Variable Annuities Facts

A variable annuity is a particular type of annuity in which the principal amount – that is, the amount of money used to purchase the product – is invested, usually in stocks and mutual funds, by the insurer in specific choices selected from a list of options presented to the owner.

History and popularity

While variable annuities were introduced to the American market in the early 1950's (by TIAA-CREF), they experienced extremely slow growth during their first few decades of existence. In 1977, there were only about 4.37 million annuities in the United States, and of them, only 670,000 were variable annuities. The slow growth of variable annuities' popularity can be attributed to the possibility of loss of principle, the process of getting them approved in each of the fifty states, and the wide variety of existing tax-avoidance strategies available for the affluent. By 1993, however, the overall number of annuity contracts had skyrocketed to 21.5 million, with 5.25 million of them being variable annuities. In addition, while the vast majority of early sales (through 1977) were in group policies, by 1993 individual contracts were more than double the number of group annuity contracts. In 1998, Americans had close to $100 billion in variable annuities.

Annuitization

One of the features of variable annuities that makes them an attractive option in retirement planning is the possibility they offer of keeping pace with inflation. That is, once the annuity is annuitized and the annuitant starts receiving the monthly annuity checks, the value of those payments might increase if the investments underlying them increase – a distinct possibility in a bull market. The converse of this is true as well, unfortunately – in a bear market, the securities might decline in value, leading to a reduction of the monthly annuity check.

Who can Sell Variable Annuities?

Because of the possibility of loss of principle, variable annuities are considered to be investments, and their sale is regulated by the Securities and Exchange Commission (SEC). Anyone selling variable annuities must have a securities license; agents selling fixed annuities or equity indexed annuities require an insurance license, because there's no possibility of loss of the original premium.

Thus, while variable annuities as an element of a retirement income portfolio hold out the possibility of providing a hedge against inflation, their potential for loss, both of principle during the cash accumulation phase and of the monthly annuity income during the annuitization phase, makes these annuities of questionable value, at best, when one considers that there are other options which will guarantee a minimum annual growth plus a guaranteed monthly stream of income upon retirement, even if those monthly annuity payments lose some of their purchasing power.

Additional Benefits of Variable Annuities

Bonuses: Insurers, anxious to provide added benefit to variable annuities to encourage their purchase, have added benefits to make them more attractive. For example, many companies selling variable and fixed annuities have added a bonus feature. While this bonus, a percentage of the initial premium, is usually added to the annuity value either at inception or at the end of the first year. Consumers need to be very certain when considering the purchase of a bonus annuity, however, because some insurers add the bonus to the value of the monthly annuity payment. Since less than ten percent of all deferred annuities are ever actually annuitized, a bonus that's implemented only upon annuitization isn't much of an incentive.

Death Benefit: Another feature offered with some variable annuities is a death benefit. Most death benefits in variable annuities sold today provide that upon the death of the owner of a non-annuitized variable annuity, the beneficiary will be paid at least the value of all premiums paid in, less withdrawals and routine fees and charges. The death benefit is a relatively new feature, and was introduced to overcome the objection that if the owner died while the value of the annuity had declined due to poor performance of the stocks the annuity is invested in, his beneficiaries wouldn't even receive what he'd put into the annuity – a significant drawback for an investment choice touted as a retirement savings vehicle.

Interestingly, when death benefits were first introduced as features of some variable annuities, some didn't properly account for the possibility of withdrawal, and some owners, outraged by significant losses in their variable annuities, withdrew most, but not all, of their funds, leaving the insurer with a massive liability.

Variable Annuity FAQ

Why buy an annuity?

• To create a lifetime income stream to supplement what you receive from Social Security, pension plans, and other employer-sponsored retirement plans.
• To maintain financial independence. For example, you can use annuity funds to pay for long-term care expenses and stay in your own home, rather than rely on your children for care.
• To invest for any specific purpose or long-term goal, such as providing a legacy for your heirs or making a charitable gift.
• To grow funds on a tax-deferred basis.

Pros and Cons of the Variable Annuity

For some people, variable annuities offer a great opportunity for financial success. Others are not so lucky, and should consider pursuing other retirement avenues. How well a variable annuity actually works depends largely on the individual's financial picture. There are both pros and cons to going forward with one which should be carefully weighed before making any kind of decision. After all, the wrong decision can leave the investor out a significant amount of money. It is just important that the investor keep a reasonable expectation of their return in mind otherwise they might not be able to fully realize the benefits that an annuity can offer them.

