Variable Annuities Learning Guide

Variable annuities have become an increasingly more popular part of the retirement and investment plans of many Americans, both retired and non-retired. However, before purchasing any variable annuity, it’s important to know some of the basics about them. You should also be prepared to ask your financial professional lots of questions to help determine whether a variable annuity is right for you. You should also be aware that in order for a financial professional to offer you a variable annuity, they must have an insurance license, as well as a securities license (series 6 or 7 )

Before purchasing a variable annuity, you may wish to review the prospectus. The prospectus will contain important information about the investment options, payout features, and insurance components of the annuity. In addition, it will detail the costs associated with the annuity itself. Carefully compare the benefits of the product and weigh the costs associated to receive those benefits.

What Is a Variable Annuity?

A variable annuity is a contract between you and an insurance company. Like a fixed annuity, you can either purchase a variable annuity with a lump sum payment or with a series of purchase payments. The insurer agrees to provide certain things to you, the investor. A variable annuity offers a range of investment options for the investor to choose from. The value of your investment as a variable annuity owner will vary depending on the performance of the underlying investment options inside of the annuity. These are typically known as subaccounts. Generally speaking, you will have the option to invest in a number of different mutual funds that vary in risk. Some may be stock based, while others may have more bond exposure. In addition, there may also be money market instruments available to you.

While variable annuities are usually invested in mutual funds, they differ from mutual funds in several important ways:

First, variable annuities let you receive periodic payments for the rest of your life (or the life of your spouse or any other person you designate) – this can be accomplished through annuitization or special withdrawal features. These features may help protect against the possibility that you will outlive your assets after you retire.

In addition, variable annuities often have a death benefit associated with them. If you die before the insurer has started making payments to you, your beneficiary may be guaranteed to receive a specified amount – typically at least the amount of your purchase payments upon your death. This can be beneficial if your investments declined in value because your beneficiary may receive a higher amount. But, be aware, there are costs associated with this benefit.

Lastly, variable annuities are tax-deferred. This means that you will not pay taxes on income or gains from the contract until such time you withdraw money from the contract. You may also transfer your money between the various investment options offered in the contract without paying taxes. When you take income (either through withdrawals or annuitization) from the annuity, you will be taxed on that income. You will be taxed on any earnings at ordinary income tax rates rather than capital gains tax rates. This can be a big factor to consider, depending upon your tax situation. Generally speaking, a variable annuity should be viewed as a long-term investment in order to receive the most benefit from the tax deferral.

IMPORTANT NOTE: Other investment vehicles, such as IRAs and defined contribution plans such as 401(k)’s and 403(b)’s also may provide an investor with tax-deferred growth. There is not an added benefit to owning a variable annuity inside of an IRA or other retirement vehicle since they already have tax deferral features to them. If you consider purchasing a variable annuity with IRA money, be sure to understand this fact and weigh the other features of the variable annuity contract more heavily into your decision. Review the tax rules with a qualified professional before making such an investment.

Keep in mind that variable annuities are designed to be long-term investments. They are designed to help you meet retirement and other long-range goals. Variable annuities are not suitable for meeting short-term goals for a few reasons, including the taxes and charges that may apply to you. In addition, they usually carry stock market risk, thus making them more of a long term arrangement vehicle.

How Variable Annuities Work

A variable annuity has two main phases: an accumulation phase and a payout phase.During the accumulation phase, an investor will make purchase payments (either through a lump sum or flexible premiums), which can be allocated to a number of different investment options. you For example, you could allocate 60% of your purchase payments to a bond fund, 30% to a U.S. stock fund,  5% to an international stock fund, and 5% to a money market fund. The money you have chosen to allocate to the different mutual fund investment options will increase or decrease over time, depending on that particular fund's performance. Many variable annuities have “fixed” accounts. A fixed account, unlike a mutual fund, pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum interest rate.

