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Understanding Variable Annuities

Variable annuities often draw comparisons with mutual funds, which has often led to criticisms over their higher expenses and lack of flexibility. While they are similar to mutual funds, variable annuities provide investors with a number of guarantees that long term investors who have endured volatile stock market swings can appreciate. And, when they are really understood, it becomes clear that variable annuities do offer investors enough flexibility to prevent that “locked in” feeling. Understanding variable annuities would be important for investors who have their sights set on a secure retirement.

Additionally, since their inception and subsequent rise in popularity, variable annuity products have undergone some major changes which has resulted in enhanced features, greater security and more guarantees, all at less cost than past versions of the product. So, even for those who have dismissed them in the past, variable annuities today certainly warrant a second look.

First, while variable annuities are similar to mutual funds to the extent that they are investments in professionally managed portfolios of stocks and bonds, the similarities end there. Variable annuities have three very distinctive features that set them apart from any other investment:

Distinct Variable Annuity Features

Tax Deferral

The earnings from the investment accounts are not currently taxed until they are withdrawn. Plus, funds may be transferred between investment accounts without incurring any taxes. If held for a period of time, the benefits of tax deferral will not only offset any of the costs associated with variable annuities, they will enable you to accumulate more money than if the earnings had been taxed each year. When the earnings are finally withdraw, they are taxed as ordinary income.

Guaranteed Death Benefit

All variable annuities have a death benefit, much like a life insurance policy. The difference is that the life insurer guarantees a payment to your beneficiary equal to your original principle, no matter how the investments performed. Some variable annuity contracts offer options, for an additional cost, that will guarantee the account value as payment if it is higher than your principle at the time of your death. Death benefit payments will reflect any reduction in the account value due to withdrawals.

Guaranteed Period Payments

When a variable annuity is converted to income, the life insurer will guarantee that you or your spouse cannot outlive it.

How Variable Annuities Work

Variable annuities were designed as an accumulation vehicle that could later be converted into an income distribution vehicle, so they are comprised of two distinct parts: an accumulation stage and a distribution stage.

Accumulation Stage

In the accumulation stage, your funds are deposited into a choice of separate investment accounts. In essence, these are mutual funds wrapped inside of an annuity contract, and there are typically a half dozen or more investment options from which to choose. There are usually enough options for an investor to develop a well diversified and balanced portfolio of stocks, bonds, cash, and even real estate, with variations of each to create an allocation for any investment objective or risk tolerance. Most variable annuities include a fixed account which, like a fixed annuity, offers a fixed yield with a minimum guarantee.
As your investment objectives or risk tolerance changes, you are able to adjust your allocation as needed. Most variable annuity allow for a certain number to transfer each year without a transfer fee. So, it is important to periodically review your investment allocation to ensure it continues to match your investment objectives and preferences.
Variable annuity contracts due allow for withdrawals, once per year, of 10% of your account value without charges. Withdrawals in excess of 10% are charged a surrender fee on the excess. The fees usually start off high, in the range of 7% to 12%, but diminish over the length of the surrender period (7 to 12 years) until the surrender fee disappears. Any withdrawal made prior to the age of 59 ½ may be assessed a penalty of 10% by the IRS. In certain hardship or disability cases the penalty could be waived.

Distribution Phase

When you are ready to begin receiving income from your annuity, the life insurer will take your account value and calculate a payout rate based on your age and your life expectancy (or a specified period of time). Once your income begins, payments are received a regular intervals, usually monthly. Since you funds are still invested in separate investment accounts, your income will vary depending on the performance of the accounts. In rising markets, your income will increase, and in declining markets it will decrease. Generally, variable annuity income payments are considered to be a good hedge against rising costs over your lifetime.

Some contracts offer an option to lock in a payout based on a fixed rate as opposed to a variable rate. Or, if you would prefer to receive the variable rate payout, you could purchase an option that will guarantee a minimum payment even if your account values decline.

Variable Annuity Expenses

Another difference between variable annuities and mutual funds that critics like to point out is that variable annuity expenses are higher. In addition to paying an investment management fee which is similar to that charged in a mutual fund, you will also incur a mortality expense which the insurer charges to cover the risk it assumes for the death benefit. These charges, typically in the 1.25% range, are deducted from your account values each year.

Additionally, you are likely to pay an administrative fee, typically a flat dollar amount around $25 per year, that the insurer uses to defray record keeping and other administrative costs.
Also, for most of the additional guarantees and options that have been discusses here, such as the minimum income guarantee, there are additional charges. Many of these options serve to enhance the guarantees and provide more security, so the additional charges can be considered as “insurance premium”.

While the variable annuity expenses are higher than those of mutual funds, the question that risk adverse investors might ask is how much would they be willing to pay to be able earn market-like returns, without paying current taxes, and the peace-of-mind that, no matter how the market performance, they are assured of getting at least a minimum return.

To better understand how any one variable annuity product works, it is important to ready and study the prospectus which includes detailed information on the investment accounts, the various charges and any minimum guarantee options.

A variable annuity purchased with a minimum rate guarantee