Variable Annuities: A Basic Guide
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What is a Variable Annuity?
Variable annuities are complex investment products, often described as mutual funds wrapped in an insurance policy. Under a variable annuity contract, an insurance company agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.
Variable annuities have become part of the retirement and investment plans of many Americans. But, before you buy a variable annuity, do your research on the company and the product, and get advice from someone you trust about whether a variable annuity is right for you.
This guide provides a general description of variable annuities — what they are, how they work, the charges you will pay and the questions you should ask. But, before you buy, find out everything you can about the particular annuity you are considering. Request a prospectus from the seller, read it carefully, and ASK QUESTIONS.
What Do You Need to Know About A Variable Annuity Purchase?
Product Knowledge: Learn all you can about how the annuity works, the benefits it provides, and the charges you will pay. Read the prospectus, which contains important information including fees and charges, investment options, death benefits and costs of the annuity compared to other variable annuities and other types of investments, such as mutual funds.
Suitability: Make sure an annuity is something you can afford and is an appropriate investment for your age and financial situation. If you are over 65 years old, annuities are probably NOT for you.
Volatility: Consider the amount of risk you can tolerate since the account value of some annuities may decline if the underlying investment performs poorly.
Rate of Return: Watch out for introductory or teaser rates that may be significantly higher than the actual rate of return specified in the contract.
Liquidity: Find out how long your money will be tied up. Most annuities have expensive surrender charges if you try to withdraw money before the maturity date.
Professional Advice: Discuss any potential variable annuity purchases with a stockbroker, attorney, accountant, or
financial adviser you trust BEFORE you buy.
Rollover: Before cashing in one annuity to purchase another, make sure the benefits of the purchase outweigh the costs, such as additional commissions, surrender costs, penalties, and tax liabilities. Switching annuities frequently benefits the seller more than the investor.
Optional Features: Consider whether you can purchase additional benefits, such as long-term care insurance as a separate product at a better price.
Death Benefit: Understand what happens to the proceeds of your annuity upon death. Not all annuities provide an enhanced death benefit.
Know your salesperson: Do not do business with anyone who tries to scare or pressure you to buy. You should be
completely comfortable with the product and the salesperson before you commit any of your hard-earned money.
How Does a Variable Annuity Work?
A variable annuity offers a range of investment options. The value of your investment as a variable annuity owner will vary depending on the performance of the investment options you choose. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.
Although variable annuities are typically invested in mutual funds, variable annuities differ from mutual funds in several important ways:
Periodic payments — Variable annuities let you receive periodic payments for the rest of your life (or the life of your spouse or designated beneficiary). This feature offers protection against the possibility that, after you retire, you will outlive your assets.
Death benefit — Most variable annuities have an enhanced death benefit. If you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount — typically at least the amount of your purchase payments.
Tax deferral — Variable annuities are tax deferred, which means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates.
In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals.
While variable annuities have tax benefits, be sure to compare them to other retirement plans. For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plan before investing in a variable annuity.
In addition, if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA), you will get no additional tax advantage from the variable annuity. The tax rules that apply to variable annuities can be complicated You may want to consult a tax adviser about the tax consequences BEFORE you invest.
Remember: Variable annuities are designed to be long-term investments, to meet retirement and other long-range goals. Variable annuities also involve investment risks, just as mutual funds do.
A variable annuity has two phases: an accumulation phase and a payout phase.
The Accumulation Phase — During this phase, you make purchase payments, which you can allocate to a number of investment options. The money you have allocated to each mutual fund investment option will increase or decrease over time, depending on the fund's performance.
The Payout Phase — At the beginning of this phase, you may receive your purchase payments plus investment income and gains (if any) as a lump sum payment, or you may choose to receive them as a stream of payments at regular intervals (generally monthly). If you choose to receive a stream of payments, you may have a number of choices of how long the payments will last. During the payout phase, your annuity contract may permit you to choose between receiving payments that are fixed in amount or payments that vary based on the performance of the mutual fund investment options.
What Charges and Fees Apply to Variable Annuities?
You will pay several charges and fees when you invest in a variable annuity. Be sure you understand all the charges before you invest. These charges will reduce the value of your account and the return on your investment. Often, they will include the following:
Surrender charges — A surrender charge is a type of sales charge or penalty you will pay if you withdraw your money from a variable annuity within a certain period after purchase (typically within six to eight years).
Mortality and expense risk charge — This charge is equal to a percentage of your account value (typically about 1.25% per year) and compensates the insurance company for risks it assumes under the annuity contract.
