Variable Annuities


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What is a Variable Annuity?


As its name implies, a variable annuity’s rate of return changes with the stock, bond and money market funds that you choose as investment options. Variable annuities are sometimes compared to mutual funds because they offer similar investment features, including investment choices—called “separate accounts”—that resemble mutual funds. However, they are different products.

A typical variable annuity offers three basic features not commonly found in mutual funds:

  • tax-deferred treatment of earnings;
  • a death benefit; and
  • annuity payout options that can provide guaranteed income for life.

While a variable annuity has the benefit of tax-deferred growth, its annual expenses are likely to be much higher than the expenses on a typical mutual fund. And, unlike a fixed annuity, variable annuities do not provide any guarantee that you will earn a return on your investment. Instead, there is a risk that you could actually lose money.

In general, variable annuities have two phases: (1) the “accumulation” phase, when the premiums you pay are allocated among investment portfolios, or subaccounts, and your earnings on these investments accumulate; and (2) the “distribution” phase, when the insurance company guarantees a minimum payment to you based on the principle and investment returns (positive or negative).

During the accumulation phase, it can be difficult and costly to access the money you’ve invested. You often have to pay what are called “surrender charges” to withdraw your money early—and you might incur tax liabilities on the earnings your investment has made. In the distribution phase, you typically can choose to withdraw money in a lump sum or as a series of payments over time. Regardless, your distribution will depend on the performance of the investment options you chose.

Things to Consider

The variety of features offered by variable annuities can be confusing. For this reason, it can be difficult to understand what’s being recommended for you to buy. It’s smart to take the following steps, before you purchase a variable annuity:

  • Fully understand all of its terms, fees and expenses, and carefully read the prospectus.
  • Ask specific questions like how long your money will be tied up, whether the annuity has sales or surrender charges, and if the investment poses liquidity risks, has early withdrawal penalties or potential tax consequences.
  • Find out whether the policy has a “free look” period that allows you to cancel an annuity purchase within a specific period if you have second thoughts.
  • Ask how your broker is being compensated. In addition to annual fees and other charges, the sales person who sells you a variable annuity is likely collecting a commission for the sale. Variable annuities have many features that can drive up commission charges to customers. Sometimes, a salesperson will also receive special compensation for selling these products.

Fees and Expenses

Variable annuities typically have high annual fees and expenses, in addition to potential sales and surrender charges and early withdrawal penalties. These annual fees and expenses can include:

  • Mortality and expense risk charges, which the insurance company charges for the insurance to cover guaranteed death benefits, annuity payout options that can provide guaranteed income for life or guaranteed caps on administrative charges.
  • Administrative fees, for record-keeping and other administrative expenses.
  • Underlying fund expenses, relating to the investment subaccounts.
  • Charges for special features, such as stepped-up death benefits, guaranteed minimum income benefits, long-term health insurance or principal protection.

Make sure you understand all the fees, expenses and other charges related to the variable annuity recommended to you before you make a purchase.

Exchanging or Replacing Your Current Annuity

If you already have a variable annuity, you may be presented with an option to exchange or replace it. There can be benefits to what is called a “1035 exchange,” which refers to a provision in the U.S. tax code that permits a direct transfer of funds in a life insurance policy, endowment policy or annuity policy to another policy without tax consequences.

If you consider exchanging or replacing your annuity, be sure to do a close comparison with your existing annuity, and only make a change when it is better for you, and not just better for the person trying to sell you a new product. Remember that exchanging one contract for a new one usually means the clock restarts for purposes of early withdrawal penalties.

Variable Annuity Regulation

Variable annuities are securities registered with the Securities and Exchange Commission (SEC), and sales of variable insurance products are regulated by the SEC and FINRA.