Characteristics of Variable Annuity Products
Annuities are potential investment vehicles used mainly by people who are saving up money for retirement. Annuity products give you the option to annuitize your investments or assets so you can be assured of a regular income for life.
Variable annuities are just one of the two main types of annuities. The other type is the fixed annuity product. Fixed annuities, as opposed to variable annuities, give their owners the assurance of a regular and consistent amount of income.
Variable annuity products, on the other hand, provide their owners a regular but variable amount of income. Payouts from a variable annuity, therefore, will vary from one payout interval to the next.
This article discusses the characteristics of annuities. While some of the characteristics discussed here are generally apply to both fixed and variable annuities, the discussion revolves mainly around variable annuity products.
4 Essential Features of Variable Annuity Products
A variable annuity product has 4 main essential features, and they are the following:
1. Savings Feature
Variable annuities allow their owners to save money for a long-term financial goal. If you are currently employed or earning income from other sources, you may purchase a variable annuity to save money for your children's college education or retirement. A variable annuity gives you a systematic way of ensuring that you won't neglect saving up enough money for your future financial needs.
Note: You should be aware that a variable annuity product is only one of your options for retirement savings. If your company sponsors 401k plans for its employees, you can use that to save for retirement. You may also open your own Individual Retirement Account or IRA (traditional IRA or Roth IRA) for the same purpose.
You can also make a variable annuity purchase part of your 401k or IRA plan. This is not recommended, however (read Tax Deferral section below). It is best to keep variable annuities separate from other tax-sheltered retirement plans.
At the end of it all, you should compare all of your available options before deciding on which retirement plan to take.
2. Regular Income
Variable annuities have a regular income feature (which you may choose not to take up by withdrawing your assets in one lump payment). This is its most attractive feature. When activated or selected, this feature ensures that you'll have a regular source of income for a fixed number of years, for your lifetime or for the life of your spouse or any other person designated in your annuity contract.
Note: As mentioned earlier, the payout amounts you'll receive from one interval to the next is variable. It will vary according to the performance of the investments in your annuity account.
You should know, however, that even if the investment products in your annuity account consistently increase at huge rates, your payouts (also known as distribution) will not grow by the same rate.
To determine the amount of payout per interval, the insurance company uses as basis not only the actual performance of investments but also their Assumed Interest Rate. Only if your annuity account's assets grew more than the assumed interest rate will your payout amount increase. Your payout amount, moreover, will increase only by the rate at which your assets' performance exceeds the assumed interest rate.
3. Guaranteed Death Benefit
Variable annuities from insurance companies have a life insurance component. Specifically, they provide that the beneficiaries named in the annuity contract will receive a death benefit, guaranteed, if the account owner dies before he starts receiving annuity payouts.
The amount of the death benefit is computed as the greater of the following:
- The total face value of the annuity account.
- The sum of payment installments made by the annuity contract owner, minus any withdrawals made from the account (or benefits used, if applicable).
Let's say that an annuity account owner has just died. Prior to his death, he has made purchase payments amounting to $60,000. He has also withdrawn $3,000 from the account. At the time of his death, moreover, his account's face value has grown to $70,000. How much death benefit will his beneficiaries receive?
In this example, the 1st formula will be used to calculate the death benefit since the account's total value ($70,000) exceeds the total amount of payment installments made on the account minus withdrawals ($57,000). Thus, the beneficiaries of our hypothetical annuity contract owner will receive gross death benefits amounting to $70,000.
4. Tax Deferral
Variable annuities generally come with a tax deferral feature. If you purchase a variable annuity product, the taxes on the earnings you accumulate in your annuity account are deferred. You will only be taxed when you start receiving payouts or make withdrawals.
To illustrate, let's say that a specific asset in your annuity account - Stock Fund A - has earned dividends and has appreciated in value. Such earnings will not be taxed and will go into your annuity account in its entirety.
This means that with an annuity account, you have the opportunity to accumulate assets faster than when you can by making individual investments. Earnings from your investments will not be diminished by capital gains tax and could therefore be reinvested and put to use to earn more income.
Note: The following are some things you should remember about the tax deferral feature of variable annuities.
tax, not capital gains tax
You should know that payouts received or withdrawals made from your variable annuity will be treated as income and subject to the prevailing income tax rate at the time such payouts or withdrawals are made. It doesn't matter who is receiving the payout or making withdrawals (you or your designated beneficiaries/heirs); all payouts and withdrawals will be levied the going income tax rate.
One disadvantage of this is the fact that income tax is higher than capital gains tax. Drawing your capital gains as income, therefore, will cost you higher taxes in the future. It will also cost your heirs income taxes whereas, if you left your heirs assets outside of an annuity account, such assets will not be treated as your heirs' earnings or income and will not be subject to income tax.
