Glossary
Variable annuity, defined
A retirement contract whose balance is invested in sub-accounts chosen by the owner, so it rises and falls with the markets, and which can later be turned into an income stream. The insurer wraps that investment account with tax deferral, a death benefit and optional income guarantees sold as riders.
In practice
Fees are the main thing to understand: a mortality and expense charge, administrative fees, fund expenses and rider charges all come out of the account each year, and together they can be substantial. The living benefit riders that promise a minimum income base regardless of market performance are the reason many people buy one; read how the base grows, when withdrawals can start, and what happens to the rider if the owner takes more than the allowed amount. Surrender charges run for several years. Gains are taxed as ordinary income when withdrawn, not at capital gains rates. It is a security, so the seller needs a securities licence and the prospectus governs. A buyer who does not want the rider guarantees may find lower-cost ways to get the same market exposure.
A worked example
Suppose a fifty-five-year-old invests $200,000 and the sub-accounts fall 25% in the first year, leaving $150,000. With an income rider whose base rolls up 5% a year regardless of performance, the base stands at $210,000, and a later lifetime withdrawal is calculated on that base, not the $150,000. The rider costs, say, 1.2% of the base annually. Hypothetical figures.
Applies to: Annuities