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Variable Annuities

Variable annuities have become part of the retirement and investment plan for many investors. Before you consider purchasing a variable annuity, you should know some of the basics. Variable annuities provide a variety of services and benefits that help make investing simple, accessible and affordable. It is important to realize that these benefits and services come with a cost.

Variable annuities are generally designed to be long-term investments to meet retirement and other long-range goals. Variable annuities are generally not suitable for meeting short-term goals due to charges that may be imposed if you withdraw your money early. Variable annuities also involve investment risk. The following is a general description of variable annuities — what they are, how they work and the charges you can expect to pay.

What is a Variable Annuity?

Variable annuities are long-term, tax deferred investment vehicles designed for retirement purposes and contain both an investment and insurance component. They are sold only by prospectus.

A variable annuity is a contract between you and an insurance company where the insurance company promises to make periodic payments to you, starting immediately or at some future time. You buy the annuity either with a single payment or a series of payments. An annuity generally provides for two stages:

  • The accumulation period, during which contract values build (and receipt of income is deferred), and
  • The payout period, when values are distributed.

In a variable annuity, assets are accumulated by investing in various stock, bond and money market portfolios called subaccounts. As its name implies, a variable annuity’s rate of return is not stable or guaranteed, but varies with the subaccounts you choose as investment options. The investment returns and principal value of the available subaccount portfolios will fluctuate sothat the value of an investor’s unit, when redeemed, may be worth more or less than their original value. There is a risk that you will lose money. Most variable annuities will also offer a fixed interest rate account, providing a set return guaranteed by the insurance company, in combination with the variable investment options.

Variable annuities may impose a variety of fees upon the investor, such as: surrender charges, which may be imposed upon withdrawals from the annuity before a specified period; mortality and expense risk charges, which the insurance company charges for the insurance risk it takes under the contract; admin­istrative fees, for recordkeeping and other administrative expenses; underlying fund expenses, relating to the subaccount investment options; and charges for special features, such as a stepped-up death benefit or a guaranteed minimum income benefit. For further explanation, please read the complete section on Expenses and Fees.

Parties to an Annuity Contract

There can be several parties named in an annuity contract. It is important to decide who should be named for each party prior to investing.

  • Contract Owner - The owner has control of the contract.
  • Annuitant - Named by the contract owner, the individual(s) upon whose life annuitization payments are based. (The contract owner and the annuitant can be and often are the same person.)
  • Beneficiary - Recipient of the death benefit at the death of the contract owner or, in some situations, the death of the annuitant.
  • Insurance Company - The issuer of the contract.

Guarantees

The guarantees (e.g., death benefit, living benefit, and payout options) in a variable annuity are made by the insurance company issuing the contract. Guarantees are based on claims paying ability of the issuer. There are several credit rating agencies (e.g., Moody’s Standard and Poors) that rate the financial strength and claims paying ability of insurance companies.

Potential Benefits

Annuities provide many features that offer a variety of investment options and potential benefits. The potential benefits include the following:

  • Diversification within each portfolio and among investment choices to help reduce risk.
  • Professional management among investment options.
  • Tax-deferred growth of earnings until withdrawn. Withdrawals prior to age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.
  • Ability to move money between subaccount investment options inside the annuity without incurring a tax liability.
  • Ability to allocate money to both a fixed interest rate subaccount (which is offered in many contracts) and stock and bond subaccount investment options – all within one product.
  • No IRS annual limit to the amount invested.
  • A guaranteed death benefit, depending on the contract and the owner’s age. Often available to contract holders through the maximum issue age, this may ensure that beneficiaries will receive at least the full amount of money that has been invested, less withdrawals, in case of death during the accumulation period. Many death benefit features are not available for purchase over certain contract issue ages (e.g., 75). It is also common to see death benefit features suspended once the contract owner reaches a certain age (e.g., 75). Under these circumstances, the death benefit payout may comprise account value only.

Other optional death benefits may include, at an additional cost:

High Anniversary Value

On the annual anniversary of the contract’s issuance, the account value is compared to that of all prior anniversaries. At death (of either owner or annuitant, depending on the contract), the highest anniver­sary value is paid to beneficiaries.

Annual Step-Up

The account value is guaranteed to increase annually at a set percentage (e.g., 5%). This feature may also be referred to as a ratcheted death benefit.

Earnings Enhancement

In order to help beneficiaries pay the tax on the gain in the contract, some contracts pay the benefi­ciary an additional percentage (e.g., 25% – 40%) of earnings. Of course, a death benefit only ensures against market loss if the contract is in force at the time of death of either the owner or annuitant, depending upon the contract.

