Annuities are among the oldest investment options; In fact, they have centuries of history. Especially during the last century, fixed income annuity contracts have gained popularity among conservative investors as a sure means to grow their money with deferred taxes.

But in the bull markets of the 1980s, a new type of annuity contract allowed investors to participate in the debt and stock markets and enjoy the benefits of annuities at the same time.

These vehicles, known as variable rate annuities due to the variability of realized yields, began in 1952 as a financing vehicle for pension plans. Originally started by the Teachers Insurance and Annuities Association - College Retirement Equity Fund (TIAA-CREF), these vehicles became more popular after the Tax Reform Act of 1986 closed many of the other tax loopholes that were available to investors.

Since then, they have grown into a multi-billion dollar industry that is now regulated by insurance and securities agencies such as FINRA and SEC, as well as by state insurance commissioners.

How do variable annuities work?

Variable annuities can provide big profits, but they are the most risky type of life annuity contract you can buy. Unlike fixed and indexed annuities, variable annuities do not guarantee your principal investment, interest or other earnings.

When you invest in a variable annuity, your money is allocated among a pre-set selection of mutual fund accounts. Life insurance companies negotiate with several mutual fund companies so that one or more of your funds are included in the contract, and you will get between 15 and 50 secondary accounts for you to choose from. Your money will grow with deferred taxes until you start receiving disbursements. But unlike other annuities, variable contracts are not subject to a specific period of time. Once you purchase the contract, it remains in effect until you start to retire.

On the contrary, variable annuities accommodate investors with a high risk tolerance and a lot of time to recover from losses. Investors who traditionally invested in mutual funds can use a variable annuity to avoid paying taxes on capital gains each year. Variable contracts are commonly used to finance retirement plans for companies, such as the 401k and 403b retirement plans (a practice that has been a source of controversy in the financial industry for years due to the volatility of these investments).

Obtaining (and losing) money

Be paid

Beneficiaries can withdraw funds using one of six methods:
  1. Straight Life . The simplest and riskiest form of payment, these payments are based on the actuarial calculations of your insurance company on your life expectancy. You will be paid every year, even if the total value of your contract survives. But if you die before getting all the funds in your account, you will lose the money.
  2. Joint life . You can extend the duration of those payments by adding a co-beneficiary. While one of you is alive, the payments keep coming.
  3. Life with the true period . To cover part of the risk of a direct payment for life, you can agree on a certain number of payments, in a period of 20 years, for example, and if you die before the end of the period, then a contingent beneficiary will get the rest of the payments. years.
  4. Joint life with a certain period . Add a co-beneficiary at the end of your particular plan period.
  5. Systematic withdrawal . A periodic payment in dollars or percentages that ceases upon death or when the annuity funds run out, whichever occurs later.
  6. Lump-Sum . Settle all the funds of the contract and take the income in cash.

Fees and expenses

  1. Along with the possibility of earning a lot of money, it will also deal with various fees and expenses on an annual, quarterly or monthly basis.
  2. Contingent deferred delivery charges . Like fixed and indexed annuities, variable annuities generally have a declining sales charge schedule that reaches zero after several years. You may have to pay a penalty of 8% to settle the contract in the first year, a penalty of 7% next year, and so on until the calendar expires.
  3. Contract maintenance fee . To (supposedly) cover the administrative and recordkeeping costs of the contract, this fee generally ranges between $ 25 and $ 100 per year, although it is often exempt from larger contracts, such as those worth at least $ 100,000.
  4. Mortality rates and expenses . These cover many other expenses incurred by the insurer, such as marketing and commissions. This rate can be executed between 1% and 1.5% per year; The industry average is approximately 1.15%.
  5. Cost of riders Most variable annuity contracts offer different types of riders of life and death benefits that you can buy within the contract. These brokers offer some additional guarantees, but each broker usually costs from 1% to 2% of the value of the contract.

