Variable Annuities
Contents
Can I lose money in a variable annuity?
How can I research a variable annuity?
How do variable annuities work?
What are some optional benefits of variable annuities?
What will I pay for a variable annuity?
Should I exchange my variable annuity for another?
What are the tax consequences of variable annuities?
What is a variable annuity?
A variable annuity is a contract between you and an insurance company that serves as an investment account. The value of your contract will vary depending on the performance of investments you choose from a menu of investment options—typically mutual funds. The insurance company might make changes to the available investment options.
A variable annuity also includes certain insurance features, such as the ability to turn your account into a stream of periodic payments and death benefits.
Variable annuities are designed to help you meet retirement and other long-term goals. They are not suitable for meeting short-term goals. Certain benefits of variable annuities, such as tax deferral, make variable annuities most beneficial to those with a long time horizon.
Each variable annuity is unique with its own set of features, risks and costs. It is important to understand the variable annuity you are considering, including fees and expenses, investment options, death benefits and other insurance features, and annuity payout options.
Can I lose money in a variable annuity?
Yes. You can lose money in a variable annuity, including potential loss of your original investment.
Investment risk. The value of your investment and any returns will depend on the performance of the investment options you choose. If the investment options you selected for the variable annuity perform poorly, you could lose money. Each underlying fund may have its own unique risks. Review each fund’s prospectus before making an investment decision.
Insurance company risk. The financial strength of the insurance company that issues the contract backs all guarantees, including death benefits, living benefits, and your annuity payments. If the insurance company experiences financial distress, it may not be able to pay what it owes you under your policy.
How can I research a variable annuity?
Ask your financial professional for the variable annuity prospectus, which will describe the contract you’re considering in detail. Read the prospectus carefully and ask questions about what you don’t understand.
The underlying mutual fund options will also each have a prospectus. Review each fund’s prospectus before making an investment decision. Consider, for example, the fund’s investment objectives and policies, fees and expenses, risks, and whether it contributes to the diversification of your overall investment portfolio.
You can find variable annuity and mutual fund prospectuses by searching the SEC’s EDGAR database.
If you are considering purchasing a variable annuity through an investment professional such as a broker or an investment adviser, check them out using our Check Out Your Investment Professional tool. See if they are registered with us and if they have any disciplinary history.
How do variable annuities work?
Accumulation phase
You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments. Your purchase payments get invested in a selection of investment options—typically mutual funds—that you can choose. Your investments may grow on a tax-deferred basis. The period when you make purchase payments and your money is allowed to grow is called the accumulation phase.
The amount of your purchase payments that get invested may be less than you paid because fees were taken out of the payments.
Free look period
You may cancel your contract within a short period (usually 10 to 30 days) of receiving it without a penalty fee called a surrender charge. This is called the free look period. Upon cancellation, you will typically receive a refund of your purchase payments. The refund may be adjusted up or down to reflect the performance of your investment options. Your contract should prominently state how long your free look period is and how to return your contract.
Payout phase
The payout phase, also called the annuitization phase, is when you receive payment from your annuity. You can choose when to annuitize (begin payment). You may choose to receive your contract value as a stream of income payments at regular intervals (such as monthly). In addition, your contract may automatically annuitize at a certain age, typically an advanced age (such as age 95).
The ability to annuitize your variable annuity offers protection against the possibility that you will outlive your assets.
You may have a number of choices of how long the payments will last. Under most annuity contracts, you can choose to have your income payments last for a period that you set (such as 20 years) or for an indefinite period (such as your lifetime or the lifetime of your spouse). You may be able to choose between receiving income payments that are fixed in amount or payments that vary based on the performance of mutual fund investment options.
The amount of each periodic income payment will depend, in part, on the time period that you select for receiving payments. Be aware that, in general, annuities do not allow you to withdraw money from your account once you have started receiving income payments.
Death benefit
A common feature of variable annuities during the accumulation phase is the death benefit. If you die, a person you select as a beneficiary (like your spouse or child) will receive money. For example, your beneficiary may receive the greater of: (i) all the money in your account; or (ii) some guaranteed minimum, such as all purchase payments minus prior withdrawals.
What are some optional benefits of variable annuities?
Variable annuities commonly offer other optional insurance benefits, for which you must pay extra. Optional features may also carry investment restrictions and other limitations. The benefits of the optional features may be significantly reduced if you take withdrawals over a certain amount or before you reach a certain age.
Before deciding to pay extra for any of these features, carefully consider whether you need it and whether you can buy the benefit more cheaply separately (such as through a long-term care insurance policy).
Optional death benefits
Some variable annuities allow you to choose optional death benefits for an additional charge. For example, you might be able to pay extra for:
An optional stepped-up death benefit. This benefit increases your minimum death benefit amount by locking in market gains as of a specified date if your investment options perform well.
An optional earnings enhancement death benefit. This benefit pays an additional amount that is usually equal to a percentage (like 25% or 40%) of the contract’s earnings at death. The purpose of this benefit is to help offset any taxes due upon death.
Optional living benefits
Some variable annuities allow you to choose optional insurance features called living benefits for an extra charge. Such living benefits may include:
Guaranteed lifetime withdrawal benefits. These benefits allow you to withdraw up to a certain amount each year for as long as you live regardless of market performance. For example, you might be able to withdraw up to 6% of your purchase payments each year for as long as you live, even if your contract value is reduced to zero.
