The first Variable Annuity was the College Retirement & Equities Fund (CREF), designed by Teachers Annuity and Insurance Association. Since that time it has grown into one of the most successful and heavily used insurance product in financial planning.
One of the earliest deviations from traditional fixed annuities was the Variable Annuity, which offers the potential for a greater rate of return if the annuity owner is willing to take a greater investment risk. Fixed annuity premiums are deposited in the insurance company's general investment account so that every annuity buyer's funds are commingled and the insurance company takes the risk on the investments it makes as a whole. With a Variable Annuity, however, premiums are invested separately, with the buyer assuming all of the investment risk.
According to a recent Life Insurance and Marketing & Research (LIMRA) Deferred Annuity Buyer Study, 81% of annuity buyers and their spouses own life insurance, compared with 62% of the general adult population. However, only 15% of the 29.4 million economic households owning individual permanent life insurance own an individual annuity (leaving 85% of life insurance owners available for annuity discussion!). And in the same vein, the number of companies that offer Variable Annuities has grown from 48 companies soon after introduction of the product, to approximately 665 companies offering nearly 400 products.39 .
The annuity started as a tax-deferred, simple payout product, but now is an investment “vehicle,” offering tax deferment plus several various payout options, plans that allow for systematic withdrawals, dollar cost averaging and other options.
The primary benefits of variable annuities are:
The benefits, as discussed in detail in this text, are legitimate benefits and should be emphasized by an agent.
Premiums deposited in a Variable Annuity go into a separate account where they are invested in a variety of securities, similar to investing in a mutual fund. Because Variable Annuity premiums are used to buy securities, they are subject to fluctuating market conditions, resulting in a variable rate of return that depends upon the performance of those securities. There are no guarantees about the value of the annuity at any given time since the value depends upon the separate account performance. Not even the principal amount invested by the annuity owner is guaranteed, which means it could be diminished or lost entirely.
Insurance companies continue to add optional types of investment portfolios from which Variable Annuity buyers may choose. Typically, investors may choose from such securities as common stocks, bond funds, U.S. government securities, short-term money market instruments and others depending upon their investment needs. For example, the insurer might offer different funds whose separate goals are long-term growth, capital preservation, high yields, or some combination. The annuity buyer may switch investments, if desired, subject to any insurer limits on the number of times changes may be made.
Historically, over many years, the markets rise and fall periodically but generally provide an average long-term rate of return that is greater than fixed rates. However, regardless of past performance, it is important to note again that absolutely no guarantees are made about the performance of the Variable Annuity separate account.
Because the separate account is invested in securities, Variable Annuities are regulated in part by the Securities and Exchange Commission (SEC) and in part by state insurance departments. The SEC requires that potential purchasers of Variable Annuities must be provided with a prospectus that discloses certain information about the underlying investments. This is the same regulation that applies to all securities Investments, such as mutual funds.
Agents who sell Variable Annuities must be licensed as securities sales people and registered as brokers with the National Association of Securities Dealers (NASD).
FFunds invested in a Variable Annuity separate account are referred to as Accumulation Units.
Rather than buying a certain number of stocks or having a specific dollar value, the buyer purchases "units" based upon the dollars invested and the total value of the stocks on the day of purchase.
A formula is used to determine the value of one Accumulation Unit:
Separate Account Value = Accumulation
Total of All Accumulation Units Unit Value
As an example: The insurance company managed separate account value is $5 million and all of the investors own a total of one million Accumulation Units. Therefore, using the above formula, dividing the $5 million account value by one million total Accumulation Units results in a value of $5 per accumulation unit:
$5,000,000 = $5
1,000,000
Therefore, a Variable Annuity buyer who invests $1,000 when the value of each Accumulation Unit is $5, can purchase 200 Accumulation Units: ($1,000 + $5 = 200)
Because the $5,000,000 account value can change daily according to market conditions, the value of this Variable Annuity could be higher or lower than $1,000 as early as the next day. For example, if the market took a nosedive and dropped to $4,000,000, with everything else remaining equal, the Accumulation Unit value would now be $4. This investment value is now $800 ($4 x 200 Accumulation Units) instead of $1,000.