There are many advantages that a variable annuity can offer to the right person. The two largest ones are tax deferment and liability protection. With an annuity, a person can expect to be responsible for significantly less taxes than when they were in the work force. For some, this is a great motivator. A variable annuity also offers liability protection for the money invested. This is a very attractive option for business owners who expect they may be faced with a liability lawsuit at some point in time. Under the liability protection, a variable annuity is not subject to a lawsuit and therefore cannot be lost as an asset during the court proceedings. A variable annuity also offers a very viable source of life insurance. Should the annuity holder pass away, their beneficiary can easily inherit their annuity. Most of the time this can happen very seamlessly- a lot quicker than if they were required to wait for a probate to clear.

The number of disadvantages that a variable annuity holds is not nearly as many as the advantages. However, they are there and should be carefully reviewed before making the plunge. One of the biggest cons of an annuity is the high fees they carry with them. For instance, a holder will be responsible for some very steep fines if they find that they need to withdraw the annuity prematurely. Generally, they are expected to wait until they are at least sixty years of age before taking out the money from their annuity. The expenses associated with a variable annuity can be as high as three percent- sometimes they can be much higher. Occasionally, depending on the product terms and conditions, an annuity holder may incur fees after a certain amount of transactions have been reached each year. The surrender charges associated with prematurely withdrawing the annuity can be especially high. One of the other big concerns with a variable annuity is that once the investment has been cashed out, the income it generates is then subject to taxes- sometimes very high ones.

For some, a variable annuity offers a very attractive option for their investment future. As long as they are the right age group with the correct type of assets, they can greatly benefit from taking out an annuity. However, they are not meant for new investors who do not have a significant amount of financial security already available to them. For them, a variable annuity can spell out disaster in a very quick way. It is important to keep in mind that although they do act similarly to life insurance they should not be substituted for a good policy- they generally cannot offer enough to be a viable option. In the end, the choice is up to the individual investor. As long as they have done their research on how the potential consequences of a variable annuity may affect their situation, they shouldn't dismiss the idea of an annuity as opposed to a 401K plan.

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Variable Annuities Glossary

1035 Exchange: An investment that is transferred from one company to another without being taxed.

Account Value: The value of an annuity. This adds the principal and interest together and subtracts out any withdrawals.

Annuitant: This is the person that is entitled to or receives the annuity payments. This is generally the policyholder and the person that is used for the “measuring life” part of the contract.

Annutization: This is the event of converting the sum of the annuity in order to take annual income are guaranteed monthly payments from it.

Annuity Certain: If the annuitant passes away, this is a contract that provides the annuitant or beneficiary a set income for a certain number of years.

Beneficiary: This is the organization or individual that has been named as the annuity insurance proceeds recipient in the case the annuity holder passes away.

Death Benefit: After the policy holder dies, these are the annuity benefits that are offered under the agreement.

Exclusion Ratio: The “return of capital” portion of a annuitized payment that is not taxed by the Internal Revenue Service.

Forced Annuitization: The forced liquidization of an annuity contract because it had reached a specified age.

Guaranteed Death Benefit: This provides the beneficiary the account value or principle, which ever is greater, on the date the annuitant dies.

Guaranteed Income: After an annuity as been annuitized, this is the payment that is made by the insurance company. These can be annual payments or monthly payments.

Immediate Annuity: An annuity where money is paid very quickly to the annuitant. This can happen within 1 month, 3 months, or 1 year. These are designed for people that require income on a constant basis.

Issue Age: This is the age of the annuitant on the day the policy is issued.

Joint Annuitants: This is where two people take out an annuity policy together. This is often times a husband and wife and payments will continue for this annuity until both policy holders have died.

Legal Reserve: Each state has an insurance code which states the minimum funding that an insurance company must keep on hand. These must be kept so that future obligations and claims can be met.

Life Annuity: This is an annuity that will provide income until the end of life.

Lifetime Minimum Interest Rate Guarantee: The smallest amount of interest that is guaranteed with an annuity for the entire length of the contract.

Multi-Year Interest Rate Guaranteed Annuity: This annuity offers a guaranteed interest rate for several years. The number of years is usually a set number.

No-Load: This is a term used to describe an investment which doesn’t charge an investor with a fee for a commission. Annuities are considered to be this type of investment.

Nonqualified: This is an annuity that is not designed to provide funding to a plan that is tax qualified.

Probate: This is the process of validating a will to make it legal. An annuity does not have to go through this process.

Qualified: An annuity which is involved in the sell of a plan that is tax qualified.

Reserve: This is an amount that is required to be reported on financial statements for an insurance company. This is listed as a liability and is required to help cover obligations to outstanding polices.

Settlement Options: The options available to the beneficiary or insured to receive payment from a policy.

State Insurance Department: A state administrative department that regulates the insurers in each state. They help to supervise and enforce the applicable laws.

Variable Annuity: This an annuity that varies based on the performance associated with the investment chosen.

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