Variable annuity

As a financial product sold by life insurance companies, it's no surprise that variable annuities have similar features to life insurance. Variable annuities are a hybrid financial product, combining features of mutual fund investing and life insurance.

A variable annuity is a contract. You buy the contract with an initial purchase payment, investing in a variety of subaccounts that the insurance company sells. Similar to investing in a mutual fund, you should always read the prospectus of a subaccount before investing.

Some of the features that variable annuities share with life insurance include:

Designating a beneficiary. Life insurance policies and variable annuities require you to designate a beneficiary. In the event you die during an annuity's accumulation period, or before a certain point in the payout period, your beneficiary receives a death benefit.

Your beneficiary is generally entitled to receive the greater amount of the annuity's contract value or value of purchase payments. Death benefits are paid as a lump sum or as an annuity. For an extra charge, you can usually buy an enhanced death benefit.

Payments based on investment performance. When you buy a life insurance policy, you pay a premium. With permanent life insurance, your premiums accumulate a cash value. Depending on the type of permanent life insurance coverage, some of your premiums are invested in riskier investments such as stocks or bonds. Universal and variable universal life insurance policies let you switch to flexible premiums, or stop paying premiums temporarily, when your cash value grows to an adequate level.

Cash value accumulates to provide continued coverage. With permanent life insurance, the cash value of your policy continues to provide insurance coverage even if you stop making premiums. (If you're buying term life insurance, your premiums do not accumulate a cash value and your policy lapses when you stop paying premiums.) In other words, the cash value is a reserve of funding future premiums. This reserve gives you flexibility in paying your premiums.

It's helpful to think of a variable annuity's contract value in a similar way. The contract value is the source of annuity payments when the payout period begins. If investment performance is better than expected, it boosts an annuity's contract value, giving you a respite from additional purchase payments.

Optional premiums buy extra or enhanced coverage. With life insurance policies, you can often pay a premium to guarantee a minimum death benefit. Variable-annuity contracts also include options (at an extra charge) for guaranteeing a minimum annuity payment or death benefit. Guarantees are insurance in their purest form: a chance for you to swap uncertainty for certainty with an insurer that is willing to underwrite that risk in exchange for a fee.