Conversely, if the market improves markedly to where the separate account value is $6,000,000, and everything else remains equal, this investment value grows to $1,200. Obviously, this is a simplistic illustration of how the values fluctuate, as realistically, within a short period of time the values would fluctuate much more modestly and the total Accumulation Units would change as other Variable Annuity Units are purchased.
Note that while the value of the investment changed, the number of Accumulation Units the individual purchased (200), did not change.
FThe investor will never have fewer Accumulation Units than the number purchased, although the value of those units changes in response to market fluctuations.
Every time investors make additional annuity payments, they buy more Accumulation Units based upon the value of one unit at that time. Using the same example, if the investor would then pay $1,000 to the insurance company, the value of the separate account has risen and so has the total Accumulation Units owned by all investors.
$8,000,000
2,000,000 = $4
Annuity Premium $1,000 = 250 units
Accumulation Unit Value
At this point the investor purchases 250 additional Accumulation Units with the same dollars that previously purchased 200 units, although at this purchase each unit is worth less. This investor now owns 450 Accumulation Units and will always own at least that many units regardless of their value.
Because of the variability that characterizes these annuities, a similar mathematical computation occurs when the liquidation phase begins, as discussed later.
Loading is an addition to the pure cost of insurance that reflects agent’s commissions, premium taxes, administrative costs associated with the acquisition of new business, and other contingencies. The previous examples do not show the effect of loading (as part of the cost to the consumer of a Variable Annuity) on the amount of money that actually goes to work for the investor, nor of other charges imposed by the insurer.
The Variable Annuity has, in many cases, a death benefit which is payable to the heirs, and is, at least, equal to the amount of money invested into the Variable Annuity. This insurance guarantee will cost approximately 0.6% more in fees than a similar investment without this guarantee. In addition, most charge annual account fees from $30 to $40, which also diminish the investor’s total return. Loading and fees are not returned to the customer and do not contribute to the investment value of the Variable Annuity.
F NOTE: For Senior Citizens – those age 65 or older – there is a 30 day cancellation period by law, during which the annuitant or insured may rescind the policy with full refund of all premiums. For variable annuities the premiums may be invested only in fixed-income investments and money-market funds, unless the investor specifically designates that the premium be invested in the mutual funds underlying the Variable Annuity contract. If this occurs, then cancellation shall entitle the owner to a refund of the account value.40
Immediate Variable Annuity fees vary by company, but one survey indicated that they approximate 1.8%. By comparison, some mutual funds will only charge 0.3 percent.41
While most Variable Annuities are deferred annuities, the Immediate Variable Annuity has emerged as an interesting vehicle for some investors.
When an immediate Variable Annuity is purchased, the customer pays a lump sum to an insurance company and immediately starts receiving monthly payment. The payments will rise or fall, just as with a deferred Variable Annuity. And, comparing the immediate Variable Annuity to immediate fixed annuities, some investors like the idea of receiving different amounts each month, depending upon the performance of the stock market. It is generally believed that investments in the stock market will always beat inflation, therefore an immediate Variable Annuity will provide inflation protection that a fixed immediate annuity will not do.
F People who are approaching retirement and have a large sum of money, are the best customers for this type of Variable Annuity.
They have been around for several years, but only within the past 2 years have they grown in popularity. The reason, some experts believe, for the increased interest, is that older “baby-boomers” are willing to take on some risk, probably because the baby-boomer generation simply has not been saving enough, plus there is concern as to whether the Social Security program will continue when they reach retirement age.
However, most financial planners do not recommend an Immediate Variable Annuity if the customer is not of retirement age. It is much less expensive for younger persons to maximize their 401(k) plans first. Actually, it may be cheaper for the person retiring with a substantial 401(k) to simply roll over the money into an IRA and it would be less expensive. It could also be rolled over to a mutual fund for less expense; however, the security of the financial strength of the insurer is not present.
The success of this type of annuities has not been as forecast when the product was first offered for a variety of reasons, including the roller-coasting of the stock market. Another reason was because these annuities are difficult to understand, even for trained professionals in the investment field. Besides having a complex sales process for the marketing of an annuity, the explanation of how an immediate annuity works and the various payout options can be quite overwhelming at times.
