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Variable Annuity Contracts Explained

Variable annuities are annuity products that you may purchase from insurance companies. A variable annuity contract is an agreement between the annuity provider (i.e. the insurance company) and the variable annuity owner.

Basically, a variable annuity contract involves the initial purchase of the annuity product from the insurance company. The insurance company will then invest this purchase money in various assets as per the annuity account owner's instructions. At a future date, the insurance company will return the funds in the annuity account to its owner, either in one big payout or at smaller but periodic payouts.

The total amount of money that the account owner will receive from his annuity may be more or less than his actual purchase price. It depends on how well the annuity's investments have performed through the years, the fees deducted by the insurance company and the withdrawals he has made.

Variable Annuity Purchase

There are two ways through which variable annuities may be purchased. To purchase a variable annuity contract, you can:

  1. Pay the insurance company a lump sum (say, $20,000). That will be the starting or face value of your annuity account, minus fees.
  2. Make payment installments to your insurance company. In this case, your annuity account's value increases over time with your additional installments. It also increases or decreases with the value of the investments linked to your annuity account. Annuity service fees are also deducted from the total value of your annuity account.

Variable Annuity Payouts

Variable annuities vary by payout types. Some variable annuities involve recurring payouts at fixed intervals (e.g., monthly, quarterly, biannually, etc.). Some variable annuities give the contract owner the option of receiving all of his annuity payouts in one lump sum.

  • Lump Sum Payout

    In a lump sum payout annuity, the annuity contract owner can withdraw the assets he has in his annuity account at a future, pre-agreed upon date. The date after which an annuity owner can withdraw his money without penalties is stipulated in the variable annuity contract. The amount of payment, moreover, will be assessed as the face value of the account at the time of withdrawal (minus administrative fees, if any).

  • Periodic Payouts

    The schedule of periodic payouts is predefined in the variable annuity contract. It is a variable product because the amount of money that the variable annuity contract owner will receive may vary from one payment interval to another, thus the "variable" modifier in this annuity contract's name.

In contrast, a fixed annuity contract ensures that the annuity contract owner will receive a fixed amount every payment interval. Fixed annuities are for those who want income stability more than asset growth. A fixed annuity contract owner foregoes the opportunity to grow his assets. Insurance companies are not obliged to share with annuity contract owners the investment returns on fixed annuity accounts.

Of course, the insurance company also bears the risks associated with investing such fixed annuity accounts. The account owner is assured that what he has put in will remain untouched and intact even if the securities market suffers a downturn.

Variable Annuity Investment Options

Variable-Value Investment Instruments

Variable annuity payout amounts vary mainly because variable annuities are invested in securities, the value of which fluctuates depending on market conditions.

If the securities in the annuity's portfolio are doing well, the account's value grows. If the securities in the portfolio are doing badly, however, then the account's value declines as well. Since annuity payments are based on the annuity account's value, annuity payments naturally fluctuate with the performance of the account's underlying investments.

The money in a variable annuity account is often invested in mutual funds. These mutual funds are usually asset-specific. Thus, a variable annuity account's funds may be allocated to stock funds, money market funds or bond funds. There are also mixed mutual funds that are invested in several asset categories.

The variable annuity account owner has control over his annuity assets' allocation. He picks and chooses which funds he'd like to invest in and how much to allot for each selected fund.

Actual asset weighting in an annuity account changes over time due to the variable performance of different fund products. Let's suppose, for instance, that you have chosen to allocate 30% of your annuity's value in Stock Fund A, 30% in Bond Fund B, 30% in Money Market Fund C and 10% in Mixed Fund D. If Stock Fund A gives the highest rate of return, your asset weighting will vary over time in favor of Stock Fund A.

If you want to maintain your original asset weighting, you'll have to do some periodic asset rebalancing. You'll have to ask your insurance company to transfer some of your investment in one fund (say, Stock Fund A) to another account (say, Mixed Fund D).

Fixed Account Component

In some cases, the annuity contract owner may be permitted to allocate part (say, 10%) of his account's value to a fixed investment account. In this case, most of the annuity's assets are in variable-value securities, but a small part is invested in an account (much like a savings account) that has a low but fixed rate of return. This ensures that the annuity owner has a minimum amount of interest earnings.

Interest earnings from the fixed part of an annuity account generally remain the same over time. Of course, the insurance company may chance the going rate from time to time if such a provision has been made in the annuity contract. In this case, interest earnings from fixed investment accounts will also vary. Nevertheless, such earnings will always be guaranteed.

Types of Variable Annuities

Specific variable annuity products vary by structure. Nonetheless, they may be classified into two main types according to fund availability. These two are:

Immediate variable annuities

Immediate variable annuities are annuities where the annuity contract owner immediately starts receiving annuity payouts upon his purchase of the annuity. They are typically purchased with a lump sum investment. Moreover, they come with a recurring payout structure.

Immediate annuities are for people who have a lump sum to invest now and would like to ensure that they won't be able to spend all of it and run out of spending money in the future.

Non-immediate annuities

Non-immediate variable annuities are annuities where the annuity contract owner has to wait a while before he may start receiving payouts. They are usually purchased through payment installments for a period of several years. Non-immediate annuities usually give owners the option to receive their payout in one lump sum or through recurring payouts.

A non-immediate annuity has two stages. The first one is the accumulation stage where the annuity owner makes annuity purchase payments to the insurance company. The second one is the payout stage where you may start receiving payouts or may withdraw your assets.

During the accumulation stage, no withdrawals can be made from the account or the annuity owner will pay penalties. However, as mentioned earlier, the annuity owner may transfer the assets in his account from one investment to another to reallocate or rebalance his assets.

Transfers from one investment to another within an annuity account will not incur capital gains taxes. Thus, a variable annuity owner can transfer gains made in one part of his account to another (say, the fixed investment component) without incurring taxes. However, transfers may still cost money since some insurance companies charge transfer fees.

Variable Annuities from Institutional Investors

Variable annuities are largely offered by insurance companies. However, there are now institutional investors that offer annuitizable investment plans for retail investors.

Such annuitizable investment plans are usually sponsored by mutual funds. They have features comparable to variable annuity contracts offered by insurance companies. More often than not, however, they offer more favorable rates than variable annuities from insurance companies.

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