What You Should Know
Variable annuities have become a part of the retirement and
investment plans of many Americans. Before you buy a variable
annuity, you should know some of the basics and be prepared to ask
your insurance agent, broker, financial planner, or other financial
professional lots of questions about whether a variable annuity is
right for you.
This is a general description of variable annuities what they
are, how they work, and the charges you will pay. Before buying any
variable annuity, however, you should find out about the particular
annuity you are considering. Request a prospectus from the insurance
company or from your financial professional, and read it carefully.
The prospectus contains important information about the annuity
contract, including fees and charges, investment options, death
benefits, and annuity payout options. You should compare the
benefits and costs of the annuity to other variable annuities and to
other types of investments, such as mutual funds.
What Is a Variable Annuity?
A variable annuity is a contract between you and an insurance
company, under which the insurer agrees to make periodic payments to
you, beginning either immediately or at some future date. You
purchase a variable annuity contract by making either a single
purchase payment or a series of purchase payments.
A variable annuity offers a range of investment options. The
value of your investment as a variable annuity owner will vary
depending on the performance of the investment options you choose.
The investment options for a variable annuity are typically mutual
funds that invest in stocks, bonds, money market instruments, or
some combination of the three.
Although variable annuities are typically invested in mutual
funds, variable annuities differ from mutual funds in several
First, variable annuities let you receive periodic payments
for the rest of your life (or the life of your spouse or any other
person you designate). This feature offers protection against the
possibility that, after you retire, you will outlive your assets.
Second, variable annuities have a death benefit. If you
die before the insurer has started making payments to you, your
beneficiary is guaranteed to receive a specified amount typically
at least the amount of your purchase payments. Your beneficiary will
get a benefit from this feature if, at the time of your death, your
account value is less than the guaranteed amount.
Third, variable annuities are tax-deferred. That means you
pay no taxes on the income and investment gains from your annuity
until you withdraw your money. You may also transfer your money from
one investment option to another within a variable annuity without
paying tax at the time of the transfer. When you take your money out
of a variable annuity, however, you will be taxed on the earnings at
ordinary income tax rates rather than lower capital gains rates. In
general, the benefits of tax deferral will outweigh the costs of a
variable annuity only if you hold it as a long-term investment to
meet retirement and other long-range goals.
Other investment vehicles, such as IRAs and
employer-sponsored 401(k) plans, also may provide you
with tax-deferred growth and other tax advantages. For
most investors, it will be advantageous to make the
maximum allowable contributions to IRAs and 401(k) plans
before investing in a variable annuity.
In addition, if you are investing in a variable
annuity through a tax-advantaged retirement plan (such
as a 401(k) plan or IRA), you will get no additional
tax advantage from the variable annuity. Under these
circumstances, consider buying a variable annuity only
if it makes sense because of the annuity's other
features, such as lifetime income payments and death
benefit protection. The tax rules that apply to variable
annuities can be complicated before investing, you may
want to consult a tax adviser about the tax consequences
to you of investing in a variable annuity.
Remember: Variable annuities are designed to
be long-term investments, to meet retirement and other
long-range goals. Variable annuities are not suitable for
meeting short-term goals because substantial taxes and insurance
company charges may apply if you withdraw your money early.
Variable annuities also involve investment risks, just as mutual
How Variable Annuities Work
A variable annuity has two phases: an accumulation phase
and a payout phase.
During the accumulation phase, you make purchase payments,
which you can allocate to a number of investment options. For
example, you could designate 40% of your purchase payments to a bond
fund, 40% to a U.S. stock fund, and 20% to an international stock
fund. The money you have allocated to each mutual fund investment
option will increase or decrease over time, depending on the fund's
performance. In addition, variable annuities often allow you to
allocate part of your purchase payments to a fixed account. A fixed
account, unlike a mutual fund, pays a fixed rate of interest. The
insurance company may reset this interest rate periodically, but it
will usually provide a guaranteed minimum (e.g., 3% per
Example: You purchase a variable annuity with an
initial purchase payment of $10,000. You allocate 50% of that
purchase payment ($5,000) to a bond fund, and 50% ($5,000) to a
stock fund. Over the following year, the stock fund has a 10%
return, and the bond fund has a 5% return. At the end of the
year, your account has a value of $10,750 ($5,500 in the stock
fund and $5,250 in the bond fund), minus fees and charges
Your most important source of information about a variable
annuity's investment options is the prospectus. Request the
prospectuses for the mutual fund investment options. Read them
carefully before you allocate your purchase payments among the
investment options offered. You should consider a variety of factors
with respect to each fund option, including the fund's investment
objectives and policies, management fees and other expenses that the
fund charges, the risks and volatility of the fund, and whether the
fund contributes to the diversification of your overall investment
portfolio. The SEC's online publication, Mutual Fund Investing:
Look at More Than a Fund's Past Performance, provides
information about these factors. Another SEC online publication,
Invest Wisely: An Introduction to Mutual Funds, provides general
information about the types of mutual funds and the expenses they
During the accumulation phase, you can typically transfer your
money from one investment option to another without paying tax on
your investment income and gains, although you may be charged by the
insurance company for transfers. However, if you withdraw money from
your account during the early years of the accumulation phase, you
may have to pay "surrender charges," which are discussed below. In
addition, you may have to pay a 10% federal tax penalty if you
withdraw money before the age of 59½.