The “Exclusion Ratio” was discussed earlier, but Variable Annuities have their own situations and rules. The amount of each Variable Annuity payout can fluctuate. which makes it impossible to determine the total benefits expected. However, assume an Individual had paid premiums of $90,000 and expected to receive payments for 20 years. Dividing $90,000 by 20 years, results in $4,500 per year - representing return of premiums only. Then, for example, if the earnings on the account resulted in the annuitant receiving $6,000 for one year, $1,500 (“interest” paid over and above the $4,500 base) would be taxable. If this annuitant received only $3,000 for one year, none of it would be taxable since it all represents return of premium, no interest. With a Variable Annuity, the exclusion could be recalculated when payments change, following IRS procedures.
One of the benefits of a Variable Annuity is management of the account by professionals when the separate account is company managed. With a company managed account, professional investment managers employed by the insurer decide which particular securities are included in the accounts made available to the investor. Again, this is similar to mutual fund investment management. As a result, the annuity owner is not required to monitor individual securities and decide whether to buy or sell.
For investors who have the time, temperament and desire, a self-directed annuity account might be appealing. Experienced investors can personally choose their investment portfolios and decide how much of each premium will be allocated to the available investment funds. The investor typically may make changes in investment strategies during both the accumulation and liquidation phases. Although the annuity buyer bears the risk of any Variable Annuity, self-directed annuities can be even riskier if the investor does not have the knowledge and ability to follow the stock market carefully and consistently.
The Death Benefit option was briefly considered in the discussion of loading and fees. To continue discussions of this option, as a matter of practice (and of law in some jurisdictions) deferred annuities provide some type of death benefit when the owner dies before liquidation begins. Variable Annuities create a special situation because account values can fluctuate violently - enough to erase any death benefit provided by traditional means. Therefore, insurers have developed innovative optional death benefit provisions in order to guarantee minimum death benefits and take into consideration the potential increases.
A ratcheted or step-up death benefit is an increase in the guaranteed "floor," which is the account value, provided the value of the investments has increased. The increase could occur every five years or at whatever interval the insurance company specifies. If death occurs, the survivors would receive the greater of two amounts: (1) the accumulated cash value (typically premiums paid plus separate account earnings) or (2) the increased value that last went into effect before the annuity buyer died. Under this option, the increase is tied directly to the performance of the underlying investments in the separate account.
The Death Benefit Adjustment is similar to the step-up death benefit. Under this arrangement, at the end of the surrender charge period, the annuity owner may adjust the benefit to match what will be, (it is hoped) the increased value of the account. Again, any increase in death benefits is tied to the separate account performance.
A third death benefit option is more concrete than the ones previously discussed. The Annually Increasing Death Benefit specifies a percentage by which the death benefit will increase each year (e.g. by 5% of the years premiums), with an overall cap of 200%. This is tied only to the amount of premiums paid, not to the performance of the Variable Annuity separate account. At death, the survivors may choose to receive the account value if it is greater than the death benefit provided by this option.
Insurers who offer any of these options typically make them part of the standard Variable Annuity with no additional premium required. Where appropriate, additional costs to the insurer are built into the premium, but for the most part, the annuity buyer is expected to live to the liquidation phase, so annuity death benefit costs are not usually a big risk for the insurance company.
When the liquidation phase begins the insurer starts paying income to the annuitant on a regular basis. The total cash value accumulated for the amount of the lump sum with a single premium payment is annuitized by the insurer using established procedures that consider:
The age consideration involves the annuitant's age when the liquidation phase begins. For example, an annuitant that wants to begin receiving lifetime income at age 55 will receive smaller payments than one who waits until age 65. In the former case, the insurer makes a commitment to pay lifetime income for what is assumed will be a longer period.
As discussed earlier, since some states use “Unisex” ratings, premiums would be the same for male and female. From all of the factors considered (as discussed earlier), the insurer arrives at a certain "fixed" dollar amount of income the annuitant will receive every time an annuity payment is made.
In their original concept of Variable Annuities, one of the "variable” parts of Variable Annuities was the amount of each income payment. However, many annuitants were unhappy with the uncertainty of each payment amount, so insurers now permit payments from Variable Annuities to be determined in the same way as fixed annuity payments, therefore each payment remains constant during the liquidation phase. The amount is based upon the value of the annuity when liquidation begins. Therefore, at the liquidation phase, the only remaining "variable" in the Variable Annuity is the interest rate, or earnings, paid on the remaining principal. While most annuitants (about 90% currently) prefer this type of payout, insurers will make variable fluctuating-amount payouts if the annuitant desires.
