Variable annuities are used to provide lifetime income in retirement. They allow unlimited contributions and can make payments that fluctuate until the annuitant dies. In that sense, an annuity can function like a self-created pension. You contribute money to the contract, and later you can choose to receive payments for life.
Contributions (sometimes called premium payments) can be made as periodic payments or as a lump sum. Variable annuities are generally considered non-qualified retirement plans*, so contributions are not tax-deductible (there’s no tax benefit just for contributing).
There are two general types of annuities - immediate and deferred. The difference is how long the annuity spends in the accumulation phase (the period when you’re contributing and building value).
*You should assume variable annuities are generally non-qualified, but it’s possible to roll over qualified funds into an annuity. That creates a qualified annuity. We’ll cover this below.
If someone reaches retirement with a large sum of money, they can convert that lump sum into lifetime payments without a long accumulation period. This is an immediate annuity: retirement income begins soon after the insurance company receives the lump sum.
If the contribution is made as one large payment, it may be called a single premium immediate annuity. For example, an investor deposits $1 million into an immediate variable annuity and begins receiving monthly payments starting at $2,500. Those payments then fluctuate based on the investment performance of the separate account (discussed below).
As with most financial choices, there are trade-offs.
Immediate annuity benefits
Immediate annuity risks
*The inaccessibility of the lump sum only becomes an issue if the investor needs more money than they’re receiving in their annuity payments.
**An annuity typically stops making payments once the account owner dies. For example, assume an investor deposits $1 million into an immediate annuity in return for average monthly payments starting at $2,500. If they were to pass away after one year, the investor would’ve only received roughly $30,000 in total payments ($2,500 x 12 months). Exchanging $1 million for $30,000 of payments obviously represents an incredible loss. This is one of the primary risks investors face with annuities.
Deferred annuities are designed to build value over time before income begins.
For example, assume an investor contributes $2,000 per month to a deferred variable annuity starting at age 40. By age 60, they would’ve contributed $480,000 ($2,000 x 12 months x 20 years). Because contributions are invested, the account value could grow beyond $480,000 - say, to $1 million.
In retirement, the investor may annuitize the contract, which means giving up control of the $1 million to the insurance company in exchange for monthly payments for life.
Deferred annuity benefits
Deferred annuity risks
*Deferred annuities are not required to be annuitized. We’ll learn more about this below.
Regardless of annuity type, there are two general phases:
The accumulation phase is when money is contributed to the annuity and invested. This phase could last a day (immediate annuity) or several decades (deferred annuity).
Money contributed during the accumulation phase goes into a separate account. It’s called “separate” because it’s kept separate from the insurance company’s own assets and capital.
When a contribution goes into the separate account, the investor buys accumulation units. Like shares of stock, accumulation units are a way to measure the investor’s basis (the amount invested). Each new contribution buys additional accumulation units. In general, the more accumulation units an investor owns, the larger their investment in the separate account.
The investor controls the separate account and chooses how the money is invested. The available choices are typically diversified portfolios of stocks, bonds, and other investments that are very similar to mutual funds. The investor’s choices (especially the level of risk) have a major impact on returns.
Assets in the separate account grow tax-deferred, similar to other retirement plans. Dividends and capital gains aren’t taxed as they occur; taxes are generally owed only when distributions are taken (often in retirement). During the accumulation phase, income is typically reinvested.
Variable annuities also follow many retirement-plan-style rules. Investors generally must wait until age 59 ½ to withdraw funds without penalty; withdrawals before then are typically subject to a 10% penalty.
Variable annuities typically provide a death benefit that applies only during the accumulation phase. This benefit applies if the account owner dies before annuitizing the contract (before electing lifetime payments).
