How Variable Annuities Work

Variable annuities are contracts between an insurance company and an individual that provide the investor with tax-advantaged growth and future income payments, based on the performance of the annuity's underlying investments.

The funds that are in a variable annuity are invested in equity and bond "sub-accounts." So, while the owner of a variable annuity can participate in gains (and losses), their money is not actually invested directly in the market.

Unlike fixed annuities, which offer a set rate of return, a variable annuity has the potential to generate a substantially higher return, provided that the underlying investments perform well. If, however, these investments perform poorly, there is the risk that principal may be lost. In addition, the income payments that are provided by a variable annuity can vary, also based on the performance of the annuity's sub-accounts.

The Benefits of Owning Variable Annuities

Variable annuities allow investors to invest in a number of professionally managed sub-accounts. These may consist of different asset classes, such as mutual funds - and provided that these investments perform well, the investor can attain higher rates of return.

As with other types of annuities, the funds that are inside of a variable annuity are allowed to grow on a tax-deferred basis. This means that there is no tax due each year on the gain (until the time of withdrawal), which can allow the funds to compound over time.

In general, a variable annuity could be a good option for those who wish to invest in a broad spectrum of equities that offer the opportunity for more growth than a fixed or a fixed indexed annuity - especially over the long term.

Variable annuities may also be an option to consider for those who have already "maxed out" their annual contribution to their retirement plans - such as a 401(k) and/or IRA account - and who still want to contribute funds into an account that allows for tax-deferred growth.

Some Considerations Before You Purchase a Variable Annuity

While variable annuities can provide the opportunity to grow your account based on market performance - which in turn could generate a higher return than a fixed annuity - there are some things to consider before committing to this type of annuity.

One of the key drawbacks is the potential risk to your principal. For instance, if the underlying investment vehicles perform poorly, your principal could be at risk of loss. And, depending on when you plan to convert the annuity over into an income stream, a negative return on your funds could equate to a lower amount of income in retirement. (This, then, could even have an impact on your future lifestyle, and on whether or not you are able to purchase the goods and services that you need and want).

Will a Variable Annuity Be Right for You?

Even though a variable annuity can offer some nice features, they are not right for everyone. With that in mind, before you move forward with purchasing a variable annuity, it is recommended that you discuss your financial goals and needs with an annuity expert. That way, you will be better able to narrow down which financial vehicle (or vehicles) can best help you reach those objectives, in both the short- and long-term time horizons.