Deferred Variable Annuity: Growth, Fees and Risks

What is Deferred Variable Annuity?

A deferred variable annuity is a long-term investment and insurance product that helps you grow your money on a tax-deferred basis while preparing for future income. You invest in market-linked subaccounts, similar to mutual funds, so your returns can rise or fall based on market performance.

Instead of paying the income immediately, deferred variable annuity allows your investment to grow over time before you start withdrawals, typically during retirement. It may also include optional benefits, such as lifetime income or death protection, making it a flexible tool for retirement planning.

Key Features of a Deferred Variable Annuity

A deferred variable annuity stands out because it blends growth potential with built-in protections, making it more than just a typical investment. Here are some of its key features:

• Tax-deferred growth: Your money grows without being taxed year after year, which helps it compound faster. You only pay taxes when you start withdrawing, which is typically during retirement.
• Investment subaccounts: You can invest in a range of subaccounts that function similarly to mutual funds. These options let you choose how your money is allocated based on your risk tolerance and goals.
• Optional riders: You can add riders for an extra cost, such as guaranteed lifetime income or a death benefit for beneficiaries, providing added financial security.
• Long-term investment horizon: It is designed for long-term planning, especially retirement, and works best when you stay invested for many years.

How a Deferred Variable Annuity Works

A deferred variable annuity works in two main stages: a growth phase where your money is invested and a payout phase where it provides income. Here’s a detailed overview of how it works:

Accumulation Phase

• You invest your money into subaccounts, which function similarly to mutual funds and offer exposure to stocks, bonds, or balanced portfolios.
• Your investment value changes based on market performance, meaning it can grow during strong markets or decline during downturns.
• Earnings grow on a tax-deferred basis, allowing compounding without annual taxes until withdrawal.

Annuitization/Payout Phase

• You can convert your accumulated savings into a stream of income payments.
• You can choose lifetime income, which continues as long as you live, or payments for a fixed period along with other options.
• Some annuities offer guaranteed income options, even if the underlying investment value decreases.

Withdrawal Options

Understanding your withdrawal options and their tax implications can help you plan when and how to access your annuity funds.

During the Accumulation Stage:

• Withdrawals are taxed on a LIFO (last-in, first-out) basis, meaning earnings are withdrawn first and taxed as ordinary income.
• Withdrawals are also subject to surrender charges depending on the policy terms.
• Withdrawing money early (before 59½ years) may result in a *10% federal tax penalty, in addition to regular taxes.

During the Income Stage:

• You can choose from several payout options, including a lump-sum withdrawal, systematic withdrawals for regular income, or an annuitized income stream based on your selected payout structure.
• Payouts are taxed as ordinary income on the earnings portion.

Fees and Charges in Deferred Variable Annuities

Deferred variable annuities include several layers of fees, which can affect your overall returns over time. These charges pay for insurance features, investment management, and administrative services, so it’s important to understand what you’re paying for before investing.

Common Fees Breakdown

• Mortality & expense (M&E) fees: On average, M&E fees typically range from 0.50% to 1.50%, with an industry average of approximately 1.25%1 of your account value annually for commission-based variable annuity contracts.
• Administrative fees: These are charged for maintaining your account, handling records, and providing customer service. They may be structured as a flat annual fee or a small ongoing charge.
• Investment management fees: Each subaccount you invest in has its own management costs, similar to mutual funds. These fees depend on the type of investment and the fund manager.
• Rider costs: Optional add-ons, such as guaranteed lifetime income or enhanced death benefits, come with additional charges but increase the overall safety net of your retirement portfolio.

Surrender Charges Explained

Surrender charges apply when you withdraw money from your annuity during the initial contract period, often called the surrender period. These charges typically start higher in the early years and gradually decrease over time. 

Once the surrender period ends, you can access your funds without these charges, although taxes and other withdrawal rules may still apply.

Tax Benefits of Deferred Variable Annuities

Deferred variable annuities are often used for their tax efficiency, especially by investors who want to grow wealth without ongoing tax drag. The structure allows your investments to compound uninterrupted, which can make a meaningful difference over long time horizons.