For example, assume a 30-year-old contributes $500 per month and plans to continue until age 60. They pass away unexpectedly at age 50 after contributing $120,000 over 20 years ($500 per month x 12 months x 20 years). The death benefit guarantees a payment to the listed beneficiary. Specifically, the beneficiary receives the greater of:
Continuing the example, assume the separate account performed poorly and the account value at death is $100,000. The beneficiary would receive $120,000 (the basis). The death benefit ensures that, if the owner dies before taking distributions, at least the original contributions are returned - even if investments performed poorly.
If investments performed well, the beneficiary receives the current account value. Using the same $120,000 basis, assume the account grew to $200,000. The beneficiary would receive $200,000.
When an investor is ready to take money out of a variable annuity, they enter the distribution phase. Common choices include:
When distributions are taken from a non-qualified annuity, only the growth is taxable. Contributions (basis) are made with after-tax dollars, so they aren’t taxed again.
Example: If an investor contributed $50,000 and the account grew to $75,000, only the $25,000 of growth is taxable as ordinary income.
If a lump sum or periodic withdrawal is taken from a deferred annuity*, the investor is not guaranteed income for life. If enough money is withdrawn, the separate account will eventually be depleted. Investors who are concerned about outliving their assets generally avoid these payout options.
*We are not discussing this option with an immediate annuity because immediate annuities are almost always annuitized (payments for life). Otherwise, an investor with a large lump sum would often be better off placing those funds in a brokerage account, investing what they didn’t need, and taking distributions as needed.
If an investor wants guaranteed income for life, they annuitize the contract. Annuitization means giving up ownership of the separate account in exchange for lifetime payments.
When an investor annuitizes, their accumulation units convert into a fixed number of annuity units. The value of those annuity units depends on the performance of the separate account, which directly affects future payouts.
Annuity payments are typically made monthly. The first payment is determined by the annuitization structure (discussed later in this section). After the first payment, future payments depend on the performance of the separate account.
When an investor annuitizes, they’re given an assumed interest rate (AIR). The AIR is a conservative estimate of the projected growth of the separate account.
The separate account’s performance is continually compared to the AIR. Assume the AIR is 3% (annualized):
This is why these annuities are considered “variable.”
There are three specific annuitization structures to know.
First, the investor can choose a life annuitization (also called straight life annuitization), which pays for life. After the investor dies, payments stop and the insurance company keeps the remaining assets in the separate account. Depending on how long the investor lives, the outcome may be favorable or unfavorable.
Assume an investor chooses a straight life annuity when their separate account is worth $200,000:
Because the insurer must estimate how long payments will last, insurance companies often require medical history and/or a medical exam. That information is reviewed by an actuary, who estimates life expectancy. The insurer then sets payouts based on that estimate.
Those estimates can be wrong. If the investor lives longer than expected, the insurer must continue making payments. This is called longevity risk. It’s a risk to the insurance company, but it’s the guarantee the investor is buying. Pensions face this same risk.
Investors who want to reduce the risk of “dying too soon” under a straight life annuity can choose life with period certain. For example, with a 10-year period certain:
Because this structure reduces risk for the investor, it typically produces lower payouts than straight life.
Primarily used by married couples, there is also a joint with last survivor annuitization. This structure pays two account owners until both have died. After the first death, payments are typically reduced.
Investors may also choose a unit refund annuitization. This structure pays for life, but “refunds” the beneficiary if the annuitant dies before receiving payments equal to their basis.
Example: An investor contributes $100,000, annuitizes, and then dies after receiving $70,000 in payments. The remaining $30,000 is paid to the beneficiary, either as a lump sum or on a schedule (depending on the contract).
Now that you understand a variable annuity, let’s briefly cover a fixed annuity. You shouldn’t expect many test questions on this product because it is not considered a security. That’s because the investor does not take investment-related risk (for example, market risk).
With a fixed annuity, contributions go into the insurance company’s general account (not a separate account controlled by the investor). The insurance company invests the funds and guarantees a (typically low) rate of return (for example, 3%).
Compared with a variable annuity, there are pros and cons.
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