Variable annuities are financial tools that allow annuitants to invest in sub-accounts for a higher rate of return. Because the investment value is dependent on the performance of the financial market, they carry the risk of losing interest.
What Is a Variable Annuity?
A variable annuity is a type of annuity that is dependent on another financial entity’s performance. An annuity is a financial contract that protects financial assets and provides a steady income stream. Because of its extensive benefits and potential for long-term growth, lottery recipients and working professionals looking to invest in their nest egg frequently use annuities to secure their financial futures.
Variable annuities can potentially earn interest, but also incur risk, because they are partially invested in mutual funds, stocks, bonds or other financial markets. This option offers a potentially higher rate of return than the other major type of an annuity, a fixed annuity.
How Do Variable Annuities Work?
Variable Annuity Types: Immediate vs. Deferred
Immediate annuities provide immediate access to the financial disbursement. The payout begins promptly after the contract is established. In this case, an annuitant would pay for the contract in lump sum, and in return would immediately begin receiving income payments.
- Single-Premium Deferred Annuity – An annuitant pays a one-time lump sum for this variable annuity contract.
- Periodic-Payment Deferred Annuity – An annuitant makes gradual premium payments for this annuity contract until the annuitization date, or date in which the annuity begins paying out to the annuitant.
Variable Annuity Pros and Cons
- Guaranteed Payout – No matter the state of the financial market, variable annuity owners are guaranteed to receive annuity payments through the end of the annuity term or until their death, though the amount may fluctuate per pay period according to the performance of the invested sub-accounts. If the annuity owner dies before the end of the contract term and they have a death benefit, the remaining funds will be transferred to a beneficiary.
- Growth Potential – Variable annuities allow annuitants the opportunity to invest in sub-accounts, providing ample long-term growth potential. If the investment performs well within the financial market, the interest can increase.
- Tax-Deferred Growth – Variable annuity investments are tax-deferred. Therefore, any interest earned on top of the annuity savings are not taxed until they are withdrawn from the contract.
- Death Benefit – Variable annuity owners can choose to include a death benefit within their contract, ensuring any remaining annuity funds left after their death are passed on to an heir. Should the interest or investment decrease in value from poor financial market performance, the beneficiary is guaranteed to receive no less than the initial investment. A contract without a death benefit risks forfeiting any remaining assets to the issuing insurance company.
- Surrender Charges – If an annuity owner chooses to break the variable annuity contract before the end of the term, they will be charged surrender fees. Though fees differ from one insurance company to the next, in some cases it can be more expensive to cancel the contract and pay surrender fees than to continue with annuity premium payments.
- Excess Expenses – Variable annuities carry a number of additional fees required to maintain the contract. Some of these fees include management fees, administrative fees and mortality fees. Annuitants also risk being charged withdrawal fees if they decide to use a portion of their variable annuity investment prior to the payout phase.
- Investment Risks – Though variable annuities offer the opportunities for long-term pay increase, they carry a major risk. If the sub-accounts you choose to invest in perform poorly, you risk losing a portion of your investment and a lower payout.
- Inflexibility – Once contract terms are finalized for variable annuities, they cannot be altered. This is specifically true for the annuitization phase.
Selling Your Variable Annuity
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