s monthly payout increases if the separate account performs better than 3%. The payout decreases if the separate account performs worse than 3%. This is why these annuities are considered “variable.”
There are four specific annuitization structures to be aware of. First, the investor can choose a straight life annuitization, which pays for life. After the investor dies, payments stop, and the insurance company keeps the assets in the separate account. Depending on how long the investor lives, the return may be favorable or unfavorable.
Assume an investor chooses a straight life annuity when their separate account is worth $200,000. If they pass away one month after receiving one payment of $1,000, the insurance company profits $199,000. In this situation, the insurance company “wins.” It can also go the other way: the investor could live much longer than expected and receive payouts totaling $450,000, which would be a $250,000 gain relative to the $200,000 account value. In that case, the investor “wins.”
Because payouts depend heavily on how long the investor lives, insurance companies often require full disclosure of medical history, a medical exam by a doctor of their choosing, or both. That information is reviewed by an actuary, who estimates life expectancy. The insurance company then sets payouts based on that estimate.
Those estimates aren’t always correct. If an investor lives longer than expected, the insurance company must continue payments until death. This is longevity risk - a risk to the insurance company, but a valuable guarantee to the investor. Pensions face this same risk regularly.
Investors who want to reduce the “life-only” risk can choose a life with period certain annuitization. Assume an investor chooses life with a 10-year period certain. They are guaranteed payments for life, regardless of how long they live. However, if they die within 10 years, payments continue to their listed beneficiary for the remainder of the period. For example, if they die after 8 years of payments, 2 more years of payments continue to the beneficiary.
With a period certain feature, payments are guaranteed for a minimum time period. Because this reduces risk to the investor, life with period certain annuities typically have lower payouts than straight life annuities.
Primarily used by married couples, there is also a joint with last survivor annuitization. This payout structure covers two account owners and continues until both have died. After one annuitant dies, the payments are typically reduced.
Investors may also choose a unit refund annuitization. This structure pays for life, but “refunds” the beneficiary if the owner dies before receiving their basis back through payments.
For example, assume an investor contributes $100,000, annuitizes the contract, and then dies after receiving $70,000 in payments. The remaining $30,000 would be paid to the annuitant’s beneficiary in a lump sum or on a payment schedule (depending on how the annuity is structured).
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