Who Assumes the Risk With a Variable Annuity

When planning for retirement, it’s important to know not just how your money will grow, but who’s responsible when markets fluctuate. With a variable annuity, the potential for higher returns comes with added exposure to investment risk. Unlike fixed annuities, where the insurance company guarantees your payout, variable annuities tie your earnings to the performance of underlying investments. That means you, the investor, assume more of the risk, but also stand to benefit from stronger market performance over time.

A financial advisor can help you determine whether a variable annuity is a good fit for your retirement plan.

How a Variable Annuity Works

A variable annuity can offer you a tax-advantaged way to save for retirement and an additional stream of income. The value of your annuity will depend on the performance of your chosen investments and the terms that will govern how you receive payments or make withdrawals. Variable annuities typically have two phases:

Accumulation phase: This is the initial phase when the policyholder makes contributions or investments into the annuity contract. During this phase, the invested funds have the opportunity to grow through a selection of investments. These often include mutual funds or other securities. The value of your annuity will fluctuate based on the performance of those investments. And the earnings within the annuity are generally tax-deferred, which means that taxes on the gains are postponed until you make withdrawals.
Annuitization or distribution phase: This phase begins when you, the policyholder, decides to start receiving payments from the annuity. This is typically done during retirement. There are various options for this phase, including annuitizing the contract to get a series of periodic payments. These payments can be fixed, variable, or a combination of both. Alternatively, the you can make withdrawals or take lump-sum distributions.

The distribution method that you will pick can affect the how much and when you will get income during retirement.

Additionally, you should keep in mind that variable annuities can offer optional features or riders that provide added benefits for an additional fee. These can include death benefits, which guarantee your beneficiaries a minimum amount upon your passing. These features can add a layer of security, but will also increase the overall cost of the variable annuity.

Risks of a Variable Annuity

A man researches his options before taking out a variable annuity.

Before you buy a variable annuity, you should carefully consider the risks against the benefits. Here are five common risks that could affect your investment:

Market risk: Variable annuities are subject to market fluctuations, and the value can go up or down based on the performance of the underlying investments, potentially even resulting in a loss of principal.
High fees: Variable annuities can come with various fees, including mortality and expense charges, administrative fees and investment management fees, which can significantly reduce your overall returns over time.
Surrender charges: Many variable annuities have surrender charges that penalize policyholders for withdrawing funds before a specified holding period, limiting liquidity and making it expensive to access your money in the short term.
Tax consequences: While variable annuities offer tax-deferred growth, withdrawals may be subject to ordinary income tax. And if you take money out before age 59½, you may also incur a 10% IRS penalty, which will reduce your tax advantages.
Complexity: The wide range of investment options, riders and contract features associated with variable annuities can make them complex and difficult to understand. And as a result, misinformed decisions could have a negative impact on your investments.

Who Bears All Risk in a Variable Annuity?

As the policyholder, you will bear the majority of the risk associated with a variable annuity. Because the performance of the underlying investments in your annuity is directly tied to financial markets, any gains or losses will get passed on you.

During the accumulation phase, when your annuity gets funded, you will choose from a range of investment options that often include mutual funds or other similar investments. The returns on these are not guaranteed and can fluctuate with market conditions, therefore passing on the market risk to you.

Additionally, you may also be at risk of outliving your savings during the distribution phase, if you choose to annuitize the variable annuity. The periodic payments received during retirement are based on the performance of the investments that you selected and if the investments perform poorly, the policyholder may receive less income than expected. This risk, however, can be mitigated to some extent by selecting optional living benefit riders that provide income guarantees. But as noted earlier, these typically come at an additional cost.

You should also be aware that while policyholders bear the investment risk in a variable annuity, insurance companies offering these products do provide some level of protection against certain risks. For example, you may have optional features for death benefits or living benefit riders. But these often come with additional fees.

How Variable Annuities Differ From Fixed Annuities

Variable annuities offer potentially higher returns and tax-deferred growth, but can lead to losses due to market instability. Comparatively, fixed annuities can provide guaranteed returns, but may not keep up with the pace of inflation.

Additionally, while a fixed annuity can offer you a guaranteed interest rate, it will come with less investment flexibility and a smaller opportunity for growth. This annuity typically invests in fixed-income securities like bonds and other fixed-interest instruments. Whereas variable annuities can invest in equity funds, bond funds, money market funds, and other investment options.

When it comes to taxation, both annuities tax withdrawals as ordinary income. And both annuities could also charge you a surrender fee if you take out funds during the accumulation phase. You may also face an early withdrawal fee of 10% from the IRS if you make a withdrawal before age 59½.

How to Choose the Right Retirement Strategy

When deciding whether a variable annuity fits your retirement plan, your first step should be understanding your comfort with risk. Because the value of a variable annuity depends on the performance of its underlying investments, your returns can fluctuate with market conditions. If you can tolerate some volatility in exchange for the potential of higher long-term growth, a variable annuity might align with your goals. However, if you prefer guaranteed income and stability, a fixed or indexed annuity could be a better fit.

A sound retirement strategy balances growth opportunities with protection against downside risk. Variable annuities offer tax-deferred growth and access to market-driven returns, but they can also include optional riders that add income guarantees or death benefits. These features can help manage risk while maintaining growth potential, though they come with additional fees. Understanding how these trade-offs affect your future income is key to choosing the right product mix.

Relying on a single source of income in retirement can leave you vulnerable to market shifts or unexpected expenses. Instead, consider combining different income streams, such as Social Security, investments, and annuities, to create a more stable financial foundation. Variable annuities can play a valuable role in this mix by providing both growth potential and the option for lifetime income once annuitized.

Bottom Line

A man researching the risks of a variable annuity.

A variable annuity can be a powerful tool for building retirement income, but it comes with a unique balance of risk and reward. Because you, not the insurer, assume the market risk, your returns depend on how the underlying investments perform. That flexibility can lead to higher growth, but it also requires a clear understanding of your tolerance for volatility and long-term goals.

Tips for Retirement Planning

When you’re planning for retirement, it’s important to know what your long-term goals are and what investment options will help you get there. A financial advisor can be a great resource in helping get to where you want to go. They can provide expert advice or manage your investments for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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