Under the original variable payment method, Variable Annuities require a different means to determine the payout. When the liquidation phase begins, the insurer uses the number of Accumulation Units to arrive at a number of Annuity Units. Annuity Units are an accounting measure representing a fixed number of payout units rather than a fixed number of dollars. The determination of the exact number of Annuity Units resulting from the annuity’s accumulation value, is as follows:
First, the insurer determines the dollar value of the accumulation account by multiplying the number of Accumulation Units times the value of each. (This is the same calculation used to determine value during the accumulation period.) If the value of each unit is, for example, $5 and the annuitant has 50,000 Accumulation Units, the value is $250,000.
Then, using annuity tables that consider such things as age, sex (where permitted), the insured’s guarantees and any transaction charges or loading, the insurer then determines the dollar amount that will be paid per $1,000. For example, assume the payment will be made monthly and the tables indicate a payment of $10 for every $1, 000 of value. The annuitant in the example has $250,000 or "250 thousands" - $10 times 250 equals a monthly payment of $2,500, which is the amount the annuitant will receive for the first payment. Once the number of Annuity Units has been determined, that number remains the same during the entire payout phase. However, the value of each annuity unit varies according to the performance of the investments in the separate account. This means the amount of each payment can vary. Sounds complicated? Keep reading…
In the previous example, the value of each annuity unit was $5. Dividing the $2,500 payment by $5 results in the number of Annuity Units - 500 in this case. From this point forward, the monthly payment is equal to 500 Annuity Units times the value per unit at the time the payment is made.
Using the same example, if, during the next month, the value per unit has dropped from $5 to $4, then the monthly will be ($4 times 500) Annuity Units or $2,000. Later during the annuitant's lifetime if the value rises to $7, it would result in a monthly payment of $3,500. Throughout the “liquidation period” fluctuations continue as the separate account investments fluctuate.
Fixed annuities have been perceived as essentially risk-free in terms of safety of the principal amount invested. The primary risk associated with fixed annuities was inflation risk - the possible loss of purchasing power resulting from high inflation. Variable annuities, on the other hand, greatly increase the investment risk to the annuity owner with the hope of offsetting the inflation risk. To reiterate the obvious:
FThe higher the risk, the greater the reward.
Insurance company annuities have on occasion, been compared negatively to bank savings instruments in regard to safety of principal since bank deposits are protected by deposit insurance and annuities are not. However, careful selection of the insurance company that provides the annuity virtually eliminates the question of financial soundness. Also, remember the previous chart that shows comparative results of annuities and CD’s.
As for risks involving future income, only an annuity can guarantee a lifetime income stream to the buyer. For example, money deposited in a savings account and withdrawn periodically during retirement can run out eventually. But the annuity buyer can be guaranteed lifetime income even if the annuitant is still alive when the original principal and interest amounts are depleted.
While both fixed and variable annuities are capable of earning a competitive rate of return, Variable Annuities, in particular, provide greater opportunity to earn a higher rate of return on investments in the separate account but, of course, earnings may fluctuate during the life of the annuity. Interest rate guarantees vary widely among insurers, providing a broad range of options. Careful shoppers will also look at the investment management track records of companies offering Variable Annuities. While past performance is no guarantee of effective future account management investors can identify companies whose annuity returns have increased over time.
To repeat so that it will always be remembered,
F not only have annuity interest rates become competitive with other investment products, but annuities also enjoy deferral of income taxation on earnings.
Returns on bank products and securities are taxed as current income in the year they are paid to the investor. Even Variable Annuities, with their reliance upon securities to determine income, are eligible for tax-deferred interest.
Annuities are not as easily converted into cash as some investments, bank accounts for example, but they are relatively liquid subject to certain costs. Since annuities are intended to be long-term investments, penalties are assessed under certain circumstances if the owner withdraws all or part of the annuity's value. These charges can be substantial in some situations.
Typically, the annuity owner can withdraw 10% during the first year, with an additional 10% increase each year until the final year of the annuity term. As an example, with a 7-year annuity period, the first year 10% could be withdrawn without penalty, the second year it would be 20%, 30% the third year, etc., until the end of the accumulation (annuity) period.
