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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.

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