Guaranteed minimum income benefits. These benefits provide a minimum value you can turn into a stream of income payments, regardless of market performance. For example, this type of benefit might provide that, at a minimum, you will be able to annuitize the value of your initial purchase payments accruing interest at 5% per year.
Guaranteed minimum accumulation benefits. These benefits provide that your contract value will be at least equal to a stated minimum amount after a specified number of years, regardless of market performance. For example, this type of benefit might provide that, at the end of year 10, your contract value will be at least 120% of your first year’s purchase payments.
Long-term care insurance. This benefit pays for home health care or nursing home care if you become seriously ill.
Bonus credits
Some variable annuities offer a feature called bonus credits. Be aware that the fees and expenses of this type of variable annuity might outweigh the benefit of bonus credits. Variable annuities with bonus credits may impose higher fees and expenses than variable annuities that do not offer bonus credits.
Variable annuities offering bonus credits promise to add extra money to your contract value based on a specified percentage (typically ranging from 1% to 5%) of purchase payments. For example, if you pay $100,000 for a variable annuity with a bonus credit of 3%, the insurance company adds a bonus of $3,000 to your account.
A bonus may only apply to your initial purchase payment, or to purchase payments you make within the first year of the annuity contract.
What will I pay for a variable annuity?
You will pay several ongoing and transaction-based fees and expenses when you invest in a variable annuity. These fees and expenses may be significant and will reduce the value of your account and the return on your investment. Be sure you understand all the fees and expenses before you invest.
Often, variable annuity fees and expenses include the following:
Base contract fee. This fee is often referred to as a Mortality and Expense (M&E) Risk Charge. It is calculated as a percentage of your contract value, such as 1.25% per year. Contract fees may go towards your financial professional’s compensation. They may receive higher compensation for selling some contracts (and for different share classes of the same contract) than for others.
Administration fees. The insurer may deduct fees to cover record keeping and other administrative expenses. This may be charged as a flat account maintenance fee (perhaps $25 or $50 per year) or as a percentage of your account value (typically in the range of 0.15% per year).
Underlying fund fees. When you buy a variable annuity, your investment options are typically a range of mutual funds. You will indirectly pay the fees and expenses of the mutual funds you pick as your underlying investments. This is because mutual funds charge fees and expenses to their investors. These fees are in addition to the fees charged by the insurance company and are deducted from the returns of the investment options.
Surrender charge. This fee is charged if you withdraw money from a variable annuity within a certain period after a purchase payment. It is generally calculated as a percentage of the amount withdrawn or purchase payments made. The surrender charge often declines gradually over a period of several years, known as the surrender period.
Optional benefit fees. Optional features offered by some variable annuities, such as enhanced death benefits and living benefits, carry additional fees.
Other fees may also apply. These may include initial sales loads/charges or fees for transferring part of your account from one investment option to another.
In addition, a variable annuity may offer different share classes with different fees and expenses and different surrender periods. Consider how long you expect to own the variable annuity and your need to access funds when weighing any tradeoff between fees and length of surrender period.
Ask your financial professional to explain all fees and expenses that may apply. You can also find fees and expenses in a variable annuity’s prospectus.
Should I exchange my variable annuity for another?
In some cases, you may wish to exchange an existing variable annuity contract for a new annuity contract that has features you prefer. If you are considering replacing your annuity with another, here are some things to consider:
Surrender charges. Surrender charges are typically higher in the early years you own an annuity. If you exchange an annuity, you may be subject to a surrender charge on your existing annuity and a new surrender period on the new annuity.
Compare annuities. Be sure to compare the old and new annuities to determine which one better suits your needs. Consider the features, fees, surrender period, investment restrictions, benefits and risks.
Tax consequences. Consider the tax consequences associated with any exchange.
Conflicts of interest. Consider the financial motivation your financial professional may have to recommend that you exchange one annuity for another.
What are the tax consequences of variable annuities?
Variable annuities are tax-deferred. That means you pay no federal taxes on the income and investment gains from your annuity until you make a withdrawal, receive income payments, or a death benefit is paid.
When you withdraw your money or receive annuitized payments, you will pay tax on the gains at ordinary federal income tax rates rather than lower capital gains rates.
If you invest in a variable annuity through a tax-advantaged retirement plan, such as an IRA or a 401(k) plan, you get no additional tax advantage from the variable annuity.
In general, the benefits of tax deferral outweigh the costs of a variable annuity only if you hold it as a long-term investment.
The federal tax rules that apply to variable annuities can be complicated and may change over time. In addition, there may be state tax implications. Before investing, you may want to consult a tax adviser about the tax consequences of investing in a variable annuity.
Additional Information
Using EDGAR to Research Investments
Investor Bulletin: Variable Annuities – Should You Accept A Buyout Offer?
Characteristics of Mutual Funds and Exchange-Traded Funds (ETFs) – Investor Bulletin
How Fees and Expenses Affect Your Investment Portfolio – Investor Bulletin
National Association of Insurance Commissioners (NAIC) — Variable annuities are regulated by state insurance commissions, as well as by the SEC. You can find your state insurance commissioner through NAIC’s website here. You may contact your state insurance commissioner with questions or complaints about variable annuities.