Some of the plans offer surrender-free withdrawals for terminal illness, for confinement in nursing homes, and other similar situations.
Many are the agents who have lost an existing annuity case by way of a Section 1035 exchange to another annuity that offered an extra credit payment (See following discussion on Extra Credit Annuities). Or perhaps the client wanted to know why he (or she) is paying over 200 basis points in Variable Annuity fees while at the same time, his brother-in-law pays less than 100 basis points on an annuity purchased directly from a mutual fund company. Perhaps the agent lost a sale because a competitor’s product offers a guaranteed minimum income benefit.
As with most things nowadays, new annuity products seen to appear every month and even more companies are offering annuities. While it may be is good for the consumers, it makes it more difficult for the agent to determine which products are best for the interests of the customers.
The first thing that a true professional should do would be to determine whether the annuity has certain important features that must be present on all annuities offered to customers, keeping in mind that annuities for those over age 60-65 have severe restrictions, particularly in replacement of existing annuities. According to professionals, the proper annuity should always have all of the following four features.
An analogy could be the purchase of an automobile. While Dad would love to have a Corvette, Mom might not feel that it is appropriate, considering that she is 7 months pregnant – and with their 3rd child. And even a family van with leather seats and built-in television, might not be the right car if they lived on a ranch accessed only by a 3-mile dirt road that can be deep in snow in the winter (can anyone spell SUV?). Similarly, extra features do not make an annuity the right choice for the agent’s prospects if the product doesn’t meet their needs or if it obviously is not the proper product to begin with.
More than 10 companies offer “Extra-credit” annuities, and they have become quite popular. These Variable Annuities (VA) credit investors’ payments with an additional payment, generally ranging from 3% to 5%. One of the most frequent usages of this annuity is for Section 1035 exchanges. Unfortunately, some agents have moved annuities by explaining that their current annuity has a surrender charge of 2% (as an example) while the proposed annuity will pay a bonus of 4% (example). This, therefore, covers the surrender charge plus credits an additional 2% to the account.
While this sounds good, one must always remember that insurance companies are not in the business of “giving away” money. If something sounds too good to be true, it probably is. While there are differences among the various extra-credit products, it should be kept in mind that most of them come with high charges – known as M+E (mortality and expense, plus administration) charges, plus investment management fees, high surrender charges, and limited standard death benefits.
In reviewing six of the most popular of these contracts, it is interesting to note that all six contracts have surrender charges that are longer and higher than most VAs. As an example, the lowest surrender charge in the fourth year is 7%, 6% in the fifth year, and 3.5% in the seventh year — all of which are much higher than the average VA.
Obviously, the higher fees associated with the extra-credit annuities will lessen the benefits of the extra-credit payments over a period of time.
CONSUMER APPLICATION
Ridley, a financial planner and agent, has a 60 year old client with an annuity valued at $100,000. James, an insurance broker, suggested to the client that they move the annuity into an extra-credit annuity. By doing this, the client would receive a bonus of $4,000, just for exchanging the annuity. However, this would fall a little short of the $4,100 surrender charge that would be charged against her account.
Since this is almost a “wash”, the client reported this to Ridley, who pointed out that the fees on the extra-credit product were 30 basis points higher than the current product. These fees would reduce her account value by about $25,000 after 20 years - and more than $80,000 after 30 years (assuming a steady 10% growth per year before fees).
Ridley also pointed out that there would be a new surrender charge when the client purchased the replacement annuity. With her current annuity, the client would be free of any surrender charge after three more contract years. On the other hand, the extra credit annuity imposed a 7% sales charge for the first four contract years, 6% in the fifth year, 5% in the sixth year, and 4% in the seventh year.
Ridley also discovered that the extra-credit product did not offer a better standard death benefit than the one the client she currently had. Then, as frosting on the cake, the company offering the extra-credit has a lower rating than the existing annuity carrier.
This is not to say that extra-credit products are never appropriate. However, a professional will carefully weigh all of the product’s costs and features when doing any comparison. Since the extra-credit annuities have higher fees than many other VA’s, these fees will generally offset the bonus payment over a period of time. Further, if the product is being used as a Section 1035 exchange vehicle for contracts still subject to surrender charges, the performance will suffer further as the bonus is partially or fully offset by the surrender charge.
