Variable annuities have become a part of the retirement and other long-term investment plans of many Americans.
Before you buy a variable annuity, though, you should have a basic understanding of what they are, how they work and how they compare to other types of investments. Being informed and understanding the options will help you and your financial professional decide if a variable annuity is right for you. Variable annuities involve risk, so knowing what you are purchasing is important.
A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.
Variable annuities are designed as long-term investments. They are not suitable for meeting short-term goals because substantial taxes and insurance company charges may apply if you withdraw your money early.
The amount you earn on a variable annuity will depend on the performance of the investment options you choose. Generally, options are mutual funds that invest in stocks, bonds, money market instruments or some combination of the three.
Variable annuities invested in mutual funds differ from mutual funds in the following ways:
A variable annuity has an accumulation phase and a payout phase.
During the accumulation phase, you make purchase payments, which you can allocate to a number of investment options. If you allocate to mutual fund investment options, each investment option will increase or decrease over time, depending on the fund's performance. If you allocate to a fixed account, which some variable annuities allow, you will earn a fixed rate of interest. Though the insurance company may reset this interest rate periodically, it will usually provide a guaranteed minimum.
During this phase, you also may be able to transfer your money from one investment option to another, although the insurance company may charge you to do this. If you withdraw money from your account during the early years of the accumulation phase, you may have to pay surrender charges.
At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals (generally monthly).
If you choose to receive a stream of payments, you may have a number of choices regarding payment duration. Under most annuity contracts, you can choose to have your annuity payments last for a period that you set or for an indefinite period (such as your lifetime). During the payout phase, your annuity contract may permit you to choose between receiving payments that are fixed in amount or payments that vary based on the performance of mutual fund investment options.
The amount of each periodic payment will depend, in part, on the time period that you select for receiving payments. Be aware that some annuities do not allow you to withdraw money from your account once you have started receiving regular annuity payments.
In addition, some annuity contracts are structured as immediate annuities, which means no accumulation phase and annuity payments begin right after you purchase the annuity. These annuities require one large lump-sum payment to fund the account.
A common feature of variable annuities is the death benefit. If you die, a person you select as a beneficiary will receive the greater of: (1) all the money in your account or (2) some guaranteed minimum (such as all purchase payments minus prior withdrawals).
Some variable annuities allow you to choose a "stepped-up" death benefit. With this feature, your guaranteed minimum death benefit may be based on a greater amount than purchase payments minus withdrawals. The purpose of a stepped-up death benefit is to "lock in" your investment performance and prevent a later decline in the value of your account from eroding the amount that you expect to leave to your heirs. This feature usually carries a charge, however, which will reduce your account value.
Variable annuities sometimes offer optional features, which also have extra charges. One common feature, the guaranteed minimum income benefit, guarantees a particular minimum level of annuity payments, even if you do not have enough money in your account to support that level of payments.
You may pay several charges when you invest in a variable annuity. Be sure you understand all the charges before you invest. These charges will reduce the value of your account and the return on your investment. Often, they will include the following:
Other charges, such as initial sales loads, or fees for transferring part of your account from one investment option to another, may also apply. You should ask your financial professional to explain all charges that may apply. You can also find a description of the charges in the prospectus for any variable annuity that you are considering.
Before you invest, learn about variable annuity investment options by carefully reading each option’s prospectus. A prospectus provides valuable information about a fund’s investment objectives and policies, management fees and other expenses that the fund charges, the risks and volatility of the fund and whether the fund would contribute to the diversification of your overall investment portfolio.
Financial professionals who sell variable annuities have a duty to advise you as to whether the product they are selling is suitable for your particular investment needs. Before you buy a variable annuity, make sure any questions you have are answered.
This article is part of an ongoing series of articles regarding retirement savings. The information has been provided by various A&M System ORP and TDA vendors and SEC educational articles. 