Variable annuities

Variable annuities are utilized to provide lifetime income to a person in retirement. They allow unlimited contributions and make fluctuating payments until death. Essentially, an annuity can act as a self-made pension. The investor puts money into the account, then may opt later to receive payments for life.

Contributions (sometimes referred to as premium payments) to variable annuities are made through periodic payments or a lump sum. Variable annuities are considered non-qualified retirement plans*, which results in their contributions being non-tax deductible (no tax benefits simply for contributing). Let’s discuss the two general types of annuities - immediate and deferred. The difference relates to the amount of time needed to contribute to the annuity during the accumulation phase.

*You should assume variable annuities are generally non-qualified, but it’s possible to roll over qualified funds into an annuity. In turn, this creates a qualified annuity. We’ll learn more about this below.

Immediate annuity

When a person has access to a large sum of money in retirement, they can obtain annuity payments for life quickly without the need for a lengthy accumulation phase. Known as an immediate annuity, this type of plan provides retirement income soon after the lump sum is accepted by the insurance company. If the lump sum is made in one big payment, it may be referred to as a single premium immediate annuity. For example, an investor deposits $1 million into their immediate variable annuity, and begins receiving monthly payments starting at $2,500 that then fluctuate depending on the investment performance of the separate account (discussed below).

As with anything else in finance, there are pros and cons to choosing this type of annuity. In particular:

Immediate annuity benefits

Receive retirement income immediately
Provides income for life
No need for a lengthy accumulation phase build-up

Immediate annuity risks

Typically requires a large lump sum to qualify
The lump sum is generally inaccessible without significant fees once deposited*
Low or negative return if death occurs earlier than expected**
Likely subject to a substantial amount of up-front fees and/or sales charges

*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.

Sidenote

Annuity bonuses

Some insurance companies offer annuity bonuses as a way to entice investors to purchase annuities. This provides additional money to customers when they originally fund their accounts, typically on a matched basis.

For example, assume an insurance company offers an 8% annuity bonus on the initial premium payment. A customer makes a premium payment of $100,000, resulting in the insurance company crediting their account an additional $8,000 ($100,000 x 8%). With this annuity bonus, the investor’s starting annuity value is $108,000.

Deferred annuities

Deferred annuities require time to grow the investor’s assets. For example, let’s assume an investor signs up to contribute $2,000 a month to their deferred variable annuity starting at age 40. When they reach age 60, they would’ve contributed a total of $480,000 ($2,000 x 12 months x 20 years). Contributions are invested, so the $480,000 would likely grow to a higher amount - let’s say it grew to $1 million. Once in retirement, the investor may annuitize their account, which essentially relinquishes control of the $1 million to the insurance company in return for monthly payments for life.

Deferred annuity benefits

Longer accumulation period allows for a higher growth potential of contributions
Provides income for life if annuitized
No need for a significant lump sum to qualify

Deferred annuity risks

Assets may not grow as much or lose value if investments perform poorly
Income is typically not received for years or decades
Low or negative return if death occurs earlier than expected (once annuitized*)
Likely subject to a substantial amount of up-front fees and/or sales charges

*Deferred annuities are not required to be annuitized. We’ll learn more about this below.

Accumulation phase

Regardless of annuity type, there are two general phases:

Accumulation phase
Distribution phase

The accumulation phase is the period of time when money is contributed to the account as the investor builds their investment. This phase could last a day (immediate annuity) or several decades (deferred annuity). Money received during the accumulation phase is placed into a “separate” account. The name refers to the account being separated from the insurance company’s own assets and capital. When a contribution is placed into the separate account, the investor purchases accumulation units. Similar to buying shares of stock, accumulation units provide a measurement of the investor’s “basis” (amount invested). When funds are contributed to the separate account, more accumulation units are purchased. The more accumulation units an investor owns, the more valuable their investment is.

The investor controls the separate account and dictates where their money is invested. They are given the opportunity to invest in a number of diversified portfolios of stocks, bonds, and other products, which are very similar to mutual funds. The investor chooses their level of risk, which has a big impact on their return.

