What Is a Variable Annuity?

So an annuity can start paying out one day in the future and it can start paying out the month after you’ve paid the insurance company. But how much will it pay out?

When you buy an annuity, you’re paying the insurance company to do something that you couldn’t do yourself: to invest the funds so that you get a return that your own investments wouldn’t earn. And those returns also have to be high enough to cover the annuity’s usually high fees.

Variable Annuity Breakdown

There are two ways to determine the rate of an annuity’s return. The first is to use a variable annuity. The payouts from a variable annuity depend on the performance of the mutual bonds portfolio in which the annuity funds are invested. You can usually choose the portfolio in which you want to invest so you’ll have some control over the level of risk you want to assume.

But there is always an element of risk in a variable annuity. The value of the portfolio can fall so you may find that you’re receiving less than you would have received if you had opted for a fixed rate annuity.

Because variable annuities are more complex than fixed-rate annuities, they also tend to be more expensive. You can expect to pay about 2.3 percent of the value of the contract and even as much as 3 percent for a variable rate annuity. That’s much more than you would expect to pay if you simply took the sum that you’re investing and placed it in similar portfolio outside an annuity contract.

The Benefits of a Variable Rate Annuity

So you’re getting less certainty, more variability, higher risk, and you’re paying a lot more for it. The benefit though, is that you’re still going to get tax deferments, the annual income, and the inheritance rights. In addition, though, if the market performs well and the bonds in your portfolio rise at a good rate, there is a good chance that you’ll outperform the returns that a fixed-rate annuity would have produced.

Understanding a Variable Annuity

So how can you decide whether a variable annuity is the right choice for you?

A good place to begin is to consider not just your appetite for risk but how much variability you can endure. Look at the volatility of the portfolio you’re considering and calculate how low your returns could go if the economy entered another recession. (And you should bear in mind that recessions occur about once a decade so there is a good chance that your investments will take a hit at some point.) If you can still meet your expenses in the worst-case scenario, then any additional income is extra and you can absorb more risk.

Whether you wish to do so, though, is up to you. A variable annuity doesn’t just include risk; it also carries uncertainty. Payments can vary and you won’t know exactly how much you’ll have during the payout phase until you reach it. If you prefer the certainty of knowing your income—in the same way that you knew how much money you earned each month, for example—then a fixed index annuity may be better choice.

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