Last updated 23rd Nov 2022
A variable annuity is a written agreement with an insurance company in which the insurer promises to make a series of payments to the contract holder. Unlike a fixed annuity that guarantees a series of fixed dollar payments, the value of a variable annuity will depend on the performance of the investments chosen. In this article, we're going to discuss the two phases of any annuity: the accumulation period, and the payout phase. Next, we're going to talk about the terms and conditions investors might find in a variable annuity agreement. Then we're going to discuss some of the charges and fees that might be encountered in a contract. We'll finish up with a special topic: variable annuities and Section 1035 exchanges.
When an investor purchases an annuity contract, they are agreeing to pay the issuing company, typically an insurance company, in exchange for a future stream of income. This business arrangement consists of two phases:
- Accumulation Phase: during this phase, the contract holder, or annuitant, agrees to make a lump-sum payment, or a series of payments, and allocates this money to a set of investment options, typically mutual funds, as defined by the variable annuity contract. Over time, each of these mutual fund investments (principal) will earn the contract holder a return on their investment (earnings).
- Payout Phase: during this phase of the contract, the insurance company returns to the contract holder their investment. With a variable annuity, the value of the account, and therefore the income it provides, will depend on the performance of the investments chosen.
Deferred Annuities and TaxesOne of the advantages of buying a deferred annuity has to do with income taxes. As earnings accumulate in the account, the buyer is able to defer the payment of income taxes until a later point in time. If the annuitant believes they will be in a lower tax bracket in the future, as can happen when in retirement, then the purchaser can not only delay the payment of income taxes, but also lower their tax liability.
Benefits and FeesAs just mentioned, the holder of a variable annuity can choose to receive immediate or deferred benefits. Immediate annuities offer the contract holder an instant income stream, which is why this type of investment is often chosen by someone that is already retired and in search of a new source of income. Deferred annuities provide an income benefit that starts in the future; offering the contract holder the ability to accumulate funds on a tax-deferred basis as just explained. Other benefits offered by variable annuities may include:
- Survivor Benefits
- Long-Term Care
- Guaranteed Minimum Income
Survivor BenefitsVariable annuities typically carry a survivor benefit. If the contract holder passes away before the insurance company begins making payments, then a beneficiary may be guaranteed payment; albeit usually less than the total of the purchased payments. Beneficiaries may include a spouse or children.
Long-Term CareAnother feature found in an annuity contract has to do with long-term care. A long-term care feature may pay for home health care costs, or even the cost of nursing home care in the event the contract holder becomes ill.
Minimum Income GuaranteesA contract can also offer the annuitant a minimum guaranteed income stream or benefit. This option provides some level of protection in the event the investments chosen in the annuity fund under-perform relative to expectations. This type of "insurance" against income loss does come at a cost.
Fees and ChargesThere are several different fees, or charges, an insurance company may impose as part of their variable annuity contract. Annuities may be sold, and include, front-loads (which require fees to be paid at the start of the contract), or they may be back-loaded (which require fees to be paid later). Alternatively, the fees may be spread evenly over the life of the annuity. Purchasing a variable annuity is an important decision, so it's essential to understand all of the costs that could affect the income benefit. The following fees and / or charges may be included as part of a contract:
- Administrative Fees: usually ranges from a flat annual charge to around 0.2% of the account's value each year. This charge covers recordkeeping, mailings, and other administrative fees associated with maintaining the account.
- Fund Expenses: if any of the investments chosen charge a fee, then that underlying fund expense will be passed onto the annuity contract holder.
- Features: as mentioned above, the agreement may contain added options or features. There is typically a charge to provide the features chosen.
- Risk Expense Charges: this type of expense can run around 1% of the account balance each year. This fee provides the insurance company with payment for the risk they've assumed under the contract as well as sales fees.
- Surrender Charges: if a withdrawal occurs before a pre-determined purchase period has expired, then a surrender fee may apply. This charge is normally stated as a percentage of the contract's value. In some cases, this percentage will reduce over time and / or as the account's balance grows.
Free-Look ProvisionsLaws exist in many states that allow the buyer of an annuity a certain number of days to evaluate the contract after purchase. If the buyer decides they do not want to keep the annuity, then they can return the contract and receive a full refund. This type of arrangement is called a "right to return" or "free look" period. If the law allows for this free-look period, then this feature will be prominently described in the contract. This is just another reason why it's so important to understand all the features of an annuity before making a purchase decision.
1035 Tax ExchangesSection 1035 of the U.S. tax code allows individuals to make a tax-free exchange from an existing variable annuity contract to a new contract. A 1035 exchange can be helpful if the investor finds another annuity that offers additional features, such as those previously described, or has an assortment of investment choices that are a better fit with the investor's style or risk profile. Before making any switches, it's important to compare the features of the old and new annuity. While a 1035 exchange allows for the transfer of funds from an existing annuity to a new one without incurring a tax penalty, it does not insulate the investor from any surrender charges. In fact, the surrender charges from the old annuity, coupled with a transfer to a new contract, can often significantly erode, or eliminate, any prior investment gains. Finally, when making an annuity-to-annuity transfer, it's a good idea to work closely with a financial advisor and follow their instructions carefully to ensure the exchange is tax-free.
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