Variable annuities are used to provide lifetime income in retirement. They allow unlimited contributions and can make payments that fluctuate until death. 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).
Two broad annuity types come up most often: immediate and deferred. The difference is how long the contract spends in the accumulation phase (the time 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 contract is funded with 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 decisions, 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 cover this below.
Regardless of annuity type, there are two general phases:
The accumulation phase is the period when money is contributed 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 general 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 interest in the account and track their basis (the 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 (and risk level) strongly affect 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 when distributions are taken (often in retirement). During the accumulation phase, income in the separate account must be reinvested.
Variable annuities also follow several retirement-plan-style rules. Investors generally must wait until age 59 ½ to withdraw funds without penalty, and a 10% penalty typically applies to withdrawals taken earlier.
Variable annuities typically include a death benefit that applies only during the accumulation phase. It 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 die 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 beneficiary. Specifically, the beneficiary receives the greater of:
Continuing the example, if the separate account performed poorly and the balance is $100,000 at death, the beneficiary receives $120,000 (the basis). If the investments performed well and the account value is $200,000, the beneficiary receives $200,000.
When it’s time to take money out of a variable annuity, the investor enters the distribution phase. Common choices include:
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 taxed 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 outliving their assets generally 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 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. At annuitization, 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 is what causes future payments to rise or fall.
Annuity payments are typically made monthly. The first payment amount is set based on the annuitization structure (discussed later in this section). After that, future payments depend on separate account performance.
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. If the AIR is 3% (annualized):
That’s why these annuities are considered “variable.”
There are three specific annuitization structures to know. First is a straight life annuitization (also called a life annuity). It pays the investor for life. When the investor dies, payments stop and the insurance company keeps the remaining separate account assets.
Assume an investor chooses a straight life annuity when their separate account is worth $200,000. If they die one month later after receiving one $1,000 payment, the insurance company keeps the remaining value (effectively profiting $199,000). If the investor lives much longer than expected and receives $450,000 of payments over time, the investor receives far more than the original $200,000.
Because the insurer must estimate how long payments will last, it often requires 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 payments for life. This is longevity risk. It’s a risk to the insurance company, but it’s the guarantee the investor is buying. Pensions face the same risk.
Investors who want to reduce the “all-or-nothing” risk of a life annuity can choose a life with period certain annuitization. For example, with a 10-year period certain:
Because this structure reduces risk to the investor, it typically produces lower payouts than a straight life annuity.
Primarily used by married couples, a joint with last survivor annuitization pays two account owners until both have died. After the first annuitant dies, payments are typically reduced.
Investors may also choose a unit refund annuitization. This pays for life, but it also ensures the beneficiary receives any unrecovered basis if the annuitant dies early.
For example, assume 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).
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