A variable annuity is a mutual fund-type investment contract between the investor and an insurance company, under which the insurer agrees to make periodic payments to the investor, beginning either immediately or at some future date. This contract has an insurance component that may pay a death benefit depending on the performance of the underlying investments. An investor purchases a variable annuity contract by making either a single payment or a series of payments. Variable annuities are considered both insurance products and securities products.
Variable annuities offer a range of investment options. The value of the investment varies depending on the performance of the underlying holdings within the products. The investment options typically are mutual funds (they are actually sub-accounts that often clone mutual funds) that invest in stocks, bonds, money market instruments, or a combination of the three.
How do they work? A variable annuity has two phases, an accumulation phase and a payout phase. During the accumulation phase, the investor makes purchase payments, which can be allocated to a number of investment options. The money allocated to the various investment options will increase or decrease over time, depending on the performance of the underlying sub-accounts. During the accumulation phase, if the investor decides to withdraw money, he or she may have to pay surrender charges as well as a 10% federal tax penalty if the withdrawals are made before the age of 59 ½.
At the beginning of the payout phase, the investor may receive the purchase payments plus investment income and gains (if any) as a lump-sum payment, or may choose to receive them as a stream of payments over time. Some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and payments to the investor begin as soon as the annuity is purchased.
Are variable annuities poor investments? For a number of reasons they may be. Consider these:
- Surrender Charges: The terms of many contracts provide that the investor must pay surrender charges if they withdraw money from the annuity within a certain period of time (usually 6 to 8 years). This charge may be as high as 8% of the value of the amount invested.
- Mortality and Expense Risk Charges: Most contracts provide for charges that compensate the insurance company for the insurance risk it assumes under the contract. This charge is equal to a certain percentage of the annuity account value, usually in the range of 1.25% per year.
- Administrative Fees: The insurance company may also deduct charges to cover record keeping and other administrative expenses. This may be charged as a flat account maintenance fee ($25-$50 per year) or as a percentage of the total account value (usually in the range of .15% per year).
- Underlying Fund Expenses: Investors also pay the fees and expenses imposed by the mutual fund sub-accounts that make up the underlying investment options for the annuity.
- Fees and Charges for Additional Features: Some insurance companies offer special features for their variable annuity products. These often include additional death benefits, guaranteed minimum income benefits, and long-term care insurance. All of these additional options often carry high charges and/or fees.
- Variable Annuities in IRAs: Brokers often place variable annuities in a client’s retirement account or IRA. This is often inappropriate because, while the variable annuity provides the investor with tax-deferred growth, the IRA already provides the same benefit. So, the investor ends up paying a premium for a benefit they already have.
- Tax-Deduction Benefit: Money invested in a variable annuity is not tax-deductible as in an IRA.
- Hidden Fees: Generally, the fees and charges associated with variable annuity products are deducted from any increase or decrease in the value of the account prior to statement publication. For this reason, fees may not be clearly listed as a line item on monthly or quarterly statements.
Why Do Brokers Sell Variable Annuities? Brokers that sell variable annuities often get paid very large commissions from the insurance companies that offer the annuities. These commissions (often referred to as “loads”) may be paid to the broker as soon as the investor signs the annuity contract (“up-front load”), or may be paid throughout the time the investor holds the annuity (“trailing loads or commissions”). The amount the broker receives depends on the insurance company. These commissions are usually a percentage of the amount invested.
It is important that an investor ask questions about any product recommended to them by their broker. A few of these questions include:
- Is this product suitable for me given my risk tolerance, investment objective and age?
- Why is it suitable?
- How much will the underlying investments have to make to break even with all of the costs and fees associated with the product?
- Why is this product better than a mutual fund if I already have life insurance?
- Is the annuity adjusted for inflation?
- Explain Annuitization? If I decide to annuitize, am I giving the insurance company my entire principal in exchange for a stream of income? What happens if I die the year after I annuitize?
- What is the surrender or contingent deferred sales charge period? How much is the surrender charge in year1? Year 2? Year 3?
- What does the annuity guarantee?
- Can I lose all of my money in this product?
Remember, if you can’t understand the investment being recommended to you, it is probably wise to steer clear of it. Try to read the contract very carefully, if it doesn’t make sense, don’t buy it. If you have already signed a variable annuity contract, you may be able to get out of it. Many annuities provide a 10-day “free look” period that allows the investor to cancel the contract within 10 days of signing.