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-made pension. You contribute money to the contract, and later you can choose to receive payments for life.
Contributions (often called premium payments) can be made as periodic payments or as a lump sum. Variable annuities are generally 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 - and the key difference is how long the accumulation phase lasts.
*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 start lifetime annuity payments quickly, without a long accumulation period. This is an immediate annuity: the insurance company begins retirement income soon after accepting the lump sum.
If the lump sum is made in one 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 products, 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 grow assets 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 could grow beyond the amount contributed - 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 cover this below.
Regardless of annuity type, there are two general phases:
The accumulation phase is when money is contributed to the contract and invested. This phase might last a day (immediate annuity) or several decades (deferred annuity).
During the accumulation phase, contributions go 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 measure the investor’s ownership interest and help track their basis (amount invested). As more money is contributed, more accumulation units are purchased.
The investor controls the separate account and chooses how the money is invested. The contract typically offers a menu of diversified portfolios of stocks, bonds, and other products that are similar to mutual funds. The investor’s choices determine the level of risk and, therefore, the potential return.
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 reinvested in the contract.
Variable annuities also follow several rules that apply to retirement accounts. Investors generally must wait until age 59 ½ to withdraw funds without penalty, and a 10% penalty may apply to early withdrawals.
Variable annuities typically provide a death benefit that applies only during the accumulation phase. It applies if the account owner dies before annuitizing the contract (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: the beneficiary receives the greater of the owner’s basis or the current account value.
Continuing the example, assume the separate account performed poorly and the balance is $100,000 at death. The beneficiary would receive $120,000 (the basis). The death benefit ensures that, if the owner dies before taking funds out, at least the amount contributed is returned.
If the 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 the investor is ready to take money out, they enter the distribution phase. At that point, they can:
When distributions are taken from a non-qualified variable annuity, only the growth is taxable. Contributions (basis) were made with after-tax dollars, so they aren’t taxed again.
For 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 want to avoid running out of funds 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 don’t need, and taking distributions as needed.
If the 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 the investor annuitizes, accumulation units convert into a fixed number of annuity units. The value of those annuity units changes based on the performance of the separate account, which affects future payouts.
Annuity payments are typically made monthly. The first payout amount is set based on the annuitization structure (discussed later in this section). After the first payout, future payments depend on the performance of the separate account.
When an investor annuitizes, the insurer assigns an assumed interest rate (AIR). The AIR is a conservative estimate of the separate account’s projected growth.
The separate account’s performance is continually compared to the AIR. For example, if the AIR is 3% (annualized):
This is why these annuities are considered “variable.”
There are three specific annuitization structures to know. First is a straight life annuitization, which pays the investor for life. After the investor dies, payments stop and the insurance company keeps the remaining separate account assets. Depending on how long the investor lives, the return may be favorable or unfavorable.
Assume an investor chooses a straight life annuity when their separate account is worth $200,000. If they pass away one month later after receiving one $1,000 payment, the insurance company profits by $199,000. In that case, the insurance company “wins.”
It can also go the other way. The investor might live much longer than expected and receive total payouts of $450,000, which would be a $250,000 gain relative to the $200,000 account value. In that case, the investor “wins.”
This highlights the role of life expectancy in pricing annuity payments. Insurance companies may require medical history and/or a medical exam. That information is reviewed by an actuary, who estimates life expectancy and helps the insurer set payout amounts.
Those estimates aren’t always correct. If the investor lives longer than expected, the insurer must continue payments for life. This is longevity risk - a risk to the insurance company, but a valuable guarantee to the investor. Pensions face this same risk.
For investors who want to reduce the risk of “dying too soon” under a straight life annuity, a common alternative is life with period certain. For example, with a 10-year period certain:
So, if the investor dies after 8 years of payments, the beneficiary receives 2 more years of payments.
Because this structure reduces risk for the investor, life with period certain annuities typically pay less than straight life annuities.
Married couples often use joint with last survivor annuitization. This structure pays two account owners until both have died. After the first annuitant dies, payments typically continue but are reduced.
Investors may also choose a unit refund annuitization. This pays for life, but it “refunds” the beneficiary if the annuitant dies before receiving payments equal to their basis.
For example, assume an investor contributes $100,000, annuitizes the contract, 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 payment schedule (depending on the annuity’s structure).
Now that you understand a variable annuity, we can 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 on 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.
Remember: any investment with a fixed rate of return is subject to inflation risk. If prices rise faster (in percentage terms) than the guaranteed rate of return, purchasing power falls.
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