The assets in the separate account grow tax-deferred, similar to other retirement plans. When dividends or capital gains are realized, the investor does not owe taxes until a distribution is taken (usually in retirement). When the separate account is growing, the investor must reinvest all income received. Variable annuities are also subject to many of the same rules as other retirement plans. Investors must wait until age 59 ½ to take funds out and are subject to a 10% penalty if taken early.

Variable annuities typically provide a death benefit that applies only in the accumulation phase. This benefit kicks in if the account owner dies before annuitizing the contract (electing for lifetime payments). For example, let’s assume a 30-year-old begins contributing $500 monthly and plans to continue these contributions 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 account owner’s listed beneficiary. In particular, the beneficiary will receive the GREATER of the account owner’s basis or the current account value.

Continuing our example above, let’s assume the investor’s separate account investments performed poorly, resulting in a balance of $100,000 at the time of death. In this scenario, the investor’s beneficiary (which they declare when opening the account) would receive $120,000 (the basis). The death benefit ensures no matter how the investments in the separate account perform, at least the original amount contributed will be returned if the account owner dies prior to taking funds out.

The beneficiary would receive the current account value upon death if the investments performed well. Resetting with our same $120,000 basis example, let’s assume this time the account grew to $200,000. Upon death of the account owner, the beneficiary would receive $200,000.

Sidenote

M&E charges

In the first example above, the investor’s account value at death was $100,000 while their basis was $120,000. At death, the insurance company was on the hook for paying the $20,000 difference to the beneficiary. This added cost is known as mortality risk, which occurs when the account owner dies earlier than expected.

Another risk the insurance company faces is rising expenses. Running an insurance company can be a costly venture, especially in the face of unexpected claims, higher regulatory costs, and/or rising general business expenses. For example, what if an insurance company’s costs exceed the amount of premiums received for its products? Facing these added complexities is known as expense risk.

To compensate for these risks, insurance companies typically assess M&E (mortality & expense) charges. This charge typically averages around 1.25% annually.

Distribution phase

When an investor is ready to take payments from a variable annuity, they have a few choices. At this point, the investor enters into the distribution phase and can withdraw the entire value of the separate account out as a lump sum payment. Alternatively, they could take random or systematic withdrawals. For example, an investor could request $2,000 a month to be sent to them until the account is exhausted. When distributions are taken, only the growth is taxable. If you recall, contributions (basis) are made after-tax (and therefore are not taxed again). If an investor made $50,000 of contributions and the account grew to $75,000, they would only owe ordinary income taxes on $25,000 of growth.

If a lump sum or periodic withdrawal is taken from a deferred annuity*, the investor is not guaranteed income for life. Eventually, the separate account will be emptied if enough money is taken. Investors concerned about running out of funds should avoid these payout options.

*We are not discussing this option with an immediate annuity because they are almost always annuitized (payments for life). Otherwise, an investor with a large lump sum would be better off placing those funds in a brokerage account, investing what they didn’t need, and taking distributions as needed.

If an investor seeks guaranteed income for life, they annuitize their contract. Annuitization is the act of handing over ownership of the separate account in return for payments for life. When an investor annuitizes, their accumulation units convert into a fixed amount of annuity units. The performance of the separate account determines their value, which directly influences future payouts.

Sidenote

Taxes at distribution

In this section, we’ve learned the following about non-qualified variable annuities:

Growth is taxable as ordinary income when withdrawn
Two primary methods of withdrawal:
- Not annuitizing and withdrawing funds when needed
- Annuitizing and receiving periodic payments until death

Let’s dive a bit further into these points to better understand the tax consequences investors face when they request distributions (withdrawals).

If the account is not annuitized, Internal Revenue Service (IRS) rules require the growth to be distributed first. Known simply as LIFO (last in, first out), the after-tax contributions are taken out after all growth is distributed. For example, let’s assume an investor contributes $50,000, which grows to $70,000 at the time the first withdrawal occurs. A distribution of $25,000 is requested - how much is taxable?

