Who Assumes the Investment Risk in a Variable Annuity?

A variable annuity is a contractual agreement between an individual, known as the contract owner, and an insurance company. This financial product serves as a long-term savings vehicle, primarily designed to accumulate assets on a tax-deferred basis for retirement or other significant financial objectives. It offers the potential for investment growth, but unlike some other retirement products, its value can fluctuate based on market performance. The unique characteristic of a variable annuity lies in how investment risk is handled, which differs significantly from more traditional guaranteed products.

The Primary Assumer of Investment Risk

The individual who purchases a variable annuity, commonly referred to as the contract owner, primarily assumes the investment risk associated with the contract. This means that the annuity’s value can increase with positive market performance or decrease with negative market performance, including the potential loss of the initial principal invested. The contract owner directs how funds within the annuity are allocated among various investment options, known as subaccounts. The performance of these chosen subaccounts directly influences the annuity’s value, passing any gains or losses directly to the contract owner.

During the accumulation phase, the account balance fluctuates daily based on the performance of the underlying subaccounts selected by the owner. If chosen subaccounts experience a downturn, the contract value will decline, and the contract owner bears this risk. Conversely, strong performance can lead to substantial tax-deferred growth.

Unlike certain other financial products where an insurer guarantees a specific return, the contract owner directly participates in the gains and losses of the underlying investments. The Internal Revenue Service (IRS) permits tax-deferred growth of earnings within the annuity, meaning taxes are not paid on investment gains until withdrawals begin. This tax deferral does not mitigate the inherent investment risk; it only postpones the taxation of any accumulated gains. Therefore, the responsibility for monitoring and managing investment performance rests with the contract owner.

How Investment Performance is Determined

The investment performance of a variable annuity is directly tied to its underlying investment options, known as subaccounts. These subaccounts operate much like mutual funds, offering diverse portfolios of stocks, bonds, or money market instruments. Upon purchasing a variable annuity, the contract owner selects the subaccounts for their premiums, determining the investment strategy.

The value of the variable annuity contract fluctuates daily based on the collective performance of these chosen subaccounts. If selected subaccounts appreciate, the contract value increases proportionally. Conversely, if subaccounts decline, the contract’s value also decreases. This direct link means there is no guaranteed rate of return, as growth or decline is entirely dependent on market performance.

Contract owners typically have the flexibility to reallocate their investments among available subaccounts without incurring immediate tax consequences. This allows them to adjust their investment strategy in response to changing market conditions or personal financial goals. While such transfers are tax-free, the annuity issuer may charge transfer fees, and the overall value remains subject to market fluctuations. The prospectus provides detailed information on investment objectives, risks, charges, and expenses.

Mitigating Investment Risk with Riders

While the contract owner bears the primary investment risk in a variable annuity, insurance companies often offer optional features called “riders” that can help mitigate some of this risk. These riders provide certain guarantees or protections, often for an additional fee, and are designed to address specific concerns such as longevity risk or market downturns. One common type is the Guaranteed Lifetime Withdrawal Benefit (GLWB), which ensures a guaranteed income stream for life, regardless of how the underlying investments perform or if the contract value depletes. For instance, a GLWB might guarantee a 5% annual withdrawal from a “benefit base” for life, even if the actual account value falls to zero.

Another rider is the Guaranteed Minimum Accumulation Benefit (GMAB), which guarantees that the contract value will not fall below a certain percentage of premiums paid, or even the full premium amount, after a specified period, regardless of market performance. This provides a floor for the account value, offering some protection against significant investment losses. Similarly, the Guaranteed Minimum Income Benefit (GMIB) guarantees a minimum income stream when the annuity is annuitized, often based on a protected value that grows at a specified rate, even if the market value of the subaccounts declines. These riders provide financial security, but they do not eliminate exposure to market fluctuations within the subaccounts.

These risk-mitigating riders come with additional costs, typically charged as a percentage of the annuity’s account value or a “benefit base.” These fees, which can range from 0.50% to over 1.50% annually, reduce the overall return on the investment. For example, a mortality and expense (M&E) risk charge can be around 1.25% annually, and administrative fees might be approximately 0.15%. While these riders can provide a valuable safety net, their cost must be weighed against the level of protection they offer and the potential impact on the annuity’s long-term growth.

Variable Annuities Versus Other Investments

Variable annuities differ from other common investment or annuity products in how investment risk is allocated. Compared to fixed annuities, the distinction is clear: fixed annuities shift investment risk to the insurance company. In a fixed annuity, the insurer guarantees an interest rate, meaning the contract owner receives predictable returns regardless of market fluctuations. This contrasts with variable annuities, where the contract owner directly bears the market risk of the underlying subaccounts.

Comparing variable annuities to standard investment vehicles like mutual funds or brokerage accounts also highlights unique aspects. In both, the investor assumes investment risk, as the value of holdings fluctuates with market performance. However, variable annuities offer distinct features not typically found in standard brokerage accounts, such as tax-deferred growth of earnings until withdrawal. This means investment gains are not taxed annually, allowing for potentially greater compounding over time.

Variable annuities can include optional riders that provide guarantees, such as a guaranteed income stream or protection against significant loss of principal, features unavailable with standalone mutual funds. While brokerage accounts offer liquidity and potentially lower fees, they lack the tax-deferral benefits and contractual guarantees that riders in variable annuities provide. Therefore, while investment risk is primarily with the individual in both variable annuities and brokerage accounts, the annuity structure offers a blend of market participation with insurance-backed protections and tax advantages.