Variable Annuity Definition Examples How Does It Work

Variable Annuity Definition

The investment option for variable annuities is typically mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more that, in turn, invest in the equity markets, thereby providing higher returns to the investors than the fixed annuity plans.

Explanation

It can be availed either by a lump sum payment or a series of payments over the years.It is different from a fixed annuity, which promises fixed payments to the investor holding the instrument at the time of retirement and after that.It offers the investor a range of options in selecting the investment strategy. Accordingly, the value of the contract also changes depending upon the investor’s risk.A variable annuity’s three main important features are the insurance benefit, tax savings for the investor, and the periodic income stream generated.

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How does Variable Annuity Work?

Example #1

Let’s assume that a person wants to invest $10,000 in a variable annuity with the insurance company. In this case, the company will offer the investor the plans/strategies to invest the client’s money. The investor needs to select the plan, and accordingly, the value would be decided depending upon the risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more of the fund. Since it is a variable annuity plan, the value of the investment may vary daily. Some plans may invest 70% of the funds into equity, and 30% into debt, while some may invest 50% into equity, 30% into debt, and 20% into mutual funds.

Example #2

Suppose a person invests $10,000 in a variable annuity plan, which invests 50% into debt and balances 50% into equities. The debt investment provides a return of 10%, whereas the equity investmentEquity InvestmentEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value.read more provides a return of 15%. It gives the investor returns higher than the fixed instrument provided by the fixed annuity plans, which generally are equal to the fixed deposit rate provided by the banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more. In this case, the investor’s investment portfolio would be valued at $12,500 due to the upside in the instruments.

Variable Annuity Fees

They refer to the fees and expenses set up by the regulators in the interest of the investors and the fund. In the case of a variable annuity plan, who has an expense ratio and a surrender charge of 5% for pre-mature withdrawals will take down the value of the investment.

E.g., Mr.A has invested $10,000 in a variable annuity with an insurance company. The surrender charge is 5% after one year. If the person tries to withdraw all the money after one year, $10,000*5% = $500 would be deducted from his payout, and he will be remitted a sum of $9,500 only into his account.

Fees can also be in the form of expenses charged by the regulators and other charges, such as AMC charges, fund expenses, etc.The insurer may also deduct the administration charges of the fund to run the fund smoothly.

Advantages

The most common benefit is the death benefit facility, which provides the beneficiary the sum after the death of the primary applicant.Secondly, a minimum guaranteed amount, which refers to the total investment minus the withdrawals, is given to the beneficiary even if the investment value is lower than the purchase cost of the investor.Lastly, it allows the risk-taking investor to participate in a variable annuity scheme, which not only provides the insurance cover to the investor but also provides him with the chance to earn money with the help of different products in the investment portfolioInvestment PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor’s risk profile.read more or the account maintained with the insurer.

Disadvantages

The major disadvantage is the death of the investor since the insurer will have to give the beneficiary of the insurer the guaranteed minimum amount even if the total investment made in the account is more than the market value.

Conclusion

A variable annuity is an investment concept; as the name suggests, it is variable, unlike fixed annuities where the returns are guaranteed, but in this type of investment, there can be superior returns as well as the investment can become nil due to risk exposureRisk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Lossread more to instruments in the financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more.