A variable annuity is a financial contract between you and an insurance company. The money used to establish the contract can be invested in a variety of ways and is allowed to grow on a tax-deferred basis. This provides the potential to significantly increase future payments. However, poor investment performance can reduce future payouts.

What Is a Variable Annuity?

A variable annuity is a contract between an individual, the contract owner, and an insurance company, the issuer. In exchange for an upfront payment or a set of installment payments, the issuer provides a named annuitant, usually the contract owner, a future lump-sum payout or a series of payouts.

The payouts are usually deferred, following a specified accumulation period. The payout frequency is fixed, and the payouts end at a specified point in time. Generally, the expiration date is defined as a certain number of years or the lifetime of the annuitant.

When you purchase a variable annuity, the money paid is allocated to an investment portfolio with a range of options (sub-accounts). These are usually mutual funds that invest in stocks, bonds, money market instruments or some combination of the three.

Additionally, you may be able to invest some of your money in a fixed account, which offers a guaranteed, minimum rate of interest. The amount of income you receive from the annuity can rise or fall, depending on the performance of your investment selections.

In some cases, the annuity issuer may guarantee a return of premium (ROP). This protects your initial investment, but it does not guarantee a return on your investment. For guaranteed interest, you must buy a fixed annuity.

Two elements contribute to the value of a variable annuity: the principal, which is the amount of money you pay into the annuity, and the returns that your annuity’s underlying investments deliver on that principal over the course of time.

The most popular type of variable annuity is likely a deferred annuity. Often used for retirement planning purposes, it is meant to provide a regular (monthly, quarterly, or annual) income stream, starting at some point in the future. There are also immediate annuities, which begin paying income right away.

You can buy an annuity with either a lump sum or a series of payments, and the account’s value will grow accordingly. In the case of deferred annuities, this is often referred to as the accumulation phase. The second phase is triggered when the annuity owner asks the insurer to start the flow of income, often referred to as the payout phase. Some annuities will not allow you to withdraw additional funds from the account once the payout phase has begun.

Variable annuities should be considered long-term investments due to the limitations on withdrawals. Typically, they allow one withdrawal each year during the accumulation phase. However, if you take a withdrawal during the contract’s surrender period, which can be as long as 10 years, you’ll generally have to pay a surrender fee. As with most retirement account options, withdrawals before the age of 59½ will result in a 10% tax penalty.

How Does a Variable Annuity Work?

Generally, a variable annuity is issued with a deferred payout structure. Essentially, this means the buyer must wait a specified number of years before receiving any payments. The holding period, which is known as the accumulation period, is designed to give the upfront investment time grow. After the accumulation period ends, payments can be initiated. Read on to learn more about these two phases.

Accumulation Phase

The accumulation phase begins when you purchase the annuity and lasts for a specified number of years, often 10 to 15 years. Essentially, this is a liquidity lock-up period designed to endure near-term volatility and allow the value of your investment to grow.

You decide how your funds are to be invested across sub-accounts, incorporating the degree of diversification and aggressiveness you desire. With some variable annuities, you may be able to invest a portion of your funds in a fixed account, which offers a guaranteed, minimum rate of interest.

Throughout the accumulation period, your account balance will increase or decrease, depending on the performance of your sub-accounts. If you want to change your investments, you may be able to do so without tax consequences. However, the annuity issuer may charge transfer fees.

Payout Phase

The payout phase, which is also known as the distribution phase, is when you begin drawing funds from the annuity. This can take the form of a lump-sum payment or, more commonly, a stream of periodic payments.

For periodic payments, you can designate how long they will last. Generally, the expiration date is defined as a certain number of years or the lifetime of the annuitant or annuitants, like in the case of a joint-and-survivor annuity. That said, the longer the potential payout stream, the lower the payment you can expect.

This rule-of-thumb reflects the risk-return tradeoff between an annuity contract owner and the issuing insurance company. A longer payment stream provides greater benefit to the contract owner and higher risk for the issuer. The only way for the latter to equalize the arrangement is to reduce the payment amount.

Who Should Choose a Variable Annuity?

Because variable annuities have market exposure and, therefore, market risk, they are better suited to people who are a decade or more away from retirement. Annuity.org expert contributor Chip Stapleton said that consumers aged 50-55 can benefit from the fluctuating returns of a variable annuity.