Taxes

Fixed, indexed and variable annuities are taxed in the same way. Any increase in the contract is subject to taxes, and recovering your principal is not taxable. Each payment will reflect the growth to principal ratio in your contract. If you doubled your money, then half of each disbursement will be subject to taxes. For example, if a distribution of a $ 300,000 contract is taken for which $ 150,000 was originally contributed, then the ratio of principal to gain is 50/50. Therefore, half of each distribution is counted as a tax-free capital return. And do not forget, as with most other plans, any money you withdraw before you meet 59.5 is subject to a 10% penalty for early withdrawal from the IRS.

Subaccounts and other investment options

The sub-accounts housed within a variable annuity are the real engine that drives the returns made by the investor. These sub-accounts are actually disguised mutual funds; they are essentially clones of the underlying funds that exist outside of the contract. They resemble their parental funds in most aspects but, by law, are treated as separate values ​​with their own symbols.

For example, Allianz Life offers the Davis New York Venture fund within its variable annuity products. However, investors who decide to invest in this sub-account are technically investing in a separate value, not the fund offered directly by Davis Funds with the symbol NYVTX that can be purchased on their own. The number and quality of the funds of the subaccounts available under the contract will vary from one company to another; some variable products offer a much wider range of sub-accounts than others, and not all sub-accounts are equal, just as some funds are superior to others.

The sub-accounts that invest in shares are classified into large, medium and small, domestic, global and sectorial, as well as with funds in the outside world. There are also subaccounts that invest in all types of bonds, real estate and other securities. All variable contracts also offer a money market sub-account and usually some fixed alternatives that pay a guaranteed rate as well. An investor who buys a variable contract and then becomes suspicious of the markets can transfer the funds within the contract to one of the fixed alternatives for a time until the markets recover.

Other characteristics and benefits of variable annuities

Variable annuities also provide many other benefits besides tax deferral and market share, such as:

1. Exemptions

Like fixed and indexed annuities, variable contracts are exempt from inheritance at the national level and also from most creditors in most states. The money within an annuity contract is transferred directly to the beneficiary in the manner specified in the contract.

2. Average costs in dollars

Most modern variable annuity products also offer averages of dollar costs, which can improve the return on investments and minimize volatility. Many operators have used DCA programs as a sales tool to attract new investors.

For example, a company may promise to pay a high guaranteed interest rate in a money market or a fixed account while gradually moving the assets of that account to the sub-account portfolio it selects. Therefore, if you invest $ 100,000 in one of these products, it will review the selection of available sub-accounts within the contract and instruct the carrier to allocate a certain percentage of your money to each sub-account.

The carrier would place the money in a fixed fund that would pay an interest rate 2% or 3% higher than the current rates, and would move the money to the sub-account portfolio for perhaps 12 months, transferring $ 8,500 plus the interest paid to date in that amount in the portfolio of each month until it is fully invested in the portfolio.

3. Rebalancing the portfolio

Many contracts can also periodically rebalance the sub-account portfolio to maintain the original asset allocation percentage that was chosen. Because each sub-account will have a different performance over time, and some will grow at different rates and others may be reduced, the initial allocation of funds will eventually become at least somewhat skewed.

Therefore, many contracts offer a rebalancing function that automatically sells any unit of a given sub-account that exceeds the assigned portfolio percentage and uses the proceeds of the sale to buy additional units of low yield funds. This also helps investors control the profits of fast-growing sub-accounts and increase holdings of funds with relatively low prices.

Life and death benefit riders

Variable annuities have a strong risk of losing your money due to the underperformance of sub-accounts, so companies have developed additional clauses that you can buy to protect the value of your contract. Recipients of death benefits usually promise that the beneficiary of the contract will receive the greater of the current value of the contract, a sum equal to the growth of the original premium at a certain interest rate, or the highest value ever achieved by the subaccounts. Of course, if the current value of the contract exceeds the amounts of these guarantees, the investor can receive this amount in its place.

Example

John invested $ 100,000 in a variable annuity contract at the age of 40. He chose this type of additional clause, and when he is 62, the value of the contract reaches $ 511,000, but it is drastically reduced next year. Dies at age 70, when the value of the contract is worth $ 405, 311. Assuming that the hypothetical growth rate described is 5%, your beneficiary would receive $ 511,000, because it exceeds both the value of the current contract and the hypothetical $ 338, 635 that the contract would have grown to 5% per year until his death.

