Variable Annuity: Meaning, Benefits and Drawbacks

8 min read • Published 11 December 2022
Written by Krishna Deshmukh
Know the benefits of investing in variable annuity plans

Investing in a variable annuity plan is like investing in any other savings plan, but there’s a twist. It pairs the growth potential of the underlying investment (generally a portfolio of mutual funds)  with the steady retirement income of insurance plans.

Your insurance provider will pay you back your investment with interest, which will depend on the market conditions. Variable annuities are essentially designed to help investors accumulate wealth for retirement. 

What Is a Variable Annuity Plan? 

Variable annuities are investment products which have the characteristics of a mutual fund but the benefits of an insurance policy. You can purchase a variable annuity by making one-time or periodic investments. After a certain period, the insurer will pay your investment back to you with interest. These plans provide a guaranteed income stream, but at a fluctuating rate- tied to the investments of your choice. 

How Does Variable Annuity Work? 

You can start investing in a variable annuity with a lump sum payment or by transferring funds from another retirement account. This capital amount is then reinvested into sub-accounts of your choice.

These work like mutual funds or ETFs that invest your principal into a portfolio of different types of assets such as bonds, stocks, money market instruments or a mix of all the assets.  Some also try to replicate the returns of market indices, which is a lot like index funds. 

During your investment tenure, your principal grows on the basis of compounding and remains not taxable. As the returns from this type of annuity plan depend on stock market fluctuations, if your underlying assets perform well, you will see higher returns; similarly, if it goes down, you will face losses. 

Some insurance companies offer plans which have a limit on the losses incurred. In case the market sentiments are not favourable, they will return the principal amount. In that case, the long-term investment won’t be worth that much as inflation will eat away at its value. 

Who Should Purchase Variable Annuity Plans? 

A variable annuity might sound good for investors who do not mind taking extra risks on an insurance plan for a higher return. After all, among all the other types of annuities, only a variable annuity has the potential to earn substantial returns. Hence, if you are one of those investors who have long-term investment goals and high-risk tolerance, you can opt for a variable annuity plan. 

What Are the Benefits of Investing in Variable Annuity? 

  • Tax-deferred growth: Variable annuity investments are not taxable until withdrawal. You will have to pay taxes once you start getting periodic payments from the insurance company. 
  • No limit on investment: Other retirement plans require you to make a specific amount of investment every year. However, with a variable annuity plan, there’s no such obligation. 
  • Capital protection: Variable annuities offer an extra earning potential. Additionally, they also provide capital protection, which means that you will at least get your investment amount back even if you lose out on additional earnings. 
  • Beating inflation: While other types of annuities offer safety, they also pay lower interest options, which may not keep up with the increasing cost of living. Variable annuities have the probability of generating higher returns which might beat inflation with time. 

What Are the Disadvantages of Investing in Variable Annuity? 

Now that you know the benefits of investing in variable annuities, you should also consider knowing its drawbacks to make an informed decision: 

  • Higher risk: Variable annuities are associated with high risk as the returns depend on stock market performance. If your underlying assets perform well, then you will get good returns. But if they perform poorly, you will lose money. 
  • Complicated maintenance: When you invest in a variable annuity, you get the option to choose the investment types, and then you have to keep tracking their performance. This takes more time and dedication than other types of annuities. 
  • Higher charges: All types of annuity plans charge a certain fee from investors, such as operational charges, add-on fees, guaranteed income charges, etc. But variable annuities charge fees for maintaining your investments which certainly takes a lot more effort. When combined, these fees can go up to 3 to 4% of your annuity, which will significantly affect your returns. 
  • Surrender fees: Annuities are low on liquidity as these are meant to be long-term investments. Hence, if you want to make an early withdrawal, you will have to pay surrender charges. 

Besides, there is an age limitation by which you cannot make a withdrawal until you are 59 and a half years old. 

Variable Annuities vs Fixed Annuities

Apart from variable annuities, there are fixed annuity plans that tend to be ideal for risk-averse individuals. While variable annuities cannot guarantee any return on investment, fixed annuities offer guaranteed returns. 

Here is a table to help you understand their differences in a proper way: 

                    Variable Annuity                    Fixed Annuity 
The interest rate keeps fluctuating depending on the market conditions. Fixed-rate of interest, which stays untouched by market fluctuations. 
High risk and potential for loss as interest rate depend on market fluctuations. Low risk as the interest rate remains fixed throughout the tenure. 
Probability of earning higher gains or returns. Moderate return due to fixed interest rates. 
Higher maintenance charges Relatively lower maintenance charges 
Higher probability of beating inflationLower probability of beating inflation

What Are the Fees & Charges Associated with Variable Annuity? 

Variable annuities come with several charges and fees, which can lower your return on investment. Some of the charges are discussed below: 

  • Surrender fees: You will have to pay surrender fees if you make a withdrawal before the annuity period starts. 
  • Administrative charges: Your insurance company charges this fee for handling your annuity account. These can be charged as simple maintenance fees or as a certain percentage of your investment value. 
  • Underlying asset charges: You usually have to pay this fee indirectly as a percentage of your assets. Insurance companies charge this fee to pay the expense ratio of the underlying mutual fund assets, and it is paid annually.  
  • Other features charges: There are some special features of variable annuity which require some extra fees from the investors. Features such as long-term care insurance, a stepped-up death benefit or a guaranteed minimum income benefit often charge extra fees. 

Things to Know Before Investing in Variable Annuity

Variable annuities sound good for long-term investments, and you can get possibly higher returns than fixed annuity plans. But is it the right option for you? To make a firm decision, you should consider knowing these things beforehand: 

  • Suitability: Annuities are not for everyone. Please make sure you are of that age when you have time to reap the benefits, as these are long-term investments. 
  • Liquidity: Any type of annuity, including variables, is low on liquidity. You cannot make a withdrawal before a certain period, and if you do, you will have to pay penalties. 
  • Add-ons: Check if you can consider buying add-ons or additional features such as guaranteed minimum income benefits, which will increase the benefits of your insurance plan. 
  • Death benefit: Make it clear about what will happen to your annuity after your demise. Please note that not all annuities come with a death benefit. 

Final Word 

Variable annuities can be a suitable investment as well as an insurance option for you if you have a high-risk potential and wish to generate higher returns than fixed annuity plans. It is ideal to get professional advice from financial experts before going ahead with any kind of investment. 

Frequently Asked Questions

How does the death benefit of variable annuity work? 

The death benefit is an additional feature which can be added to an annuity plan. In case of your sudden or untimely demise, the nominee will get a certain amount from the plan, generally the principal.

How are returns on annuity taxed?

Your annuity returns are taxed as regular income and not as capital gains. Hence, you won’t be able to enjoy capital gain tax benefits on your annuity returns.  You will have to pay taxes on the returns as per the applicable tax slab rate.

What are annuity subaccounts?

Annuity subaccounts are where your assets stay invested throughout the tenure of the plan. Some common types of variable annuity subaccounts are money market subaccounts, bond subaccounts and stock subaccounts.

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Krishna Deshmukh

Investment Principal
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.

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