“It could be beneficial for them because they have enough time to weather the downs,” said Stapleton, who is a FINRA Series 7 and Series 66 license holder and CFA Level II candidate. “Over a 15-year time period, I don’t think there have been any years in the S&P 500 where 15 years have been negative. So, if they have the time to weather the down markets, that could be beneficial to them.”

Stapleton also suggested that a variable annuity might fit into a retiree’s portfolio if they already have guaranteed income.

“Maybe they have good Social Security or they have a good pension and they’re looking for some additional income. A variable annuity could be beneficial,” Stapleton said. “If the market’s up, they’re getting even more money. But if the market’s down, that’s alright because they have other guaranteed sources of income.”

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Variable annuities are a good fit for people like Tyson, who is seeking a more significant potential payout than a fixed annuity offers — and who isn’t afraid to take on some market risk. Variable annuities can help diversify Tyson’s retirement investments and grow his money tax-deferred. It can be an excellent option if he’s already maxed out his yearly 401(k) contributions.

This type of annuity is usually recommended for younger investors with longer time horizons and higher risk tolerances.

Variable annuities may also be attractive if you want more control over your investments because you can pick and choose your underlying stocks and bonds. There are a few reasons to choose a variable annuity as opposed to investing directly in the market. Stapleton cited the tax-deferred growth of variable annuities as an advantage over traditional brokerage accounts.

“You’re not going to pay any taxes on growth,” Stapleton said, “whereas in a non-qualified brokerage account, there’s often taxes you have to pay every single year.”

Variable annuities typically charge more fees than investment accounts like IRAs, but these annuities often come with additional benefits not offered by other options. Stapleton said that for some investors, the death benefit or living withdrawal benefit of variable annuities makes them a better choice than other investment vehicles. “If there’s outsize value provided by those fees, then it makes sense.”

Variable Annuity Advantages and Disadvantages

As with any financial instrument, the benefits and risks of variable annuities should be carefully considered prior to investment. Variable annuities offer the potential for higher returns than fixed annuities, but, as noted by the Financial Industry Regulatory Authority (FINRA), they pose several risks that warrant caution.

Advantages

• Possible Inflation hedge – If your investment selections perform well, variable annuity payments will increase, enabling you to better keep up with inflation. Variable annuities are similar to CDAs as they provide policyholders access to stock and bond market investments, which could potentially result in higher returns over time.
• Tax deferral growth – The money invested in a variable annuity is allowed to grow on a tax-deferred basis. You will not pay taxes on the earnings until you begin taking money out of the annuity.
• Initial investment protection – Oftentimes, the issuing company will guarantee you can access your initial investment, regardless of how poorly your investment selections perform.
• Death benefit – If you die before you start receiving payments, your beneficiary will receive a payout from the annuity company.
• Payments for life – You have the option of receiving payments for the rest of your life, regardless of how your investment selections perform. However, you will likely have to pay extra for this option.

Disadvantages

• Complexity – Variable annuities are complicated, and their various provisions and terms can be confusing to the average person. This is problematic, especially when careless salespeople push these products without considering the unique financial needs of individual investors.
• No guaranteed return – Unlike fixed and indexed annuities, there is no guarantee you will earn interest on your investment. If your investment selections perform poorly, this will affect the value of your annuity.
• Taxed as income – When you withdraw money from an annuity, the earnings are taxed as ordinary income, not at the more favorable capital gains tax rate levied on profits from securities disposals.
• Surrender charge – If you take money out of an annuity earlier than the contract allows, you will have to pay a surrender charge. Early in the contract, it can be as high as 10%. That said, some annuities allow you to withdraw small amounts in early years. Typically, this amounts to up to 10% of the current value, annually.
• High fees – Variable annuities are costly relative to other annuities and financial securities. Purchasing one entails a commission. Then, you will incur ongoing mortality and expense risk charges, administrative fees and fund management fees associated with your investment selections. Collectively, the ongoing fees can easily amount to 3% to 4% per year.

5 Types of Annuities to Know

In 2023, annuity sales in the U.S. were projected to reach a record high of more than $350 billion, up 21% over a record-setting year in 2022, according to insurance trade group LIMRA. Yet, annuities may be less familiar than other common financial products like mutual funds or 401(k)s. Many investors don’t know what an annuity is, or what the basic types of annuities are.