At the beginning of the payout phase, you may receive your
purchase payments plus investment income and gains (if any) as a
lump-sum payment, or you may choose to receive them as a stream of
payments at regular intervals (generally monthly).
If you choose to receive a stream of payments, you may have a
number of choices of how long the payments will last. Under most
annuity contracts, you can choose to have your annuity payments last
for a period that you set (such as 20 years) or for an indefinite
period (such as your lifetime or the lifetime of you and your spouse
or other beneficiary). During the payout phase, your annuity
contract may permit you to choose between receiving payments that
are fixed in amount or payments that vary based on the performance
of mutual fund investment options.
The amount of each periodic payment will depend, in part, on the
time period that you select for receiving payments. Be aware that
some annuities do not allow you to withdraw money from your account
once you have started receiving regular annuity payments.
In addition, some annuity contracts are structured as
immediate annuities, which means that there is no accumulation
phase and you will start receiving annuity payments right after you
purchase the annuity.
The Death Benefit and Other Features
A common feature of variable annuities is the death benefit.
If you die, a person you select as a beneficiary (such as your
spouse or child) will receive the greater of: (i) all the money in
your account, or (ii) some guaranteed minimum (such as all purchase
payments minus prior withdrawals).
Example: You own a variable annuity that offers a
death benefit equal to the greater of account value or total
purchase payments minus withdrawals. You have made purchase
payments totaling $50,000. In addition, you have withdrawn
$5,000 from your account. Because of these withdrawals and
investment losses, your account value is currently $40,000. If
you die, your designated beneficiary will receive $45,000 (the
$50,000 in purchase payments you put in minus $5,000 in
Some variable annuities allow you to choose a
"stepped-up" death benefit. Under this feature, your guaranteed
minimum death benefit may be based on a greater amount than purchase
payments minus withdrawals. For example, the guaranteed minimum
might be your account value as of a specified date, which may be
greater than purchase payments minus withdrawals if the underlying
investment options have performed well. The purpose of a stepped-up
death benefit is to "lock in" your investment performance and
prevent a later decline in the value of your account from eroding
the amount that you expect to leave to your heirs. This feature
carries a charge, however, which will reduce your account value.
Variable annuities sometimes offer other optional features, which
also have extra charges. One common feature, the
guaranteed minimum income benefit, guarantees a particular minimum
level of annuity payments, even if you do not have enough money in
your account (perhaps because of investment losses) to support that
level of payments. Other features may include
long-term care insurance, which pays for home health care or nursing
home care if you become seriously ill.
You may want to consider the financial strength of the insurance
company that sponsors any variable annuity you are considering
buying. This can affect the company's ability to pay any benefits
that are greater than the value of your account in mutual fund
investment options, such as a death benefit, guaranteed minimum
income benefit, long-term care benefit, or amounts you have
allocated to a fixed account investment option.
You will pay for each benefit provided by your
variable annuity. Be sure you understand the charges.
Carefully consider whether you need the benefit. If you
do, consider whether you can buy the benefit more
cheaply as part of the variable annuity or separately (e.g.,
through a long-term care insurance policy).
Variable Annuity Charges
You will pay several charges when you invest in a variable
annuity. Be sure you understand all the charges before you invest.