The beneficiaries of the life benefits guarantee a minimum flow of income at the time of payment, generally based on a hypothetical growth rate. For example, a life benefit may dictate that you will receive a payment equal to what you would get if the contract had grown by a certain percentage each year and then you annuitized it.

Of course, the protection provided by these forms of insurance protection comes at a cost. Investors can expect to pay 0.75% to an additional 1.5% for each type of additional clause purchased, which can have a substantial impact on the overall performance of the portfolio over time.

Do variable annuities fit your plan?

Of all types of annuity contracts, variable annuities tend to attract the widest range of investor types. Aggressive investors can place their money in the sub-accounts of small capitalization, technology and foreign stocks, while conservative investors can stick to the options of fixed, money market or government bonds available within a contract.

Or you can choose to aggressively invest and pay for a rider of life or death benefits to protect growth. Of course, moderate investors will find options that suit them, too. You just need to have enough time before retirement to recover from the potentially bad years in the market.

Variable annuities within IRAs and retirement plans

Deferred tax status, insurance benefits and a wide range of investment options make variable annuities natural options for use as financing vehicles for retirement plans, such as 401k and 403b and IRA plans. In fact, many companies use variable annuity contracts within their retirement plans for these reasons.

However, this practice has long been a source of debate within the financial planning and retirement community. And it has become the source of growing scrutiny by insurance and securities regulators in recent years.

There are several factors to consider in this debate, each of which must weigh carefully if you participate in your employer's retirement plan:

Investor Education Perhaps the biggest problem associated with the use of variable annuities in retirement plans is simply the fact that many people do not understand exactly what they are buying with their retirement savings. In the past, many participating employees believed that they were investing directly in mutual funds and had no idea that they were being purchased within an annuity contract that was housed within their retirement plan. The mechanics of the riders of the benefit of life and death can also be confusing in many cases. The regulatory agencies have adjusted the education requirement of investors in this area for this reason.

Costs and fees When all the costs and charges associated with variable annuities are included, most participants end up paying a total of 2% or 3% of the values ​​of their contracts each year to the annuity company. These rates are superimposed on any fee charged by the retirement plan or the account itself; Many plans charge their own annual administrative or maintenance fees that pass to participants like you.

Insurance protection. Proponents of variable annuities have argued for a long time that the various types of insurance protection offered by life and death benefit riders easily justify the cost. After all, the two largest assets of many homes in the United States are the company's home and retirement plan. Of course, no one would dream of leaving their home without homeowner's insurance coverage. Should not your retirement plan be insured too? This line of reasoning became much stronger after the Enron and Worldcom scandals, as dozens of employees saw the company's stock and related plans evaporate almost overnight. Insurance brokers in variable annuities can avoid this kind of thing.
Commissions . The real deciding factor in many decisions to fund retirement plans with variable contracts has to do with the final result, not yours, but the broker or adviser who recommends the product. Annuities pay commissions that are considerably higher than most other types of retirement products, including mutual funds. This is especially true for large amounts of money. Therefore, many large IRA transfers are placed within these contracts, which compensates the agent for a substantial check. Never discard this factor when you are analyzing the use of annuities within retirement plans.

There is no true right or wrong answer when it comes to whether variable annuities belong to retirement plans. If employees clearly understand what they are buying and paying, and still want the protection offered by the contract, then these products can be very useful. However, many employees do not fall into this category and, instead, would probably receive a better service with a selection of independent funds.

Final word

Variable annuities are complex products with many features that you need to understand clearly in order to use them correctly. These products can achieve many different investment objectives for many types of investors, from conservative to aggressive. In some cases, they may be appropriate vehicles for IRAs and other retirement plans, but not always. For more information on variable annuities, consult your life insurance agent or financial advisor.

What are your thoughts on variable annuities and how do they fit into your retirement plan and investment strategy?