Although annuities may seem to come in a million variations, the five basic types of annuities to know are fixed, variable, indexed, immediate and deferred. For a quick primer on these types—as well as what annuities are and whether they might fit into your portfolio—read on.

An annuity is a contract between you and an insurance company that provides payments to you in exchange for a purchase price, or premium. To illustrate, an annuity might work like this: You pay an insurance company $100,000 for an immediate fixed annuity, and the insurance company agrees to issue you monthly payments of $600 for life, starting now.

You can purchase an annuity with a lump sum or make payments over time. You can also choose to receive your annuity payout as a single payment or in regular installments.

Annuities may be invested in mutual funds, stocks, bonds, money markets or a range of investments. Money invested in an annuity grows on a tax-deferred basis: Investment earnings are untaxed while in your annuity account and taxed upon withdrawal. Annuities may have surrender fees and early withdrawal restrictions that can make your money expensive to access if you need it unexpectedly.

An annuity can help you create a stream of income in retirement—or anytime. Depending on your contract, an annuity can provide regular income for a specified period of time (say, five, 10 or 20 years) or even for life. For retirees who may be worried about running out of money, guaranteed lifetime income may be appealing.

Most annuities fall into one (or more) of these types: fixed, variable, indexed, immediate or deferred. Here’s how each one works.

1. Fixed Annuities

A fixed annuity guarantees a minimum rate of interest and fixed payments. Your principal is also typically guaranteed, meaning you won’t lose the money you’ve invested (and negatively affect the payments you receive).

Fixed annuities provide a high level of predictability, though not necessarily the highest potential for growth. If you want to add a baseline monthly income to your retirement plan, a fixed annuity may offer the fewest surprises. On the downside, since payments are fixed, they may not keep up with inflation over time.

2. Variable Annuities

A variable annuity directs your premium payments to investment options that may include stocks, bonds, money market funds or—often—mutual funds. Your rate of return will vary depending on how well your investments do during the accumulation period when you’re paying premiums and allowing your money to grow. When you’re ready to enter the payout phase, the insurance company will determine a guaranteed minimum payment based on your principal, returns and expenses.

Because their returns aren’t 100% predictable, variable annuities can be more complicated to understand. You run the risk of losing money on your investments, which could impact the amount you receive during the payout phase. Then again, if you enjoy a high rate of return, your payout could be larger than expected.

3. Indexed

Indexed annuities combine some of the features of both fixed and variable annuities. They may guarantee a minimum rate of return combined with a return based on the performance of a market index like the S&P 500. Because they offer both a guaranteed return and a performance-based return, indexed funds have a risk profile that’s somewhere between fixed and variable annuities.

Returns on an indexed annuity may have a floor—an agreement that you won’t sustain a loss beyond a certain level. If you have a floor of 10%, for example, your investment value won’t decrease more than 10% even if the market drops by 18%. Indexed annuities may also have a buffer that reduces the impact of a market drop on your investment value. If you have a buffer of 5% and the index drops 12%, you would only “count” 7% of the loss.

4. Immediate (or Income) Annuity

In addition to the three basic types of annuities—fixed, variable and indexed—annuities are also divided into two categories based on when they begin to pay out. An immediate annuity—also known as an income annuity or single premium immediate annuity—starts making payments right away. The idea is to create a stable income stream using a single lump-sum premium payment. Payments are often made for life.

5. Deferred Annuity

A deferred annuity has a future start date. Prior to that date, your premium payments and interest accumulate, creating the basis for your future payments.

Understanding the basic types of annuities is a first step in evaluating whether a particular annuity is right for you. You’ll also want to consider your larger portfolio and resources, as well as your retirement needs. A financial planner may be able to help if you need help deciding where to put your resources.

If you’re considering an annuity, make sure you understand your contract thoroughly. You may also want to check with your state insurance commission or the Financial Industry Regulatory Authority’s (FINRA) BrokerCheck site to make sure your insurance broker is registered to sell annuities. Rating agencies like Moody’s or A.M. Best may help you learn more about the financial strength of the insurance company, to help ensure your claim to lifetime benefits doesn’t outlive your annuity provider.