• Tax-deferred growth: Your earnings are not taxed each year, so gains can compound without annual tax drag. This allows your investment to grow faster compared to taxable accounts where returns are reduced by yearly taxes, fees, and other costs.
• Tax-deferred until withdrawal: You won't pay taxes on earnings while your money remains invested inside the annuity. Taxes are only triggered when you take distributions, giving you more control over the timing of taxation.
• Income taxed as ordinary income: When you withdraw earnings, they are taxed as ordinary income rather than capital gains and this can result in higher taxes depending on your income bracket.

Pros and Cons of Deferred Variable Annuity

While deferred variable annuity offers tax advantages and income security, their costs, complexity, and market exposure can significantly influence outcomes. Here are some of the pros and cons to consider:

Pros of Deferred Variable Annuity

• Tax-deferred compounding: Your investment grows without annual taxation, allowing compounding to work more efficiently over time and potentially increase long-term returns.
• Lifetime income options: You can convert your savings into a steady income stream that can last for life, helping reduce the risk of outliving your money.
• Death benefits for beneficiaries: Many annuities include a death benefit that ensures your beneficiaries receive a payout, even if market performance is unfavorable.
• Investment flexibility: You can choose from a range of subaccounts with different risk levels, allowing you to align your investment strategy with your financial goals.

Cons of Deferred Variable Annuity

• Market risk: Since your money is invested in market-linked subaccounts, your returns can fluctuate and you may lose value during market downturns.
• High fees reducing returns: Multiple layers of fees, including insurance and investment costs, can significantly lower your net returns over time.
• Complexity and lack of transparency: These products often include various features, riders, and fee structures that can be difficult to fully understand without careful review.
• Liquidity constraints and surrender period: Accessing your money early can be costly due to surrender charges, making this less suitable for short-term financial needs.

Who Should Consider a Deferred Variable Annuity?

A deferred variable annuity is best suited for investors with specific financial goals, particularly those focused on long-term growth and structured retirement income. Here’s who can consider this type of annuity:

• Long-term investors: Deferred variable annuities are designed for individuals who can stay invested for many years, allowing them time to benefit from compounding.
• High-income earners: Investors in higher tax brackets may find the tax-deferred growth especially valuable, particularly after maximizing other tax-advantaged accounts.
• Retirement income seekers: Those looking to create a predictable income stream can use annuities to supplement retirement savings and reduce the risk of running out of money.
• People who have maxed out retirement accounts: If you have already contributed the maximum to retirement accounts like 401(k)s or IRAs, an annuity can serve as an additional investment tool.
• Late-career professionals planning retirement income: Those approaching retirement often use annuities to convert accumulated savings into a structured and reliable income stream.

How to Choose the Best Deferred Variable Annuity

Choosing the right deferred variable annuity requires a careful evaluation of costs, flexibility, investment quality, and the insurer’s long-term reliability. Since this is a long-term commitment, even small differences in features or fees can significantly impact your overall returns and retirement income.

Here are a few factors that play an important role when you’re determining how to choose the best deferred variable annuity for your needs:

Key Factors to Compare

• Fees: Review all layers of charges, including insurance costs, fund expenses, and rider fees. Higher fees can gradually reduce your investment growth over time.
• Investment options: Assess the range and quality of available subaccounts. A well-diversified selection allows you to tailor your portfolio based on your risk tolerance and financial goals.
• Riders: Riders can provide added security and strengthen your investment portfolio, but they should align with your needs since they increase overall costs.
• Insurance company rating: Check the financial strength of the insurer through agencies like AM Best, Moody’s, or S&P. A strong rating indicates the company’s ability to honor long-term guarantees.
• Surrender period and terms: Understand how long your funds will be subject to surrender charges and what penalties apply for early withdrawals. Longer surrender periods can limit flexibility.
• Liquidity features: Check whether the annuity allows partial withdrawals without penalties, which can provide some financial flexibility if needed.