Variable Annuities: Market-Linked Income

Key Takeaways

• A variable annuity invests your premium in sub-accounts whose value fluctuates with the market, unlike fixed annuities with a guaranteed rate.
• Variable annuities are securities, regulated by the SEC and FINRA in addition to state insurance regulators, and must be sold with a prospectus.
• Total annual costs often run 2 to 3 percent or more once mortality and expense charges, sub-account fees, and rider fees are combined.
• Guarantees such as living-benefit riders can protect income, but they add cost and apply to a separate benefit base, not your withdrawable account value.

What It Is

A variable annuity has the same two phases as any annuity, accumulation and payout, but the accumulation value is tied to investments you select from a menu of sub-accounts. These sub-accounts hold portfolios of stocks, bonds, or money market instruments. Your return depends on how those portfolios perform, so the account value is not guaranteed and can fall.

Because the investor bears investment risk and the return depends on securities, the SEC treats variable annuities as securities. They are sold only with a prospectus, and the salesperson must hold the appropriate securities license. This is the key regulatory difference from fixed annuities, which are insurance products only.

Why It Matters

The appeal of a variable annuity is the combination of market upside with tax deferral and, optionally, an insurance guarantee on income. An investor who has already maxed out their 401(k) and IRA might use a variable annuity for additional tax-deferred growth, since contributions are not capped the way retirement accounts are.

The catch is cost and complexity. Layered fees can consume much of the market's return, and the contracts are dense enough that even experienced investors struggle to compare them. The SEC and FINRA have both issued investor alerts because variable annuities are frequently sold inappropriately, especially inside accounts that are already tax-deferred.

How It Works

You allocate your premium among sub-accounts. The account value moves with those investments. Several fees apply, typically:

• Mortality and expense (M&E) charge, an annual fee, often around 1 to 1.25 percent, that compensates the insurer for the death benefit and contract guarantees.
• Administrative and sub-account fees, the expense ratios of the underlying portfolios, often 0.5 to 1 percent or more.
• Rider fees, charged for optional guarantees like a guaranteed minimum income benefit, frequently another 1 percent or more.
• Surrender charges on early withdrawals during the surrender period.

Most variable annuities include a basic death benefit that pays beneficiaries at least the premiums paid (less withdrawals) if you die before annuitizing. Living-benefit riders can guarantee a minimum income stream regardless of market performance, but the guarantee applies to a benefit base used to calculate income, which is distinct from the cash surrender value you could actually take out.

Worked Example

Suppose an investor puts 100,000 dollars in a variable annuity with sub-accounts that gross 7 percent per year. The combined fees are M&E of 1.15 percent, sub-account costs of 0.75 percent, and a living-benefit rider of 1.10 percent, totaling 3.0 percent annually.

Net of fees, the account compounds at roughly 4 percent rather than 7 percent. Over 20 years, 100,000 dollars at 7 percent would reach about 387,000 dollars, but at 4 percent it reaches only about 219,000 dollars. The roughly 168,000-dollar gap is the cost of the fees and the guarantees they fund. The rider may still be worth it if it delivers protected income the investor values, but the drag is large and should be weighed explicitly. These figures are illustrative.

Common Mistakes

1. Buying a variable annuity inside an IRA or 401(k). These accounts are already tax-deferred, so the annuity's main tax benefit is redundant. Regulators specifically flag this as a frequent unsuitable sale.

2. Underestimating total fees. Investors often focus on one fee line and miss the stacking effect. Three percent a year compounds into an enormous lifetime cost.

3. Confusing the benefit base with account value. A rider may guarantee income on a growing benefit base, but that base is not money you can withdraw as a lump sum. The cash surrender value can be far lower.

4. Ignoring the surrender schedule. Variable annuities often have long surrender periods. Switching contracts via a 1035 exchange to chase a bonus can restart the surrender clock and trigger new charges.

5. Assuming guarantees are free. Living and death benefits are insurance, and you pay for them through rider fees every year, whether or not you ever need the protection.

Frequently Asked Questions

Q: What is a variable annuity in simple terms? A variable annuity is a tax-deferred contract where your money is invested in market-based sub-accounts, so the value goes up and down with the market. It can include guarantees on income or death benefits, but you pay annual fees for them.

Q: Why are variable annuities regulated as securities? Because the investor bears the investment risk and returns depend on the performance of securities in the sub-accounts, the SEC classifies them as securities. They must be sold with a prospectus by a properly licensed representative.

Q: What is a real-world example of fees eroding returns? A variable annuity with sub-accounts grossing 7 percent but carrying 3 percent in combined fees nets only about 4 percent. Over 20 years that gap can cost well over 150,000 dollars on a 100,000-dollar investment.

Q: How is a variable annuity different from a mutual fund? Both invest in market portfolios, but a variable annuity wraps them in an insurance contract with tax deferral, optional guarantees, surrender charges, and higher fees. A taxable mutual fund is cheaper and more liquid but offers no income guarantee.

Q: When does a variable annuity make sense? It can suit an investor who has maxed out other tax-advantaged accounts, wants additional tax-deferred growth, and specifically values a guaranteed-income or death-benefit rider enough to pay its annual cost.

Sources

1. SEC Office of Investor Education and Advocacy. "Variable Annuities: What You Should Know." https://www.sec.gov/investor/pubs/varannty.htm
2. Investor.gov. "Variable Annuities." https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities
3. FINRA. "Variable Annuities." https://www.finra.org/investors/investing/investment-products/annuities/variable-annuities
4. National Association of Insurance Commissioners. "Annuities." https://content.naic.org/consumer/annuities.htm

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.