The SEC (Securities & Exchange Commission) has no particular disclosure forms for Variable Annuity exchange transfers, other than generalities to the effect that there should be a rather detailed disclosure of the transaction which would aid the contract owners in determining whether it is in their best interests to exchange.
Be this as it may, the SEC has recently given considerable attention to any exchange offer that involves the “bonus” credit program and it has stated concerns about any higher surrender changers and fees associated with the bonus programs. It has required insurance companies to keep records concerning the exchange activity and how is related to the total number of contract owners that are eligible to exchange, the persistency of the new contracts and number, types, and details of complaints made about such exchanges. These records must be made available to the SEC during examination.
The SEC recently produced an educational brochure, “Variable Annuities – What You Should Know,” available on its Web site for investors, and within that brochure, they address the bonus credit plans and caution investors to carefully “take a hard look at bonus credits” before entering into an exchange.42
Brokers-Dealers who are involved in such exchange situations – including supervisory and suitability requirements – should be aware that the NASD has taken a leaf from the SEC’s book and issued an “Investor Alert” cautioning investors who are considering an exchange and in particular, those with a bonus credit plan, to only make the exchange “when you determine…that it (the exchange) is better for you and not just better for the person who is trying to sell the new contract to you.”43
An insurance company or mutual fund company may direct-market annuities directly to consumers with the result that the annuities have lower total costs as a result of low M+E charges. One might understandably feel that an agent cannot compete with direct-marketed annuities. However the client usually gets what they pay for.
A review of the 10 most popular direct-marketed annuities shows their average total expense is 124 basis points, 86 basis points lower than the average VA.44 Not good news for an agent trying to compete! But a legitimate comparison would take into consideration whether the other VA offers additional features or options to justify the added expense. Another, deeper, look at these same 10 direct-marketed annuities, reveal some interesting facts:
Additional benefits are living benefit options that provide additional guarantees to the policy owner. Some of these benefits are:
While these benefits are worthwhile for many customers, as with many extra-credit products, the options are only as good as the underlying product, and an inferior product with a living benefit still is an inferior product. And, as usual, there is generally an additional fee for these options that limits the account’s growth potential. An extra 25 or 30 bps can limit the client’s growth potential by tens of thousands of dollars over the contract’s life. In some cases the expense might be worth it, but the benefits should be weighed against the additional cost.
However, the person must annuitize and usually must take a fixed annuitization. This can rightfully be conceived as a negative. While the monthly payment is guaranteed, the amount over the years may not be as high as it could be with variable annuitization which could possibly harm the client financially during inflationary periods. This is one of the most misunderstood options.
When discussing the appropriateness of a product for a particular client, one should consider if the fees and loads are appropriate for the situation. As an example, a no-surrender-charge product may be appropriate for an older prospect but not for a younger prospect because of tax considerations. The fees should be considered in respect to the death benefit (and other product features). For instance, is the M+E lower than other products but are the sub-account fees higher? The availability of diversifying investments may be of considerable importance to the particular annuitant.
The death benefit can be very important when marketing variable annuities. The death benefit actually assures the buyer that his/her investment is protected in a falling market if the buyer were to die. The living benefit guarantees the client of a certain amount of income or value in a falling market. This assurance can be quite meaningful when the buyer is looking for retirement security or looking for protection for a spouse or other heirs.
Since there is a mortality and expense charge by the insurer in a Variable Annuity, the question arises whether the expense and mortality charge affect the overall performance of a Variable Annuity. This question may come up when dealing with a particular astute investor. The cost can range from 0.5 percent per year to 2 percent per year, depending upon the specific benefit of combination of benefits desired. This, obviously, reduces the investment earnings, so it is subject to criticisms on occasion. While this is true, the cost must be weighed against the risk protection that a purchaser of an annuity derives from the fact that the annuity has living and death benefit guarantees.
Variable Annuities are generally tax-favored investment products when purchased by an individual on a non-qualified basis. When purchased as part of a qualified retirement plan, such as an IRA, 401(k),TSA-403(b), or Deferred Compensation Plan, they are taxed under the special tax provisions governing that qualified retirement plan.
The Taxpayer Relief Act of 1997 brought two key changes that can affect Variable Annuities as to their marketability.