In this example, the investor has $20,000 of taxable growth in their account. When they request the $25,000 withdrawal, the $20,000 of taxable growth comes out first, alongside $5,000 of basis. Therefore, $20,000 would be taxable as ordinary income, while the remaining $5,000 would represent a tax-free return of principal (basis).

If the account is annuitized, IRS rules require a different type of taxation. Each payment received is taxed on a pro-rata basis, meaning they will contain part tax-free basis and part taxable growth. This is sometimes referred to as being taxed on an exclusion ratio basis. For example, assume an investor receives $1,000 in their first variable annuity payout. It’s possible that $300 of the payment is taxable growth, while the remaining $700 is a tax-free return of principal*.

*Don’t worry about the specifics or how to calculate each portion. The test is most likely to focus on generalities.

As with other retirement plans, variable annuities are subject to an early withdrawal penalty if a non-qualified distribution occurs prior to age 59 1/2.

Annuity payments are typically made on a monthly basis. The first payout to the investor is predetermined based on the structure of the annuitization (discussed later in this section). After the first payout, future payments depend on the performance of the separate account. When an investor annuitizes, they’re provided with an 'assumed interest rate,’ which is usually referred to as the AIR. The AIR is a conservative estimate of the projected growth of the separate account.

The performance of the separate account is continually compared to the AIR. Assume the assigned AIR is 3% (annualized). If the separate account performs better than 3%, the investor’s monthly payout increases. However, if the separate account performs worse than 3%, the investor’s payout decreases. This structure is why these annuities are considered “variable.”

There are three specific annuitization structures to be aware of. First, the investor can choose a straight life annuitization, which pays them for life. After the investor dies, the payments stop and the insurance company keeps the assets in the separate account. Depending on how long the investor lives, they may or may not receive a desirable return.

Assume an investor chooses a straight life annuity when their separate account is worth $200,000. If they were to pass away one month later after receiving one payment of $1,000, the insurance company makes a profit of $199,000. In this situation, the insurance company “wins.” It could go the other way, though. The investor could live much longer than expected and receive payouts equaling $450,000 until they die, profiting $250,000. In this case, the investor “wins.”

As you can see, variable annuities are a game of life and death. To estimate how long an investor will live, insurance companies often require full disclosure of medical history and/or a check-up by a doctor of their choosing. The medical data is then given to an actuary, whose job is to analyze risk and estimate how long they expect their customer to live. From there, the insurance company makes payouts that represent their estimate of the investor’s life expectancy.

The actuary and insurance company are not always right, though. If an investor’s health is misjudged and they live longer than expected, payouts still must be made until they pass away. This is known as longevity risk, which is a detriment to the insurance company, but a beneficial guarantee to the investor. Pensions face this same risk regularly.

For investors concerned about the risks associated with a life annuity, they can choose a life with period certain annuitization. Assume an investor chooses a life with a 10-year period certain. They are guaranteed payments for life, regardless of how long they live. However, if they were to die within 10 years, payments continue to their listed beneficiary. For example, if they died after 8 years of payments, 2 years of payments continue to their beneficiary.

With a period certain setup, the investor knows payments are guaranteed for a specific amount of time. Because there is less risk for the investor, life with period certain annuities result in lower payouts than life annuities.

Primarily utilized by married couples, there is also a 'joint with last survivor’ annuitization. This type of payout structure pays two account owners until both pass away. After the death of one of the annuitants, the payments are typically reduced by some amount.

Definitions

Annuitant: A person who receives annuity payments (typically the original account owner)

Investors may also choose a unit refund annuitization. This type of annuity makes payments for life, but “refunds” the account owner’s beneficiary if they pass away prior to receiving their basis. For example, assume an investor contributes $100,000 to their unit refund annuity, annuitizes the contract, then passes away after receiving $70,000 in payments. $30,000 would be paid to the annuitant’s beneficiary in a lump sum or on a payment schedule (depending on how the annuity is structured).

