Variable Annuities

A variable annuity is a contract with an insurance company in which the insurer promises to make a series of payments to the contract holder. And unlike a fixed annuity that guarantees a series of fixed dollar payments, the value of a variable annuity will depend on the performance of the investments chosen.

In this article, we're going to discuss the two phases of any annuity - the accumulation period, and the payout phase. Next, we're going to talk about the terms and conditions you might find in a variable annuity contract. Then we're going to discuss some of the charges and fees you might encounter in a contract. We'll finish up with a special topic - variable annuities and Section 1035 exchanges.

Buying Annuities

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When an investor purchases an annuity contract, they are agreeing to pay the issuing company, typically an insurance company, in exchange for a future stream of income. Therefore, this business arrangement consists of two phases:

Accumulation Phase - during the accumulation phase, the contract holder, or annuitant, agrees to make a lump-sum payment, or a series of payments, and allocates this money to a set of investment options, typically mutual funds, as defined by the variable annuity contract. Over time, each of these mutual fund investments (principal) will earn the contact holder a return on their investment (earnings).
Payout Phase - during the payout phase of the contract, the insurance company returns to the contract holder their investment. With a variable annuity, the value of the account, and therefore the income it provides, will depend on the performance of the investments chosen.

The variable annuity's prospectus will outline the terms and conditions of the annuity including investment options that include mutual funds, money market funds, stocks, and bonds. The variable annuity contract will also outline the payment options, as well as the contract holder's ability to move their account funds between those investment options.

The contract will also explain when the annuitant will receive their promised income payments - and for how long. Since most annuities are purchased for retirement income, the buyer of the annuity may elect to receive immediate benefits, which is referred to an immediate annuity. Alternatively, the contract holder may elect to delay receiving income benefits until a future date; this type of variable annuity is referred to as a deferred annuity.

Deferred Annuities and Taxes

One of the advantages of buying a deferred annuity has to do with income taxes. As earnings accumulate in the annuity account, the buyer of the annuity is able to defer the payment of income taxes until a later point in time. If the annuitant believes they will be in a lower tax bracket in the future, as can happen when in retirement, then the purchaser of the annuity can not only delay the payment of income taxes but also lower their tax liability.

Variable Annuity Benefits and Fees

As just mentioned, the holder of a variable annuity can choose to receive immediate or deferred benefits. Immediate annuities offer the contract holder an immediate income stream, which is why this type of annuity is often chosen by someone that is already retired and in search of a steady source of retirement income.

Deferred annuities provide an income benefit that starts in the future. Deferred annuities offer the contract holder the ability to accumulate funds on a tax-deferred basis as just explained. Other benefits offered by variable annuities may include:

Survivor benefits
Long-term care
Guaranteed minimum income

Always keep in mind that your investment in an annuity is as only safe as the issuing company's financial strength. Examining bond ratings, as well as certain key financial ratios, are good ways to help judge the company's financial strength. Before you enter into any contract, make sure you have a good feel for the insurance company's ability to be stay in business the entire time you're collecting benefits.

Survivor Benefits

Variable annuities typically carry a survivor benefit. If the contract holder passes away before the insurance company begins making payments, then a beneficiary may be guaranteed payment - albeit usually less than the total of the purchase payments. Beneficiaries may include a spouse or your children.

Long-Term Care

Another feature you might find in a variable annuity contract has to do with long-term care. A long-term care feature may pay for home heath care costs, or even the cost of nursing home care in the event you become ill.

Minimum Income Guarantees

A variable annuity contract can also offer the annuitant a minimum guaranteed income stream or benefit. This option provides to the contract holder some level of protection in the event the investments chosen in the annuity fund under-perform relative to expectations. This type of "insurance" against income loss does come at a cost - higher fees or charges.

Variable Annuity Fees / Charges

There are several different fees, or charges, an insurance company may impose as part of their variable annuity contract. Annuities may be sold and include front-loads (which require fees to be paid at the start of the contract), or they may be back-loaded (which require fees to be paid later). Alternatively, the fees may be spread evenly over the life of the annuity.

Purchasing a variable annuity is an important decision, so it's essential to understand all of the charges or fees that could affect the income benefit. The following fees and / or charges may be included as part of a variable annuity contract:

Administrative Fees - this type of fee usually ranges from a flat annual fee to around 0.2% of the account's value each year. This charge covers recordkeeping, mailings, and other administrative fees associated with maintaining the account.
Fund Expenses - if any of the investments chosen as part of the variable annuity charge a fee, then that underlying fund expense will be passed onto the annuity contract holder.
Features - as mentioned above, a variable annuity agreement may contain added options or features. If so, then there is typically a charge to provide the features chosen.
Risk Expense Charges - this type of expense can run around 1% of the account balance each year. This fee pays the insurance company for the payment risk they've assumed under the contract as well as sales fees.
Surrender Charges - if you decide to withdraw the money from your annuity before a pre-determined purchase period has expired, then you may be charged a surrender fee. This charge is normally stated as a percentage of the contract's value. In some cases, this percentage will reduce over time and / or as the account's balance grows.

Free Look Provisions

Laws exist in many states that allow the buyer of an annuity a certain number of days to evaluate the annuity after purchase. If the buyer decides they do not want to keep the annuity, then they can return the contract and receive a full refund. This type of arrangement is called a "right to return" or "free look" period.

If the law allows for this free-look period, then this feature will be prominently described in the contract. This is just another reason why it's so important to understand all the features of an annuity before a decision is made to buy a contract.

1035 Tax Exchanges

Section 1035 of the U.S. tax code allows you to make a tax-free exchange from an existing variable annuity contract to a new contract. A 1035 exchange can be helpful if you find another annuity that offers you additional features, such as those previously described, or has an assortment of investment choices that are a better fit with your investment style or risk profile.

Before making any switches, be sure to compare the old and the new annuity carefully. While a 1035 exchange allows you to transfer funds from an existing annuity to a new annuity without incurring a tax penalty, it does not insulate you from any surrender charges. In fact, the surrender charges from the old annuity coupled with a transfer to a new annuity can often significantly erode, or eliminate, any prior investment gains.

Finally, when making an annuity-to-annuity transfer, you'll want to work closely with a financial advisor and follow their instructions carefully to ensure the exchange is tax-free.

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