Variable Annuity
A variable annuity is an insurance contract that allows the owner to allocate premiums among a selection of investment sub-accounts, with the contract value and future income payments varying based on the performance of those sub-accounts.
Variable annuities combine features of insurance products with investment accounts. Premium payments are directed into sub-accounts — pools of assets that function similarly to mutual funds — covering a range of asset classes such as domestic equities, international equities, bonds, and money market instruments. The account value rises and falls with market performance, and the income stream in the distribution phase is not fixed, though many contracts offer optional living benefit riders that establish a minimum guaranteed withdrawal amount.
Because variable annuities involve securities, they are regulated by both state insurance departments and, through the sub-accounts, by the SEC and FINRA. Sellers must hold both an insurance license and a securities license (typically the Series 6 or Series 7). A variable annuity prospectus — a disclosure document registered with the SEC — must be provided to prospective buyers and describes the contract's fees, investment options, surrender charges, and any optional riders.
Fees are a defining characteristic of variable annuities and are considerably higher than those of comparable stand-alone mutual funds. A typical variable annuity imposes a mortality and expense (M&E) risk charge of roughly 1% to 1.5% per year, administrative fees of 0.1% to 0.3%, sub-account management fees (similar to mutual fund expense ratios), and charges for any optional riders such as guaranteed minimum income benefits (GMIB) or guaranteed minimum withdrawal benefits (GMWB), which can add another 0.5% to 1.5% annually.
The tax treatment mirrors other annuities: earnings grow tax-deferred, withdrawals are taxed as ordinary income (with the last-in, first-out rule applying to non-qualified contracts), and a 10% additional tax applies to distributions before age 59½. One commonly noted drawback is that long-term capital gains and qualified dividends earned inside the sub-accounts lose their preferential tax rates — they are converted to ordinary income upon withdrawal, unlike the same investments held in a standard brokerage account.
Optional living benefit riders have become a major selling point. A GMWB rider, for example, guarantees that the owner can withdraw a specified percentage (often 4% to 6%) of a benefit base each year for life, even if the account value falls to zero due to market losses or withdrawals. The benefit base typically grows at a stated roll-up rate (e.g., 5% per year) during a deferral period if no withdrawals are taken, creating a ratchet mechanism divorced from actual investment performance.