Sidenote

Qualified annuities

You should expect the exam to primarily focus on non-qualified variable annuities. In fact, we recommend you assume an annuity is non-qualified unless otherwise stated in a question. This type of retirement plan allows for unlimited non-deductible (after-tax) contributions and tax-deferred growth. At distribution, only the growth is taxable as ordinary income.

In some circumstances, you may encounter a question on a qualified annuity. These are annuities that have been funded with pre-tax money from another source. For example, an investor contributes $100,000 to their 403(b) plan at the charity they work at. At retirement, the account has grown to $150,000 and they roll the account over into a variable annuity.

In this example, all future withdrawals would be taxable as ordinary income. While a non-qualified variable annuity is only subject to taxation on the growth, the entire amount withdrawn from a qualified annuity is taxable. To be clear, let’s assume the investor requests a lump sum distribution of their $150,000 qualified annuity. They would be subject to ordinary income taxes on the entire amount - the $100,000 basis and the $50,000 of growth.

Like all other qualified plans, qualified annuities are subject to required minimum distributions (RMDs) starting at age 73. Non-qualified annuities are not subject to RMDs.

Fixed annuities

Now that you understand a variable annuity, we’ll briefly cover a fixed annuity. You shouldn’t expect many test questions on this product as it is not considered a security. This is because the investor does not face investment-related risk (e.g. market risk).

Instead of the investor’s assets being placed in their control within the separate account, a fixed annuity places contributions into the insurance company’s general account. The insurance company invests the funds on behalf of the account owner and guarantees a (typically low) rate of return (e.g. 3%).

As compared to a variable annuity, there are pros and cons. The pros - money grows at a guaranteed rate of return and the investor does not need to concern themselves with investment-related risks like market risk or interest rate risk. For conservative and risk-averse investors, this may seem like a suitable retirement option.

The cons - variable annuities may grow more over time (more risk, more return potential) and the fixed rate of return is especially subject to inflation (purchasing power) risk. Remember, any investment with a fixed rate of return is subject to this risk. If prices of goods and services rise more (on a percentage basis) than the guaranteed rate of return, the investor is technically losing money to inflation.

Key points

Variable annuities

Unlimited non-deductible contributions
Contribution options:
- Lump sum
- Periodic contributions
Offers tax-deferred growth
Distributions taxable above basis

Immediate annuity

Investor contributes a large lump sum
Immediately annuitizes and receives payments

Deferred annuity

Investor contributes over time
Takes withdrawals or annuitizes later in retirement

Accumulation phase

When contributions are made
Death benefit applies

Death benefit

Beneficiary keeps GREATER of:
- Amount invested
- Account value
Applies if the account owner dies during the accumulation phase

Variable annuity insurance company risks

Mortality risk
- Investor dies earlier than expected, triggering the death benefit
Expense risk
- Business expenses rise
Longevity risk
- Investor lives longer than expected, forcing annuity payments to be paid longer

Separate account

Where assets are held
Customer in control of investing
Investment choices:
- Equity-based portfolios
  - Hedge against inflation
- Debt-based portfolios
  - Subject to inflation risk

Distribution phase

Investor receives income in retirement
Non-annuitization options
- Lump sum
- Periodic payments
Annuitization options:
- Straight life annuity
- Life with period certain
- Joint and last survivor

Non-qualified annuity taxation

Growth is taxable as ordinary income
Withdrawals (non-annuitization)
- Growth is distributed first (LIFO)
Annuitization
- Basis and growth distributed simultaneously
- Taxed on a “pro-rata” basis (a.k.a. exclusion ratio)
Not subject to RMDs

Qualified annuity taxation

All distributions taxed (growth and basis) as ordinary income
Subject to RMDs starting at age 73

Fixed annuities

Like a variable annuity, but:
- Not a security
- General account instead of a separate account
- More exposed to inflation risk