Variable Annuities (VA)
A variable annuity is an annuity contract that allows the policy owner to allocate contributions into various subaccounts of a separate account based upon the risk appetite of the annuitant. The contributions can be invested in stocks, bonds or other investments. Income payments in the annuitization phase can be fixed or fluctuate with the investment performance of the underlying subaccounts of the separate account. In contrast to fixed annuities, policyholders assume all of the investment risk with variable annuities because they are separate account products that are valued at market every day. Additionally, variable annuities are registered as securities with the Securities and Exchange Commission (SEC).
Source: National Association of Insurance Commissioners and the Center for Insurance Policy and Research
Some annuities offer options riders for additional cost, known as guaranteed living benefits, which protect the insured’s income from the effects of a market decline, or help address concerns about outliving savings. Many contracts in the marketplace today offer living benefits.
One popular type of living benefit is a guaranteed lifetime withdrawal benefit (GLWB), which protects the insured’s income stream by providing a guaranteed floor of income, regardless of the actual underlying contract value, subject to the claims-paying ability of the issuing insurer. Under the terms of this type of rider, the insured is generally allowed to withdraw a specified percentage of a guaranteed benefit base each year for the insured’s life, or for the insured’s and their spouses’s life in the event of a joint life rider, even if the actual account value decreases to zero due to the annual guaranteed withdrawal or market declines. The benefit base is set to the contract value typically at the time the rider is purchased and is generally reset at varying intervals, usually each year, based on the performance of the underlying portfolios.
Most GLWBs lock in the income base at the highest value on each contract or rider anniversary. Some of these riders also include guaranteed minimum rate, which sets the income base to the higher of the highest contract anniversary value or the total purchase payments credited with a rate of interest (such as 5%). The income base is not the same as the account value and is not available for withdrawal like a cash value. The actual account value will decrease with each withdrawal, though payments under the terms of the rider will still continue for life. There will generally be no funds available for beneficiaries if withdrawal taken prior to death exceed the actual contract vale. Withdrawals in excess of the specified annual payout amount will generally reduce the future income on a permanent basis.
The guarantees provided by a GLWB rider can provide the insured confidence that they will have guaranteed income for life, no matter how long they live or what direction the market takes. It is important to understand the restrictions and fees. Guarantees are subject to the claims-paying ability and financial health of the insurance company.
Index-linked variable annuities are tax-deferred investment vehicles designed to protect against loss of principal. They offer upside potential up to a cap, with some measure of protection against market declines. Tax-deferred growth potential is based on the performance of linked-index options like the Standard & Poor’s 500 Index and is credited to the account based on a ‘cap’ rate defined in the contract.
Some ILVAs may offer a return-of-premium death benefit, and often include a combination of buffer and floor options which afford Advisors the flexibility and control to tailor a solution to a client’s particular risk tolerance. The buffer protects against losses within the buffer, but not beyond, and the floor acts as a stop-loss when index losses occur beyond the floor.
Cap rates, floors and buffers are correlated. Opting for a lower floor may limit potential upside. For instance, choosing a 0% floor (guaranteeing no losses at all) might allow for a cap rate of 3.85% in a particular linked index. While choosing a -10% floor (allowing for losses from 0 to -10%) might extend that cap in the linked index to 10.75%.
The insured in a variable annuity, names one or more beneficiaries. A death benefit is the sum that these beneficiaries will receive when the insured dies, subject to the terms of the contract. Depending on the terms and conditions of the contract, the benefit can provide the beneficiaries a guaranteed minimum upon the insured’s death.
Death benefits are usually of three general types. For all these types of death benefits, the proceeds bypass probate for the named beneficiaries.
⁕ Return of account value – in return of account value death benefits, the beneficiaries receive the current contract value.
⁕ Return of premium – return of premium death benefits provides the greater of (1) an amount equal to everything paid for the annuity, minus withdrawals; or (2) the current contract value. A return of premium death benefit is sometimes the standard death benefit in a contract, though it is often a rider that is optional and available for an additional charge.
⁕ Enhanced death benefit – many enhanced death benefits pay the higher of the contract value at death or the highest contract anniversary value since the purchase of the annuity.
If withdrawals are taken from the variable annuity, then the death benefit will be reduced accordingly. If the insured’s spouse is the beneficiary of the annuity, some contracts allow the spouse to become the new owner of the contract while still receiving a death benefit. There is generally no death benefit payable once an annuity has been annuitized.
The fees on variable annuities are typically assessed as a percentage of the account value, and can vary widely. The following are typical fees on variable annuities. Not all variable annuities charge all these fees.
Mortality and expense risk charge (M&E) – This charge covers the insurer’s expense for some of the key insurance guarantees of the contract, such as the standard death benefit, or for annuitization, the annuity payout option that can provide guaranteed income for life.
