Variable annuities
Variable annuities are a type of investment company product (regulated by the Investment Company Act of 1940) that can provide lifetime income to a person in retirement. These investment vehicles allow unlimited contributions and make fluctuating payments until death. An annuity can be a “self-made pension”. The investor puts money into the account and may opt later to receive payments for life.
Contributions (sometimes called premium payments) to variable annuities are made through periodic or lump sum payments. Variable annuities are considered non-qualified retirement plans*, resulting in 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 time needed to contribute to the annuity during the accumulation phase.
*You should assume variable annuities are generally non-qualified, but rolling over qualified funds into an annuity is possible. 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 immediately obtain annuity payments for life without a lengthy accumulation phase. Known as an [*immediate annuity*, this plan provides retirement income soon after the insurance company accepts the lump sum. If the lump sum is made in one big payment, it may be called 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, which 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 a problem if the investor needs more money than they receive 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 represents an extraordinary $970,000 loss. This is one of the primary risks investors face with annuities.
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 $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 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 when money is contributed to the account as the investor builds the annuity’s assets. 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 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). More accumulation units are purchased when additional funds are contributed to the separate account. 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 allowed to invest in several diversified portfolios of stocks, bonds, and other products, which are very similar to mutual funds. The investor chooses their risk exposure, which impacts their return potential.
The assets in the separate account grow tax-deferred, similar to other retirement plans. Investors generally do not pay taxes on dividends or when capital gains are realized; taxation only applies when a distribution (withdrawal) is taken (usually in retirement). When the separate account grows, the investor must reinvest all investment income received. Variable annuities are also subject to 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 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 (declared when the account is opened) would receive $120,000 (the basis). The death benefit ensures that no matter how the separate account’s investments perform, at least the original amount contributed will be returned if the account owner dies before taking distributions.
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 the account owner’s death, the beneficiary would receive $200,000.
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 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 involves giving 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.
Annuity payments are typically made every month. 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,’ typically called 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). The investor’s monthly payout increases if the separate account performs better than 3%. However, the investor’s payout decreases if the separate account performs worse than 3%. This structure is why these annuities are considered “variable.”
There are four 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 after receiving one payment of $1,000, the insurance company would profit $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 or a check-up by a doctor of their choosing (or both). The medical data is then given to an actuary who analyzes risk and estimates how long they expect their customer to live. From there, the insurance company makes payouts representing their estimate of the investor’s life expectancy.
The actuary and insurance company are not always right. 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, a detriment to the insurance company, but a beneficial guarantee to the investor. Pensions face this same risk regularly.
Investors concerned about the risks associated with a life annuity 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 would 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 one of the annuitants dies, the payments are typically reduced by some amount.
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 before receiving their basis. For example, assume an investor contributes $100,000 to their unit refund annuity, annuitizes the contract, and 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).
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