In a Roth IRA, as long as the money stays in the IRA for at least 5 years, and it is not withdrawn before retirement; the funds are withdrawn tax-free. If, conversely, the money was put into a Variable Annuity, the annuitant would pay tax at the ordinary income tax rate at retirement. (Also there are restrictions for Roth IRA – single income must be below $95,000, or $150,000 married filing jointly.) Since there are no restrictions as to income for a Variable Annuity, if a person made too much money to contribute to a Roth IRA and trades too actively to enjoy the long-term capital gains rate, a Variable Annuity would be the way to go.
In contract to mutual funds where income is taxed at capital gains rates, the taxation of all income from a Variable Annuity is at ordinary income rates, and this should be considered when variable annuities are marketed. One should be aware, however, that that difference may not be as significant for many investors as most think.
One method of analyzing the effects of capital gains rates is to calculate the “break-even holding period” which is the number of years of accumulation at which time the after-tax return from a Variable Annuity becomes equal to that of a mutual fund investment of comparable values. A second way to compare the performance of a Variable Annuity with that of a mutual fund is to calculate the total after-tax pay-out that can be funded by a Variable Annuity and compare that to the total after-tax pay-out that can be funded by each after a particular accumulation period.
The Variable Annuity has proven that it is a formidable financial planning tool and with its “sister” annuity, the Equity Indexed Annuity (discussed later) has grown significantly in usage for estate and financial planning purposes. Some of those applications are:
CONSUMER APPLICATION
Loren is 42 years old and inherited $25,000. He did not really need the money at this time so he purchased a Variable Annuity. The annuity returns 7% after subtracting a management fee and other expenses - which include a mortality fee that guarantees that when Loren dies, the Variable Annuity will not be less than $25,000.
20 years later, Loren reaches age 62 and is concerned about retirement funds; the $25,000 has now grown to $97,000, an increase of $72,000. This amount ($72,000) is considered regular income and not as a capital gain. Depending upon the tax laws, it is possible that Loren’s taxes may be higher than if the money had been invested in a mutual fund if capital gains taxes are lower than taxes on regular income. It would probably be best for Loren to take a series of payments, instead of a lump-sum payment, which would spread the taxes out over the payment period.
If the stock market should collapse after Loren has had the Variable Annuity for about 3 years, unfortunately Loren would have to pay a sizeable penalty for early withdrawal should he desire to do so. However, since a Variable Annuity should be purchased as a long-term investment, the market should probably also go up again before he annuitizes.
CONSUMER APPLICATION
Chris and Bertha are in their 70’s and received $100,000 from the sale of the estate of Bertha’s sister. They have been retired for several years and really do not need additional retirement funds. They contact their agent, Lambert, who is an insurance agent and registered representative. They told Lambert that they wanted as much of this money available as possible in case of an emergency. Also, they wanted as much money available as possible to the survivor when one of them died.
Lambert recommended a Variable Annuity because of the tax-deferral features and because of the growth of the stock market. Lambert had to search the market in order to find the “right” Variable Annuity, i.e. an annuity that provided the best returns and still allowed an easy “way out” in case of an emergency. He found a product with a 1.25% insurance and administrative charge. The product had a death benefit, which was equal to the highest account value the contract had ever reached. It also allowed for early withdrawal for certain situations, nursing home confinements, terminal illness, divorce and disability, plus it had a death benefit feature that resets the contract value each anniversary, and then arrives at a guaranteed amount at age 81.
It also had an optional death benefit which pays 15% of the annual contract growth as an estate benefit which means that the surviving spouse can have the money if they so desire, or it can be kept in the contract if they do not need the money immediately
Under this option, the surviving spouse would incur no income taxes, and the taxes can be deferred throughout his/her lifetime. This amount is added to the contract value and if not paid out, it will continue to grow, in effect increasing the size of the estate. On an annuity of $100,000, over 10 years this $15,000 would grow into nearly $30,000 (at continued growth of 7% which would be far surpassed if the stock market continues to grow at the rate it has over the past 10 years) which could be used to help pay taxes if this money is needed, or it can be passed to the heirs.