As mentioned before, you should carefully review a variable annuity’s prospectus, as it is an important source of information about the contract. You can request this from the insurance company or from your financial professional. Review the different investment options and align them with your current long-term goals. A qualified financial professional can help you with this. You should carefully consider a variety of factors with respect to each fund option, including the fund's investment objectives and policies, management fees and other expenses that the fund charges, the risks and volatility of the fund, and whether the fund contributes to the diversification of your overall investment portfolio. The SEC's online publication, Mutual Fund Investing: Look at More Than a Fund's Past Performance, provides information about these factors. Another SEC online publication, Invest Wisely: An Introduction to Mutual Funds, provides general information about the types of mutual funds and the expenses they charge.

During the accumulation phase, you can typically transfer your money from one investment option to another without paying tax on your investment income and gains, although you may be charged by the insurance company for any transfers that you effect. However, if you withdraw money from your account during the early years of the accumulation phase, you may have to pay "surrender charges," which are discussed below. This is arguably one of the most important things to understand…how you access your money and how you may be penalized for accessing it in the wrong manner. In addition, you may have to pay a 10% federal tax penalty if you withdraw money before the age of 59½. It is advised that you meet with a professional that understands these penalties and can communicate them to you.

At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals (generally monthly). The latter is referred to as annuitization.

If you choose to receive a stream of payments (elect to annuitize your contract), you may have a number of choices of how long the payments will last. Under most annuity contracts, you can choose to have your annuity payments last for a period that you set (such as 20 years) or for an indefinite period (such as your lifetime or the lifetime of you and your spouse or other beneficiary). During the payout phase, your annuity contract may permit you to choose between receiving payments that are fixed in amount or payments that vary based on the performance of mutual fund investment options. It is important for you to review your options carefully. Generally speaking, once you trigger an annuitization, it is an irrevocable decision. 

The amount of each periodic payment will depend, in part, on the time period that you select for receiving payments. Be aware that some annuities do not allow you to withdraw money from your account once you have started an annuitization payment.

In addition, some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and you will start receiving annuity payments right after you purchase the annuity. Please refer to the information sections on this website that discuss immediate annuities.

The Death Benefit and Other Features

A common feature of variable annuities is the death benefit. If you die, a person you select as a beneficiary (such as your spouse or child) will receive the greater of: (a) all the money in your account, or (b) some guaranteed minimum (such as all purchase payments minus prior withdrawals). Carefully review this option and understand how beneficiaries will be paid your death benefit.

Let’s look at an example: You own a variable annuity that offers a death benefit equal to the greater of account value or total purchase payments minus withdrawals. You have made purchase payments totaling $100,000. Let’s also suppose that you have withdrawn $10,000 from your account. Let’s assume a little time goes by, and because of these withdrawals and investment losses, your account value is currently $80,000. If you die, your designated beneficiary would receive $90,000 (the $100,000 in purchase payments you put in minus $10,000 in withdrawals).

Some variable annuities allow you to choose a "stepped-up" death benefit. Under this benfit, your guaranteed minimum death benefit may be based on a greater amount than purchase payments minus withdrawals. Let’s look at an example: the guaranteed minimum might be your account value as of a specified date, which may be greater than your initial purchase payments minus withdrawals if the underlying investment options have gained in value. The purpose of a stepped-up death benefit is to "lock in" your investment gain and prevent a later decline in the value of your account from eroding the amount that you expect to leave to your heirs. TAKE NOTE: This feature does carry a charge, however…which will reduce your account value. Evaluate the importance of this feature to you and the charge associated with it  before making an annuity purchase.

Variable annuities sometimes offer other optional features, which also have extra charges. These are generally referred to as “riders.” One common rider, the  guaranteed minimum income benefit, guarantees a particular minimum level of annuity income payments, even if you do not have enough money in your account (perhaps because of investment losses) to support that level of payments.  Other riders may include long-term care insurance provisions, which may pay for home health care or nursing home care if you become seriously ill. It is important for you to evaluate each “rider” before purchasing the annuity. It doesn’t make much economic sense for you to pay for a rider that you will never use.

Another important consideration for you to evaluate is the financial strength of the insurance company that sponsors any variable annuity you are considering purchasing. This can affect the company's ability to pay any benefits that are greater than the value of your account in mutual fund investment options, such as a death benefit, guaranteed minimum income benefit, long-term care benefit, or amounts you have allocated to a fixed account investment option.

