A variable annuity is a contract between the investor, you, and the issuer of the annuity, an insurance company, by which you give the issuer a principal or a batch of payments and the issuer guarantees periodic variable payments over a period, starting at that point or at any future date. These are issued by insurance companies but they are not insurance policies.
These amounts are linked to various investment options, normally a mutual fund. You can choose to link to any of the investment options on offer, and the value of your annuity will vary as per these investment options.
Now though they are linked to mutual fund-like investment options, they differ from mutual funds in three distinct ways -
- Variable annuity offers you regular payments for the duration of your life or your nominee's life. Even if you outlive your assets, this will offer safety.
- Even in case of death of the investor prior to the start of the periodic payments, the issuer will pay a minimum guaranteed amount (at least equal to the purchase payments).
- No taxes are due on the income earned from the investment on the variable annuities, until it is withdrawn. Even if there is a transfer of value from one investment option to another within this issue, there is no tax levied. It is possible to benefit from this by using variable annuity investments as a long-term investment, as for retirement savings.
Variable annuities have two phases in their life -
Phase 1 is the accumulation phase, where you make payments towards investment in different portfolios of investments, which start accumulating income for you.
Phase 2 is the payout phase where the earnings, which have accumulated over the accumulation phase, are paid out either immediately, immediate annuity, or at a later date, deferred annuity.
Since the annuity value will fluctuate depending on the behavior of the investment portfolio, the variable annuity is subject to fluctuations with a risk of loss. The importance of understanding the way variable annuities behave and the terms involved with these annuities cannot be overemphasized. Let's take a quick look at some of them.
1. All benefits under the scheme are chargeable. Understand all charges before availing of the benefit, as they diminish the value and the return on investment. Try to see if the same can be enjoyed through some cheaper option.
- Surrender or sales charges are charged when withdrawal happens within a defined period of the purchase premium and is seen as payment to the professional who sells to make the withdrawal value. These charges reduce over the life of the annuity.
- Mortality and expense risk charge pays for the insurance risk undertaken by the issuer in a variable annuity.
- Administrative fees for documentation/archival etc.
- Underlying fees, which are those charged for the underlying investments, the mutual funds and so forth linked to the variable annuity.
- Other charges for benefits enjoyed like stepped up death benefit, guaranteed minimum income benefit etc.
2. Tax benefits
- It may be beneficial for regular investors to use other investments that enjoy tax-deferred status, like 401k or IRA contributions, before going in for variable annuity for the same benefit.
- If the variable annuity is being used under a tax relief or advantaged scheme, then there will be no extra tax advantage above that.
- Sec 1035 of US Tax Code allows exchange of one annuity contract for a new annuity contract, without attracting any tax on the income earned so far on the existing account. However, the cost of surrender charges, the beginning all over again of a surrender period for the new annuity contract, the tax attracted if the old annuity was given up for cash, etc must be carefully analyzed in view of the benefits you see accruing from the new annuity.
- Bonus credit, of adding on a percentage to your contract value if a specified percentage of purchase payment is made, is offered on some annuity contracts. These, however, are normally charged back to the investor through hiking up any of the other charges levied, like surrender charges or any such.
Understand everything about the variable annuity contract before investing in one. Don't hesitate to put questions to your finance professional, and you shouldn't rest until you have all the answers. You have to be clear about where your investments are going, and once convinced they meet your needs, go ahead and invest.