The tax deferral feature of variable annuities is there mainly because the government wishes to help people save up more quickly for their retirement. Therefore, the government penalizes people who withdraw money from their variable annuity accounts long before retirement. Specifically, the federal government levies a 10% penalty tax on withdrawals made by annuity owners before they're 59 ½ years old.
If you're using a variable annuity to save up for anything other than retirement, therefore, make sure that you won't need your funds before you're 59 ½ years old.
annuities in tax-sheltered plans
You should also be aware that if your variable annuity was purchased through a tax-sheltered retirement plan, this variable annuity account's tax deferral advantages become irrelevant and unnecessary. A traditional IRA, for instance, already enjoys tax deferral advantages as contributions are made using pre-tax dollars.
Therefore, purchasing a variable annuity account through your IRA account will not give you extra tax advantages. If you really want a variable annuity, you can purchase it separately from your IRA. You can also use the funds in your IRA once they become available for withdrawal to make a lump sum purchase of a variable annuity.
Extra Features of Variable Annuity Products
Specific variable annuity products often have unique or special features that investors may choose to activate.
You should note that opting for these extra features typically mean additional annuity procurement costs. Thus, before you activate any extra feature in a variable annuity product, read the fine print. Make sure you understand the additional financial obligations you'll be required to assume with the activation of extra features. You should asses whether or not it will be cheaper in the long run to get these extra features separately (say, though a stand-alone insurance policy).
The following are some of the extra features of variable annuity products:
1. Guaranteed Minimum Income
Variable annuity products offer investors a regular income stream, but they don't provide a consistent amount of income. In fact, an annuity owner's payouts may shrink to such a point that he may no longer have enough income to pay for his recurring expenses.
For this reason, some insurance companies have begun offering variable annuity products that have a guaranteed minimum income feature. With such a product, an annuity owner is assured that his income from his annuity account will not fall below the stated guaranteed minimum even if the total value of his account could no longer support such level of payments.
Note: Naturally, you need to check the robustness of the insurance company offering the guaranteed minimum income feature. An insurance company with a weak financial position is unlikely to be able to fulfill such a guarantee.
2. Stepped-up Death Benefits
Some insurance companies have also begun offering stepped-up death benefits to make their variable annuity products more attractive to prospective investors.
In a variable annuity product with a stepped-up death benefit feature, the death benefit guaranteed to the annuity's named beneficiaries can be greater than
- the total value of the account upon the death of the account owner, or
- the total purchase payments made by the account owner minus his withdrawals.
With a stepped up death benefit feature, the account owner can lock in his death benefit at the account's total valuation a specific time - say, when his investments in the annuity account did pretty well.
To illustrate, let's use the same example we used under the "Guaranteed Death Benefit" discussion. Let's say that an account owner has made a total investment of $60,000 and withdrawals amounting to $3,000. Furthermore, his account's value at the time of his death stands at $70,000.
This time, though, this account owner had opted for a stepped up death benefit. He had locked in his death benefit at the value of his account a year before when his investments were doing particularly well. Specifically, his account's value at that time was $80,000.
In this case, then the beneficiaries of this annuity account will receive not $70,000, the value of the account at the time of the account owner's demise, but $80,000 which is the stepped-up death benefit that has been determined for the account.
Note: You should understand that stepped-up death benefits typically come with greater charges, particularly the Mortality and Risk Expense charge (M&E). Insurance companies charge the M&E annually, and they use the total value of your annuity account - not the sum of your purchase payments - to calculate this charge. M&E charges therefore represent a significant annuity investment expense, and it becomes even more expensive with stepped-up death benefits.
3. Long-Term Care Benefits
Variable annuity products may also provide long-term care benefits. Long-term care benefits vary by annuity product and insurance company. Typically, they cover the costs of staying in a nursing home or hiring a caregiver.
Activating this feature simply means adding long long-term care insurance to your annuity product. It also means additional insurance costs.
4. Bonus Credits
To make their variable annuity products even more attractive as an investment vehicle, some insurance companies have started offering annuities with bonus credits.
How does this work? In a variable annuity product with a bonus credit, the insurance company gives the annuity account owner a bonus for each purchase payment or installment he makes to his account. The bonus is calculated using a fixed bonus rate schedule.
To illustrate, let's suppose that you have activated the bonus credit in your variable annuity product. The agreed upon bonus credit is 2.5%. Thus, if you make a purchase payment of $30,000, the insurance company will add a bonus of $750 to your installment. Thus, that particular purchase payment becomes $30,750.
Note: Variable annuity products with a bonus credit feature usually have higher mortality and expense rates than variable annuities without a bonus credit. They also normally have higher surrender charges (i.e. the penalty you pay for dissolving the annuity contract prematurely).
Additionally, annuities with a bonus credit feature usually have extended surrender periods (i.e. the period of time in which you will be charged surrender charges for terminating your annuity contract).
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