What Are Variable Annuities
Variable annuities are an investment product offered by life insurance companies. Essentially, a variable annuity represents a contract between the investor and the insurance company. The contract specifies that the investor will provide the insurance company with an amount of money, known as the premium. The insurance company then guarantees it will return the premium, along with interest earned. The payments can begin either immediately, in the case of an immediate variable annuity, or at a later date in the future in the case of a deferred variable annuity.
Variable Annuity Brokers
Unlike standard life insurance products, variable annuities deal with multiple financial instruments, including securities, and are therefore subject to regulation by the Securities and Exchange Commission (SEC). Further, life insurance agents who sell variable annuities must be licensed to sell life insurance by the state in which they work, and they must be registered with the National Association of Securities Dealers (NASD). These agents are also required to have passed the Series 6 or the Series 7 general securities exam along with any other exams required by the state.
Federal and state governments regulate variable annuities for one very important reason: The investor is solely responsible for the investment risk. When he or she chooses to invest in a variable annuity, he or she alone bears the risk of loss. For this reason, those interested in investing in variable annuities are always advised to read the prospectus prior to investing.
How Do Variable Annuities Work
While variable annuities can be immediate annuities, they are most often purchased as deferred annuities as part of a retirement savings plan. There are two phases to a deferred annuity: The accumulation phase and the distribution phase.
The Accumulation Phase of Variable Annuities
During the years (or decades) of the accumulation phase, payments are made to the annuity account. For example, an employer who provides a defined contribution plan such as a 401(k) plan or 403(b) plan may offer a variable annuity as an investment choice. The money paid to the insurance company is then held in a special account and invested at the direction of the annuity owner. He or she can usually choose from a variety of funds that range from conservative to aggressive. He or she can choose to put 100% of the premium in one fund or split the premium into different percentages per fund.
Deferred annuities grow tax-deferred. The entire amount of the account, both the premium and the interest earned, compound tax-free until distributions begin. Investors who choose to take distributions prior to age 59 ½ are usually subject to a 10% federal tax penalty. Further, the insurance company will more than likely charge what is known as a “surrender charge” if money is removed from the account within the first several years of the contract. The surrender charge is usually a percentage of the amount withdrawn and is used to pay the commission to the agent who sold the contract. The surrender charge typically goes down over time. For example, it might be 8% in the first year and 7% in the second year.
Tax-deferred accounts, especially those started early in one’s career, can grow significantly over the years. When money is not deducted from the principal or earnings to pay taxes, like it is with a standard savings account or mutual fund, it grows much faster. Further, tax-deferred accounts can usually reduce the tax liability of the current year as pre-tax dollars are used to fund the accounts.
The Distribution Phase of Variable Annuities
When the owner of a deferred variable annuity begins to take distributions, he or she annuitizes the contract. He or she can choose to take the payment as one lump-sum distribution, or he or she can choose to receive payments for a set period of time or for life. The length of time the payouts are to last will affect the amount of the payouts. For example, if the annuitant chooses to receive payments for 15 years, the payouts may be higher than if he or she chooses to receive payments for life, if the annuity actuarial table indicates he or she will live another 20 years.
What is the Death Benefit Feature of Variable Annuities
Unlike almost all other investment products, variable annuities contain a death benefit feature, much like a standard insurance policy. When purchasing a variable annuity, an investor can name a beneficiary to receive the premiums that have been paid in if he or she dies before payments begin. The amount paid to the beneficiary varies by insurance company, but at the very least, most will return at least the amount of the premium that had been paid in at the time of the annuity owner’s death.
However, unlike the death benefit on most insurance policies, the death benefit paid on a variable annuity can trigger a taxable event. Depending on the relationship between the annuity owner to the beneficiary, and whether the annuity was purchased with pre-tax or post-tax dollars, the death benefit may be subject to a number of federal and state taxes. As always, before investing in variable annuities, investors are advised to seek the advice of a Certified Financial Planner who has sufficient education and experience with this type of financial investment.
How Does Investing in Variable Annuities Compare to Investing in Mutual Funds
Investing in mutual funds directly can be beneficial for those investors who have the time and inclination to research what they are purchasing. While investing directly can be a less expensive option, an investment in a mutual fund guarantees neither an increase in account value nor income.
Once the “distribution” phase of a mutual fund begins after retirement, the fund can be quickly depleted. If the required distribution is $2,500, the account value is reduced by that amount, which leaves less money in the fund to compound over time. Investors run the risk of depleting the account long before they can afford to. With variable annuities, however, an investor can set up payments for life, which eliminates the risk of outliving retirement savings.
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