Under federal regulation, the SEC must provide prior approval for substitution of underlying securities of a unit investment trust and, “(i)t shall be unlawful for any depositor or trustee of a registered unit investment trust holding the security of a single insurer to substitute another security for such security unless the Commission shall issue an order approving such substitution.”45 The SEC views this as applying to substitutions initiated by insurers as well as to substitution taken by insurers in response to actions taken by an underlying fund or its sponsor, such as the liquidation of a fund portfolio.
The number of substitutions filed by insurers has increased considerably because of competition and the introduction of a wide array of investment options, plus the reduction of the number of fund groups available in the Variable Annuity product. Also, insurance companies have more often switched to affiliated underlying funds due to increasing number of insurers becoming part of financial conglomerates, etc. The insurers have appreciated increasing revenue by including funds that will pay the insurer for performing administrative services on behalf of the funds, and insurers do like an additional source of income.
The SEC does not approve all substitution applications, and in recent months have concentrated on certain areas in determining whether they should grant an application.
Generally speaking, the SEC will not approve a substitution unless the new fund’s expenses are capped at the old fund expense levels for a period of time following the substitution. If the insurer finds this difficult to do, then the SEC can require them to lower the separate account or contract level fees to provide such a cap on the new fund and subaccount expenses that are absorbed by the contract owners.
Sometimes, making it tougher, the SEC may require that the insurer will not receive, immediately and up to 3 years in the future, after the date of substitution, any direct or indirect benefit greater than the insurer would have received from the old fund.
The SEC has expressed concern that the new fund would have a greater amount of (what they call) “fundamental risk” than the old fund.
In certain situations, such has when the new fund has a higher investment advisory fee, the SEC may require that the insurer obtain the contract owner’s permission for the substitution.
STUDY QUESTIONS
1. The Variable Annuity was introduced as it offered a potential for a greater rate of return if
A. the agent is willing to sell it with no commission.
B. the annuity owner is willing to pay 150% of the premium of a fixed annuity.
C. the annuity owner is in a very low tax bracket.
D. the annuity owner is willing to accept a greater investment risk.
2. Agents who sell Variable Annuities
A. must be licensed as securities salespeople and registered brokers with the NASD.
B. need only an insurance agent’s license.
C. may not market or participate in the marketing of any other product.
D. must hold both a life/health license and a property/casualty license.
3. Funds invested in a Variable Annuity separate account are referred to as
A. exclusion ratios.
B. indigenous accounts.
C. accumulation units.
D. accumulation accounts.
4. An addition to the pure cost of insurance that reflects agent’s commissions, premium taxes, administrative costs of acquiring business and other contingencies, is called
A. loading.
B. accumulated charges.
C. P&E.
D. extraneous charges.
5. With a Variable Annuity, if the value of the investments has increased, an increase in the guaranteed floor for the death benefits is called
A. the adjusted death benefit.
B. a sub-limital death benefit.
C. a ratcheted death benefit.
D. the exclusion ratio.
6. With the new generation of Variable Annuity, at the liquidation phase the only remaining “variable” is
A. the premium.
B. the amount of income payment.
C. the commissions paid the agent.
D. the interest rate, or earnings, paid on the remaining principal.
7. In considering the risk of a Variable Annuity as compared to a fixed annuity, a basic premise that should always be remembered is
A. the higher the risk, the greater the reward.
B. the lower the risk, the greater the reward.
C. the greater the risk, the lower the income.
D. a “variable” product always increases in value more than a mutual fund.
8. Not only have annuity interest rates become competitive with other investment products,
A. but annuities have no deferral of income taxes on earnings.
B. but annuities also have deferral of income taxes on earnings.
C. but now all annuities of any time, variable or fixed, are under the control of the SEC.
D. but the majority of investors now invest in variable and fixed annuities for all purposes.
9. A Variable Annuity that credits investor’s payments with an additional payment is called
A. an “extra-credit” or “bonus” annuity.
B. an equity-indexed annuity.
C. an add-on annuity.
D. a 1035 annuity.
10. When a Variable Annuity is purchased as part of a qualified retirement plan, such as an IRA or 401(k),
A. they are then tax-free for the life of the annuitant.
B. they are taxed as ordinary income each taxable year.
C. they are taxed under the special tax provisions governing that qualified retirement plan.
D. income taxes on the portion contributed by the employee is due each quarter.
ANSWERS TO STUDY QUESTIONS
1D 2A 3B 4A 5C 6D 7A 8B 9A 10C