These charges will reduce the value of your account and the return
on your investment. Often, they will include the following:
Surrender charges If you withdraw money from a variable
annuity within a certain period after a purchase payment
(typically within six to eight years, but sometimes as long as
ten years), the insurance company usually will assess a
"surrender" charge, which is a type of sales charge. This charge
is used to pay your financial professional a commission for
selling the variable annuity to you. Generally, the surrender
charge is a percentage of the amount withdrawn, and declines
gradually over a period of several years, known as the "surrender
period." For example, a 7% charge might apply in the first
year after a purchase payment, 6% in the second year, 5% in the
third year, and so on until the eighth year, when the surrender
charge no longer applies. Often, contracts will allow you to
withdraw part of your account value each year 10% or 15% of
your account value, for example without paying a surrender
Example: You purchase a variable annuity contract
with a $10,000 purchase payment. The contract has a schedule
of surrender charges, beginning with a 7% charge in the
first year, and declining by 1% each year. In addition, you
are allowed to withdraw 10% of your contract value each year
free of surrender charges. In the first year, you decide to
withdraw $5,000, or one-half of your contract value of
$10,000 (assuming that your contract value has not increased
or decreased because of investment performance). In this
case, you could withdraw $1,000 (10% of contract value) free
of surrender charges, but you would pay a surrender charge
of 7%, or $280, on the other $4,000 withdrawn.
Mortality and expense risk charge This charge is equal
to a certain percentage of your account value, typically in the
range of 1.25% per year. This charge compensates the insurance
company for insurance risks it assumes under the annuity
contract. Profit from the mortality and expense risk charge is
sometimes used to pay the insurer's costs of selling the
variable annuity, such as a commission paid to your financial
professional for selling the variable annuity to you.
Example: Your variable annuity has a mortality and
expense risk charge at an annual rate of 1.25% of account
value. Your average account value during the year is
$20,000, so you will pay $250 in mortality and expense risk
charges that year.
Administrative fees The insurer may deduct charges to
cover record-keeping and other administrative expenses. This may
be charged as a flat account maintenance fee (perhaps $25 or $30
per year) or as a percentage of your account value (typically in
the range of 0.15% per year).
Example: Your variable annuity charges
administrative fees at an annual rate of 0.15% of account
value. Your average account value during the year is
$50,000. You will pay $75 in administrative fees.
Underlying Fund Expenses You will also indirectly pay
the fees and expenses imposed by the mutual funds that are the
underlying investment options for your variable annuity.
Fees and Charges for Other Features Special features
offered by some variable annuities, such as a
stepped-up death benefit, a guaranteed
minimum income benefit, or long-term care
insurance, often carry additional fees and charges.
Other charges, such as initial sales loads, or fees for
transferring part of your account from one investment option to
another, may also apply. You should ask your financial professional
to explain to you all charges that may apply. You can also find a
description of the charges in the prospectus for any variable
annuity that you are considering.
Tax-Free 1035 Exchanges
Section 1035 of the U.S. tax code allows you to exchange an
existing variable annuity contract for a new annuity contract
without paying any tax on the income and investment gains in your
current variable annuity account. These tax-free exchanges, known as
1035 exchanges, can be useful if another annuity has features that
you prefer, such as a larger death benefit, different annuity payout
options, or a wider selection of investment choices.
You may, however, be required to pay surrender charges on the old
annuity if you are still in the surrender charge period. In
addition, a new surrender charge period generally begins when you
exchange into the new annuity. This means that, for a significant
number of years (as many as 10 years), you typically will have to
pay a surrender charge (which can be as high as 9% of your purchase
payments) if you withdraw funds from the new annuity. Further, the
new annuity may have higher annual fees and charges than the old
annuity, which will reduce your returns.
If you are thinking about a 1035 exchange, you should
compare both annuities carefully. Unless you plan to
hold the new annuity for a significant amount of time,
you may be better off keeping the old annuity because
the new annuity typically will impose a new surrender
charge period. Also, if you decide to do a 1035
exchange, you should talk to your financial professional
or tax adviser to make sure the exchange will be
tax-free. If you surrender the old annuity for cash and
then buy a new annuity, you will have to pay tax on the
Some insurance companies are now offering variable annuity
contracts with "bonus credit" features. These contracts promise to
add a bonus to your contract value based on a specified percentage
(typically ranging from 1% to 5%) of purchase payments.
Example: You purchase a variable annuity contract
that offers a bonus credit of 3% on each purchase payment. You
make a purchase payment of $20,000. The insurance company
issuing the contract adds a bonus of $600 to your account.
Variable annuities with bonus credits may carry a
downside, however higher expenses that can outweigh
the benefit of the bonus credit offered.
Frequently, insurers will charge you for bonus credits in one or
more of the following ways:
Higher surrender charges Surrender charges may
be higher for a variable annuity that pays you a bonus credit
than for a similar contract with no bonus credit.
Longer surrender periods Your purchase payments
may be subject to surrender charges for a longer period than
they would be under a similar contract with no bonus credit.
