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Financial Accounting: Tutoring Solution7 chapters | 124 lessons
What is a Variable Annuity? - Definition, Pros & Cons
Instructor:
Ian Lord
Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.
In this lesson we will look at how variable annuities serve as an option for retirement investing. We will also go over some of the key pros and cons of annuities compared to other types of investment accounts.
Variable Annuity
Frank has had a good experience with the fixed rate annuity he purchased a few years ago, but is looking for an investment that offers higher returns. His annuity salesman has suggested that if he is willing to take on more risk, buying a variable annuity could meet this goal. Let's help Frank understand exactly what a variable annuity is and explore the pros and cons before he makes a decision.
Definition
A variable annuity is an investment product that allows a sum of money to grow on a tax deferred basis. At retirement the balance is annuitized or begins to pay out regular payments as income. The difference compared to a fixed rate annuity is that with a variable annuity the amount of these payments will change based on the performance of the underlying investments the money is held in. The money grows tax free, and when Fred begins to draw an income in retirement the payments will be taxed at income tax rates instead of capital gains rates.
With a fixed annuity, the investment company has to make very safe, low risk investments so it can make guaranteed payments. A variable annuity has its underlying investments placed into higher risk, higher reward investments. The variable rate allows the investment company to adjust the payment rates based on total portfolio performance; when the market is doing well the investor receives a larger payment. Since management fees are based on the size of the account, the company can take out more money for management fees.
Pros & Cons
Let's look at some of the pros of a variable annuity that might benefit Frank. Within the annuity Frank can direct the funds to be invested in assets such as stocks or bonds that potentially offer higher returns. With this earnings potential, he might be able to avoid the damaging effects of inflation. Unlike other kinds of investments, Frank may be able to purchase a minimum rate guarantee which will ensure that regardless of market performance he can count on a specific rate of return on his investment each year or at least a certain amount of income each year once the payments begin.
Variable annuities feature guaranteed death benefits, which means that if Frank were to die shortly after purchasing the annuity his heirs would receive nothing less than the money he originally paid in, even if the market has had losses.
The main drawback of a variable annuity (aside from the increased risk) is the difficulty in withdrawing money from the annuity. Fred will be charged a surrender fee if he withdraws money from the investment during a period that might last as long as 15 years after his purchase. Like other investments with special tax treatment, if he pulls money out before reaching the age of 59 ½ he may have to pay a tax penalty to the IRS of 10% on top of the income taxes that would be due. Also, unlike just investing in stocks or bonds in a taxable brokerage account, the annuity company will charge management and administrative fees to operate the account. This will eat into the returns Frank enjoys.
Lesson Summary
A variable annuity allows an investor to invest in higher risk - higher return investments within a tax deferred account. The invested sum can grow tax free, and when the investor retires the balance is annuitized or used to fund regular payments back to the investor. Only when the money is paid out as retirement income does the investor have to pay income taxes on the returns. Because of the increased risk, the investor can potentially realize higher returns compared to using a fixed rate annuity.
Guaranteed death benefits ensure that the investor's heirs will receive at least the amount of money that was originally invested, ensuring that the original sum isn't lost to poor market performance. Investors can purchase variable annuities with guarantees for specific minimum rates of return or future income payments.
Once money has been invested in the annuity, the investor may be charged a surrender fee if the money is taken out of the account before retirement. In addition to the fee, if this occurs before age 59 ½ the IRS will impose an additional 10% penalty on top of the regular income tax bill. Administrative and management costs also reduce the investor's total returns.
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Lesson
13 in chapter 3 of the course:
- The Accounting Equation: Definition & Components 4:58
- Source Documents in Accounting: Definition and Purpose 3:52
- Using the Accounting Equation: Adding Revenues, Expenses & Dividends 8:08
- What Are Accounts? - Definition and Use to Categorize Transactions 7:04
- Ledgers and Chart of Accounts: Definitions and Use 3:37
- Understanding Debits and Credits in Accounting 5:17
- Recording Business Transactions in Accounting 8:00
- Using the Accounting Equation: Analyzing Business Transactions 6:25
- Computing and Interpreting Return on Assets 4:17
- Journal Entries and Trial Balance in Accounting 5:16
- Financial Statement Ratios: Determining Company Performance 7:32
- Treasury Stock: Definition, Accounting Method & Formula
- What is a Variable Annuity? - Definition, Pros & Cons
- What is a Hurdle Rate? - Definition & Formula
- CAPE Ratio (Cyclically Adjusted Price-to-Earnings)
- General Ledger Reconciliation: Policy, Process & Examples
- What is a Voucher Entry in Accounting?
- What are Journal Vouchers? - Definition & Examples
- Go to Mechanics of the Accounting Cycle: Tutoring Solution
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