Administrative charges: Some contracts assess these charges to compensate the insurance company for administrative costs associated with the contract, such as preparing the prospectus or annual report and legal and accounting expenses.
Underlying fund fees and expenses: These fees cover the management of the underlying annuity portfolios in which allocated assets and any funds are invested.
Fund facilitation fees: These are fees charged by some insurance companies on some of the underlying annuity portfolios in which allocated assets and any funds are invested.
Rider fees: These fees compensate the insurance company for any optional features and guarantees beyond the standard annuity contract. Riders fees only apply for those riders specifically selected by the insured. Riders include enhanced death benefits, GLWBs and other living benefits, and principal protection for a spouse if the insured dies.
Annuities may be purchased through a retirement account such as an IRA. In these cases, required minimum distributions (RMD) and other requirements would be in effect. Since these accounts already provide tax deferral, a variable annuity does not provide any additional tax benefits. There may be benefits such a guaranteed lifetime withdrawal benefits that would warrant consideration of a variable annuity in a retirement account. The benefits and costs should be carefully evaluated before purchasing an annuity in a retirement account.
Annuity earnings are tax-deferred during the accumulation phase, which means that the policy holder does not pay taxes on any earnings until they withdraw. The policy holder pays taxes on earnings only when they withdraw money. Any earnings payouts are taxed as regular ordinary income. The earnings payouts may be subject to a 10% withdrawal penalty if they are made before age 59 and 1/2, in addition to applicable income taxes. If it is held outside an IRA or qualified retirement plan, a variable annuity does not require a minimum withdrawal at age 70 and 1/2.
The insurance company issuing the annuity supports the guarantees, such as any death and living benefits. To support these guarantees, the insurer must set aside capital and reserves to cover these obligations. The guarantees are only as good as the insurance company backing them. It is important to know the insurance company’s financial strength and its ratings.
Section 1035 of the IRS Code permits an exchange of one annuity for another without triggering the taxation of any investment gains at the time of the exchange. The annuity contract must be directly exchanged for a new or an existing annuity contract that has the same registration designations. Annuities may be exchanged for another annuity that offers additional benefits or guarantees that better suit the insured’s needs. Important considerations are fees, investment choices, surrender fees, death benefits, guarantees, and the financial strength of the issuing insurance company.
Variable annuities have two phases, the accumulation phase and the payout phase.
The accumulation phase, during which assets are built for retirement through the selection of annuity portfolios. Any growth in the annuity contract value due to market gains is tax-deferred until withdrawal. Once withdrawn, the gains are taxed as ordinary income.
The payout phase, during which the insured receives payments either via a lump sum, via periodic withdrawals, or through the process of annuitization, which converts the assets income an ongoing income stream. Under most contracts, this income stream can be set up for a defined period or to last the insured’s lifetime. Annuitization is irrevocable, and once payments begin the insured can no longer access the accumulated contract value.
Some annuities offer optional features, called riders, that provide additional benefit for additional cost. For example, some riders protect against market, inflation, or longevity risk. A death benefit and an enhanced death benefit can protect the annuity value for beneficiaries or allow for continued income for the spouse if the insured dies.
The investment options in a variable annuity are known as “sub-accounts”. These annuity portfolios are not available directly to the public. Rather, they are available only within variable annuities or other products issued by an insurance company. Although they are not publicly available mutual funds or ETFs, annuity portfolios are similar in that they have their own distinctive investment objectives and policies, and they typically offer exposure to stock or bond market returns. The annuity portfolios generally cover different asset classes and investment strategies: equity, fixed income, balanced, and money market funds, as well as value, growth, core, and other strategies. In most contracts, you may transfer in and out of variable investment options. As with any investment, there is potential for loss of principal.
Because variable annuities are designed as long-term investments, some variable annuity contracts levy a surrender charge if money is withdraw before a certain point in the contract. Information about any surrender charges can be found in the annuity prospectus. The typical surrender period is seven years, but sometimes longer, or shorter. Variable annuities carried by RetireOne do NOT impose surrender charges.
An excess withdrawal is any withdrawal after age 59 and 1/2 that exceeds the protected income base for the GLWB rider. Excess withdrawals and any withdrawals prior to age 59 and 1/2 may significantly reduce the guaranteed withdrawal benefit amount, and a surrender fee may apply. If an excess withdrawal reduces the contact value to zero, no further amount will be payable under either benefit and the contract will be terminated.
All states have laws that give purchasers of variable annuities a set number of days to look at an annuity after they purchase it. This “free-look period” generally ranges from 10 to 35 days, depending on the state. It allows the purchaser to cancel their contract if they decide that they don’t want it. The contract and the annuity prospectus will describe the terms and conditions for the purchaser’s state.