Administrative fees — These charges cover record-keeping and other administrative expenses of the insurance company and may be charged as a flat account maintenance fee (usually $25 or $30 per year) or as a percentage of your account value (typically about 0.15% per year).
Underlying Fund Expenses — These fees and expenses are imposed by the underlying mutual funds investment and will likely be paid indirectly by you. These fees are taken annually as a percentage of your assets invested in the fund.
Charges and Fees for Other Features — Special features offered by some variable annuities, such as a stepped-up death benefit, a guaranteed minimum income benefit, or longterm care insurance, often carry additional fees and charges.
Note: The guaranteed minimum income benefit guarantees a particular minimum level of annuity payments, even if you do not have enough money in your account (perhaps because of investment losses) to support that level of payments.
Other charges, such as initial sales loads, or fees for transferring part of your account from one investment option to another, may also apply. Be sure you are aware of ALL applicable charges and also check the prospectus for a description of the charges.
What About Tax-Free“1035” Exchanges?
Section 1035 of the U.S. tax code allows you to exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in your current variable annuity account. These tax-free “1035” exchanges can be useful if another annuity has features that you prefer, such as a larger death benefit, different annuity payout options, or a wider selection of investment choices.
If you are thinking about a “1035” exchange, compare both annuities carefully. Unless you plan to hold the new annuity for a significant amount of time, you may be better off keeping the old annuity because the new annuity typically will impose a new surrender charge period. You will also want to consider the commissions and any increased fees you'll have to pay for the new annuity.
In addition, talk to your financial professional or tax adviser to confirm the exchange will be tax-free. If you surrender the old annuity for cash and then buy a new annuity, you will have to pay tax on the surrendered annuity.
What are Bonus Credits?
Some insurance companies are now offering variable annuity contracts with “bonus credit” features. These contracts promise to add a bonus to your contract value upfront based on a specified percentage (typically 1% to 5%) of purchase payments. The downside, however, is higher expenses that can outweigh the benefit of the bonus credit offered.
Frequently, insurers will charge you for bonus credits in one or more of the following ways: higher surrender fees, longer surrender periods, high administrative fees and high mortality and expense risk charges.
What Questions Should You Ask Before You Invest?
Before you decide to buy a variable annuity, consider the following questions:
Will you use the variable annuity primarily to save for retirement or a similar longterm goal?
Are you investing in the variable annuity through a retirement plan or IRA (which would mean that you are not receiving any additional tax-deferral benefit from the variable annuity)?
Are you willing to take the risk that your account value may decrease if the underlying mutual fund investment options perform badly?
Do you understand all of the features of the variable annuity?
Do you understand all of the charges and fees of the variable annuity?
Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges if you have to withdraw money?
If a variable annuity offers a bonus credit, will the bonus outweigh any higher fees and charges that the product may charge?
Are there features of the variable annuity, such as long-term care insurance, that you could purchase separately for less money?
Have you consulted with a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?
If you are exchanging one annuity for another one, do the benefits of the exchange outweigh the costs, such as any surrender charges you will have to pay if you withdraw your money before the end of the surrender charge period for the new annuity?
Are you purchasing from a seller you trust and feel comfortable with all of the information you have been provided?
Ask all of these questions and any others that would be helpful to you. Keep records of your answers so there is no confusion later. Financial professionals who sell variable annuities have a duty to advise you whether the product they are trying to sell is suitable to your particular investment needs.
You may also want to research the financial strength of the insurance company that sponsors any variable annuity you are considering. This can affect the company's ability to pay any benefits.
Your most important source of information about a variable annuity's investment options is the prospectus. Request the prospectuses for the mutual fund investment options and read them carefully. The prospectus should provide you with information such as the fund's investment objectives and policies, management fees and other expenses that the fund charges, the risks and volatility of the fund, and whether the fund contributes to the diversification of your overall investment portfolio.
Variable annuity contracts typically have a “free look” period of ten or more days, during which you can terminate the contract without paying any surrender charges and get back your purchase payments (which may be adjusted to reflect charges and the performance of your investment). You can continue to ask questions in this period to make sure you understand your variable annuity before the “free look” period ends.
Remember, it's your money and your decision. Only you can make the right choice for your financial future, but these guidelines should help you make an informed decision. For questions regarding investments, companies or representatives, visit our web site at /securities or call the toll-free investor hotline at 1-800-721-7996.
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