Higher mortality and expense risk charges and other
charges Higher annual mortality and expense risk
charges may be deducted for a variable annuity that pays you a
bonus credit. Although the difference may seem small, over time
it can add up. In addition, some contracts may impose a separate
fee specifically to pay for the bonus credit.
Before purchasing a variable annuity with a bonus credit, ask
yourself and the financial professional who is trying to sell you
the contract whether the bonus is worth more to you than any
increased charges you will pay for the bonus. This may depend on a
variety of factors, including the amount of the bonus credit and the
increased charges, how long you hold your annuity contract, and the
return on the underlying investments. You also need to consider the
other features of the annuity to determine whether it is a good
investment for you.
Example: You make purchase payments of $10,000 in
Annuity A and $10,000 in Annuity B. Annuity A offers a bonus
credit of 4% on your purchase payment, and deducts annual
charges totaling 1.75%. Annuity B has no bonus credit and
deducts annual charges totaling 1.25%. Let's assume that both
annuities have an annual rate of return, prior to expenses, of
10%. By the tenth year, your account value in Annuity A will
have grown to $22,978. But your account value in Annuity B will
have grown more, to $23,136, because Annuity B deducts lower
annual charges, even though it does not offer a bonus.
You should also note that a bonus may only apply to your initial
premium payment, or to premium payments you make within the first
year of the annuity contract. Further, under some annuity contracts
the insurer will take back all bonus payments made to you within the
prior year or some other specified period if you make a withdrawal,
if a death benefit is paid to your beneficiaries upon your death, or
in other circumstances.
If you already own a variable annuity and are
thinking of exchanging it for a different annuity with a
bonus feature, you should be careful. Even if the
surrender period on your current annuity contract has
expired, a new surrender period generally will begin
when you exchange that contract for a new one. This
means that, by exchanging your contract, you will
forfeit your ability to withdraw money from your account
without incurring substantial surrender charges. And as
described above, the schedule of surrender charges and
other fees may be higher on the variable annuity with
the bonus credit than they were on the annuity that you
Example: You currently hold a variable annuity with
an account value of $20,000, which is no longer subject to
surrender charges. You exchange that annuity for a new variable
annuity, which pays a 4% bonus credit and has a surrender charge
period of eight years, with surrender charges beginning at 9% of
purchase payments in the first year. Your account value in this
new variable annuity is now $20,800. During the first year you
hold the new annuity, you decide to withdraw all of your account
value because of an emergency situation. Assuming that your
account value has not increased or decreased because of
investment performance, you will receive $20,800 minus 9% of
your $20,000 purchase payment, or $19,000. This is $1,000 less
than you would have received if you had stayed in the original
variable annuity, where you were no longer subject to surrender
In short: Take a hard look at bonus credits.
In some cases, the "bonus" may not be in your best interest.
Ask Questions Before You Invest
Financial professionals who sell variable annuities have a duty
to advise you as to whether the product they are trying to sell is
suitable to your particular investment needs. Don't be afraid to ask
them questions. And write down their answers, so there won't be any
confusion later as to what was said.
Variable annuity contracts typically have a "free look" period of
ten or more days, during which you can terminate the contract
without paying any surrender charges and get back your purchase
payments (which may be adjusted to reflect charges and the
performance of your investment). You can continue to ask questions
in this period to make sure you understand your variable annuity
before the "free look" period ends.
Before you decide to buy a variable annuity, consider the
- Will you use the variable annuity primarily to save for
retirement or a similar long-term goal?
- Are you investing in the variable annuity through a
retirement plan or IRA (which would mean that you are not
receiving any additional tax-deferral benefit from the variable
- Are you willing to take the risk that your account value may
decrease if the underlying mutual fund investment options
- Do you understand the features of the variable annuity?
- Do you understand all of the fees and expenses that the
variable annuity charges?
- Do you intend to remain in the variable annuity long enough
to avoid paying any surrender charges if you have to withdraw
- If a variable annuity offers a bonus credit, will the bonus
outweigh any higher fees and charges that the product may
- Are there features of the variable annuity, such as
long-term care insurance, that you could purchase more cheaply
- Have you consulted with a tax adviser and considered all the
tax consequences of purchasing an annuity, including the effect
of annuity payments on your tax status in retirement?
- If you are exchanging one annuity for another one, do the
benefits of the exchange outweigh the costs, such as any
surrender charges you will have to pay if you withdraw your
money before the end of the surrender charge period for the new
Remember: Before purchasing a
variable annuity, you owe it to yourself to learn as much as
possible about how they work, the benefits they provide, and the
charges you will pay.