Important Note:

You will pay for each benefit or rider provided by your variable annuity. Be sure you understand each of the charges and benefits. Carefully consider whether you may need the benefit, whether it is today, tomorrow, or years in the future. If you determine that it is an important feature for you to have, evaluate whether you may be able to purchase the benefit more cost effectively as part of the variable annuity or separately (e.g., through a long-term care insurance policy).

Charges inside of Variable annuities

There are a number of charges associated with variable annuities. Be sure you understand all the charges before you invest. These charges will reduce the value of your account and the return on your investment. In general, they will include the following:

Surrender charges – If you withdraw money from a variable annuity within a certain period after a purchase payment (usually six to eight years, but sometimes as long as ten years), the insurance company usually will assess a "surrender" charge, which is a type of sales charge. This charge is used to pay your financial professional a commission for selling the variable annuity to you. A financial professional will earn a commission from your purchase. As a rule of thumb, the surrender charge is a percentage of the amount withdrawn, and usually declines gradually over a period of several years, known as the "surrender period." For example, an 8% charge might apply in the first year after a purchase payment, 7% in the second year, 6% in the third year, and so on until the eighth year, when the surrender charge no longer applies. This does not necessarily mean that every withdrawal you would take would be charged a surrender charge. Most annuity contracts will allow you to withdraw part of your account value each year – perhaps 10% or 15% of your account value– without paying a surrender charge. This is known as the liquidity features of the contract. Be sure to inquire with a financial professional about the liquidity features present in the variable annuity you are considering.

For Example: Let’s say you purchase a variable annuity contract with a $50,000 purchase payment. The contract has a schedule of surrender charges, beginning with a 6% charge in the first year, and declining by 1% each year. In addition, you are allowed to withdraw 10% of your contract value each year free of surrender charges. Let’s suppose that in the first year, you decide to withdraw $20,000, or 40% of your contract value of $10,000 (assuming that your contract value has not increased or decreased because of investment performance). In this case, you could withdraw $1,000 (10% of contract value) free of surrender charges, but you would pay a surrender charge of 7%, or $280, on the other $4,000 withdrawn.

Mortality and expense risk charge – This charge is equal to a certain percentage of your account value, typically in the range of 1-1.5% per year (1.25% is fairly typical). This charge compensates the insurance company for insurance risks it assumes under the annuity contract. Profit from the mortality and expense risk charge is sometimes used to pay the insurer's costs of selling the variable annuity, such as a commission paid to your financial professional for selling the variable annuity to you. These charges may be used by the insurance company for a variety of different reasons. It is important to understand what these charges are inside of your annuity, as they have a direct impact on your bottom line results.

For Example: Your variable annuity has a mortality and expense risk charge at an annual rate of 1.30% of the account value. Let’s assume your average account value during the year is $30,000, so you will pay $390 in mortality and expense risk charges that year.

Administrative fees – The insurer may also deduct charges to cover record-keeping and other administrative expenses. This may be charged as a flat account maintenance fee (perhaps $15 or $25 per year) or as a percentage of your account value (typically in the range of 0.1-0.2% per year).

For example: Your variable annuity charges administrative fees at an annual rate of 0.15% of account value. If your average account value during that year is $50,000, you will be assessed $75 in administrative fees.

Underlying Fund Expenses – This is very important to understand. Each variable annuity has “subaccounts,” commonly mutual fund investments. You will indirectly pay the fees and expenses imposed by those mutual funds for their management that are the underlying investment options for your variable annuity.

Fees and Charges for Other Features – We touched on this subject early. Many variable annuities have special features offered with them, such as a stepped-up death benefit, a guaranteed minimum income benefit, or long-term care insurance. These usually carry additional fees and charges.

Other charges, such as initial sales loads, or fees for transferring part of your account from one investment option to another, may also apply. Be sure to ask your financial professional to explain to you all charges that may apply. You can also find a description of the charges in the prospectus for any variable annuity that you are considering.