Variable Annuity – Definition

Cite this article as:"Variable Annuity – Definition," in The Business Professor, updated May 30, 2019, last accessed October 28, 2020, https://thebusinessprofessor.com/lesson/variable-annuity-definition/.

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Variable Annuity Definition

A variable annuity refers to an annuity contract type which allows for capital accumulation on a deferred tax basis. Contrary to a fixed annuity which offers an interest rate that is guaranteed, as well as, a minimum annuity payment, variable annuities give investors the chance to generate higher return rates by investing in equity, as well as, bond subaccounts. In a case where a variable annuity is annuitized for the purpose of income, the income payments can differ based on the subaccounts’ performance.

A Little More on What is a Variable Annuity

In the 1950s, variable annuities were introduced as an alternative to fixed annuities. They offer a guaranteed interest rate and also permit investors to invest in twelve or more subaccounts that are professionally managed. These professionally managed subaccounts comprise different classes of assets including bonds, stocks, and money market funds. This provides investors with the chance to earn higher return rates that can increase the capital amount they can accumulate and also provide a variable stream of income for potentially outpacing inflation. But investors bear the risk of their subaccounts not performing better than the guaranteed return of a fixed annuity, which can lead to less capital accumulation, as well as, a smaller stream of income.

Pros and Cons of Variable Annuity

The guaranteed death benefit is a major advantage which variable annuity has over mutual funds. No matter the performance of subaccounts, a variable annuity death benefit makes sure that the annuity owner’s beneficiaries get nothing less than their initial investment. Investors of variable annuity pay for protection cost through a morality charge. For an additional charge, certain variable annuities provide a minimum rate guarantee which pays a minimum return rate, even in situations where the subaccounts run at a loss for that year. For income payments, an identical rider is offered for the payment of income during annuitization which assures a minimum payout rate irrespective of the subaccounts’ performance.

Variable annuities should be seen as a long-term investment as a result of the restrictions on withdrawals. Only one withdrawal is permitted each year. But, if during the surrender period of a contract, a withdrawal is taken, which can span for as long as fifteen years, a surrender charge would be applied. Withdrawals are taxed as ordinary income mainly because variable annuities refer to tax-qualified investments where taxes are deferred. Any withdrawal made before age 59½ may have a 10% tax penalty attached to it.

Before investing in variable annuities, Investors are advised to read through the prospectus for a thorough understanding of the risks and expenses involved. Between the mortality fees, investment management fee, administrative fees, and also charges for riders, the expenses of a variable annuity can quickly add up. This can have adverse effects on returns over the long term.

References for Variable Annuity

Academic Research on Variable Annuity

Application of data clustering and machine learning in variable annuity valuation, Gan, G. (2013). Insurance: Mathematics and Economics, 53(3), 795-801.

The valuation of guaranteed lifelong withdrawal benefit options in variable annuity contracts and the impact of mortality risk, Piscopo, G., & Haberman, S. (2011). North American Actuarial Journal, 15(1), 59-76.

Valuation of large variable annuity portfolios under nested simulation: A functional data approach, Gan, G., & Lin, X. S. (2015). Insurance: Mathematics and Economics, 62, 138-150.

Analytical calculation of risk measures for variable annuity guaranteed benefits, Feng, R., & Volkmer, H. W. (2012). Insurance: Mathematics and Economics, 51(3), 636-648.

Variable Annuity–Insurance, Investment, or Both, Johnson, G. E. (1959). Geo. LJ, 48, 641.

State-dependent fees for variable annuity guarantees, Bernard, C., Hardy, M., & MacKay, A. (2014). ASTIN Bulletin: The Journal of the IAA, 44(3), 559-585.

Valuing variable annuity guarantees with the multivariate Esscher transform, Ng, A. C. Y., & Li, J. S. H. (2011). Insurance: Mathematics and Economics, 49(3), 393-400.

Optimal surrender policy for variable annuity guarantees, Bernard, C., MacKay, A., & Muehlbeyer, M. (2014). Insurance: Mathematics and Economics, 55, 116-128.

The real option to lapse a variable annuity: Can surrender charges complete the market, Milevsky, M. A., & Salisbury, T. S. (2001, September). In Conference Proceedings of the 11th Annual International AFIR Colloquium (Vol. 1).

Optimal initiation of a GLWB in a variable annuity: No Arbitrage approach, Huang, H., Milevsky, M. A., & Salisbury, T. S. (2014). Insurance: Mathematics and Economics, 56, 102-111.

The Variable Annuity: A Common Stock Investment Scheme, Long, R. H. (1956). Ins. LJ, 393.

 

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