Why Might Someone Purchase a Variable Annuity?

Many individuals purchase variable annuities as part of their investment strategies. Reading the prospectus and talking with a licensed financial professional is important. Understanding what a variable annuity is, how it works, and the relevant charges helps determine whether a contract is right for you.

What Is a Variable Annuity?

A variable annuity is a contract between you and an insurance company. You make a single payment or a series of payments, and the insurer makes periodic payments to you, either immediately or at a predetermined date.

The value of a variable annuity depends on the performance of the underlying investments. Common options include mutual funds that are invested in stocks, bonds, and money market instruments.

What Are the Benefits of a Variable Annuity?

1. A variable annuity can provide periodic payments for the rest of your life, your spouse’s life, or the life of another person you designate. This feature protects against outliving your assets during retirement.

2. Because variable annuities are tax-deferred, you pay taxes on the income and investment gains when you withdraw your money. You can transfer money from one investment option to another within the contract without paying taxes at the time of the transfer. When you withdraw money, the earnings are taxed as ordinary income, which is taxed at lower rates than capital gains.

3. If you die before receiving payments from your variable annuity, the death benefit guarantees your beneficiary a specific amount, usually at least the amount of your purchase payments.

How Does a Variable Annuity Work?

A variable annuity has an accumulation phase and a payout phase:

Accumulation Phase

The accumulation phase is where you make purchase payments that are allocated to your chosen investment options, such as stock funds, international stock funds, and bond funds. The value of each subaccount depends on the performance of the underlying mutual funds.

Many variable annuities allow investors to allocate part of their payments to a fixed account that pays a set interest rate. The insurance company might periodically reset the rate, but typically guarantees a minimum, such as 3% annually.

You can typically transfer money from one investment option to another without paying taxes. However, the insurance company might charge you for transfers.

If you withdraw funds from your variable annuity during the early years of the accumulation phase, you might pay surrender charges. You could incur a 10% penalty if you withdraw money before age 59.

Payout Phase

During the payout phase, you might receive your purchase payments plus any investment income and gains as a lump sum or stream of payments at regular intervals, typically monthly. If you choose a stream of payments, you can decide how long they will last. Most contracts allow variable annuity payments to last for a set time, such as 20 years, or for an indefinite period, such as your lifetime.

You might choose fixed-amount payments or variable payments based on the performance of the underlying funds. The amount of each periodic payment will depend on the selected time period.

Death Benefit

 If your variable annuity includes a death benefit, your chosen beneficiary will receive the greater of the money in your account or a guaranteed minimum, such as the purchase payments minus prior withdrawals, after you pass away.

Some contracts allow you to choose a stepped-up death benefit, where the guaranteed minimum death benefit could be based on a greater amount than the purchase payments minus withdrawals. The purpose is to lock in your investment performance and prevent a later decline in your account value from reducing the amount you want to leave to your beneficiary. This feature carries a charge that reduces your account value.

Optional Features

Many variable annuities offer a guaranteed minimum income benefit, guaranteeing a minimum level of annuity payments even if your account value cannot support the level of payments. Another common feature is long-term care insurance, which covers home health care or nursing home care if you become seriously ill. These features have additional costs that reduce your account value.

What Are Common Variable Annuity Charges?

Variable annuity charges decrease your account value and return on investment. Common charges include:

Surrender Charges

Most variable annuities include surrender charges to discourage withdrawals within the first 6 to 10 years. This type of sales charge is used to pay your financial professional for selling you the contract. The surrender charge is typically a percentage of the amount withdrawn and declines during the surrender period.

Mortality and Expense Risk Charge

The mortality and expense risk charge is a percentage of your account value, typically around 1.25% annually. This charge compensates the insurance company for insurance risks assumed through the contract. The profit can be used to pay the insurer’s costs of selling the variable annuity.

Administrative Fees

The insurer might deduct a flat account maintenance fee, such as $25 annually, or a percentage of your account value, such as 0.15% annually, to cover recordkeeping and other administrative expenses.

Underlying Fund Expenses

The fees and expenses relevant to the underlying accounts in your variable annuity are pulled from your account.

Charges for Other Features

A guaranteed minimum income benefit, long-term care insurance, or stepped-up death benefit often carries additional fees. Initial sales loads from the mutual funds in the underlying accounts or fees for transferring money from one investment option to another typically apply.

What Is a 1035 Exchange?

Section 1035 of the U.S. tax code allows you to exchange an existing variable annuity contract for a new annuity contract without paying tax on the income and investment gains in your current account. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that you prefer, such as a wider selection of investment choices, different annuity payout options, or a larger death benefit.

The potential disadvantages of a 1035 include:

• You might pay surrender charges on your old annuity if you are still in the surrender charge period.

• A new surrender charge period typically begins when you exchange to the new contract.

• The new annuity may have higher annual fees than the old annuity, which will reduce your returns.

What Are Bonus Credits?

Some insurance companies include a bonus credit feature with each variable annuity, typically 1% to 5% of the purchase payments. However, many of these contracts have higher expenses that outweigh the benefits offered, including the following:

• Higher surrender charges

• Longer surrender periods

• Higher mortality and expense risk charges

• Other charges

The bonus might apply to your initial premium payment or payments made within the first year of the contract. Also, according to the contract terms, the insurer might take back the bonus payments made within a specified period if you make a withdrawal, a death benefit is paid to your beneficiaries after your death, or other circumstances.

Which Questions Should You Ask Before Purchasing a Variable Annuity?

Consider the following questions before purchasing a variable annuity:

• Will you use the variable annuity primarily to save for retirement or a similar long-term goal?

• Are you investing in the variable annuity through a retirement plan or an Individual Retirement Account (IRA), which would mean that you are not receiving any additional tax-deferral benefit from the variable annuity?

• Are you willing to take the risk that your account value may decrease if the underlying mutual fund investments perform badly?

• Do you understand the features of the variable annuity?

• Do you understand all of the fees and expenses that the variable annuity charges?

• Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges if you have to withdraw money?

• If a variable annuity offers a bonus credit, will the bonus outweigh any higher fees that the product may charge?

• Are there features of the variable annuity, such as long-term care insurance, that you could purchase more cheaply separately?

• Have you consulted with a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?

• If you are exchanging one annuity for another one, do the benefits of the exchange outweigh the costs, such as any surrender charges you will have to pay if you withdraw your money before the end of the surrender charge period for the new annuity?

Why Is a Prospectus Important?

A prospectus for a variable annuity contains important information about the contract, including fees, charges, investment options, payout options, and death benefits. You should request one from a licensed financial professional and review the information to compare the benefits and costs of variable annuities and other types of investments.

Use the prospectus to consider the following factors before purchasing a variable annuity:

• The fund’s investment objectives and policies

• Management fees

• Other expenses

• Risks

• Fund volatility

• Diversification of your investment portfolio

*This information is for educational purposes only.

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