A living benefit

In order to provide a minimum guarantee of income or principal, many contracts offer various optional riders at an additional cost. Many living benefit riders are available only if you invest in subaccount investment options dictated by the insurance company. Such optional riders offering guaranteed benefits have limitations and restrictions such as minimum holding periods and age requirements.

Income Benefit

The guaranteed value increases annually at a set percentage (e.g., 5%). After a pre-determined waiting period, you may access the guaranteed value. In many contracts, in order to access to the guaranteed value, you must annuitize the contract, i.e., take a guaranteed stream of income for a period extending over your lifetime.

Withdrawal Benefit

This feature will enable you to withdraw a set percentage (e.g., 5%–7%) per year the guaranteed amount. In the event of a market loss of the initial premium, you may still continue to take set with­drawals until the guaranteed value has been reached.

Return of Premium

After a set number of years (e.g., 7), the premium is guaranteed regardless of market performance.

  • Annuities generally permit investors to invest with one single sum, or to invest periodically. A contract holder may then allocate assets among the different subaccount investment options that are available.
  • The U.S. tax code allows tax-free “1035” exchanges whereby an existing variable annuity contract may be exchanged for or replaced with a new annuity contract while deferring any tax on the income and investment gains in the original variable annuity account. 1035 exchanges can be useful if another annuity has preferable features such as death benefit options, living benefit options, different annuity payout options or a wider selection of subaccount investment options. A surrender charge, however, may be incurred and/or a new surrender charge period may begin when the annuity is exchanged. (See Expenses and Fees.) You should exchange your annuity only if the new contract will provide you with an investment advantage.

You will pay for each variable annuity benefit you receive (See Expenses and Fees). If you don’t need or want these features, you should consider whether this is an appropriate investment for you.

Expenses and Fees

Several charges may be incurred upon investing in a variable annuity. It is important to understand all the charges before investing. Additionally, certain other features of variable annuities should be considered before making an investment decision:

  • Contract Fee - An annual fee deducted directly from the annuity assets.
  • Mortality and Expense Risk (“M&E”) Fee - An asset-based charge applicable to only the variable subaccounts that may not increase for the life of the contract. The M&E fee covers death benefit costs and the guaranteed ability to annuitize at a rate established in the contract at the time of purchase.
  • Administrative Charge - An asset-based charge covering the maintenance of the contract, including record-keeping and other administrative expenses.
  • Management Fee - An asset-based charge used to pay the portfolio manager’s of the subaccounts.
  • Premium Tax - A tax imposed by some states applied to contributions made to the annuity.
  • Surrender Charge - Also referred to as a contingent deferred sales charge (“CDSC”), imposed on the contract owner for early withdrawals from the contract made before the end of the period stated in the contract’s prospectus, which varies. Some contracts charge a CDSC for three to seven years, or longer, from the date of each deposit.
  • If an existing variable annuity contract is exchanged for a new annuity contract, a CDSC may be incurred on the original annuity if it is still within the CDSC period. In addition, a new CDSC period may begin for the new annuity.
  • Additional fees or longer surrender charge periods may apply to contracts that include a stepped-up death benefit, a living benefit, or on any product that provides a bonus amount added to a contract by the insurance company at the time of purchase.

All expenses and fees should be discussed with a financial adviser prior to purchasing a variable annuity.

Payout Options

Variable annuities offer a number of payout plan options. Each option has tax implications that should be explored before making a decision.

The three primary payout options are:

  • Lump Sum - In which all assets are withdrawn and all taxes due are paid. This option generally results in the highest tax liability.
  • Systematic Withdrawal - Which pays a preset amount at regular intervals until all assets have been withdrawn. With this option, all taxable growth must be withdrawn before tax-free principal may be accessed. This option provides flexibility in the payment amount or schedule, but assets may be exhausted with many years left in retirement.
  • Annuitization (a Stream of Income Payments) - Through which the insurance company guarantees to provide the contract owner with income for a certain period of time or for the rest of the contract owner’s life. Funded with accumulated values, annuitization options can be customized to suit personal needs. The ability to change the stream of payments may be limited. A portion of each payment the contract owner receives is treated as a return of principal which spreads out the tax liability. There may be a number of ways to receive income payments.

Some common annuitization options are:

  • Lifetime Income for One Person - The insurance company guarantees that the annuitant will receive income payments for the rest of the annuitant’s life. Payments cease at the annuitant’s death.
  • Lifetime Income with a Guarantee Period - The annuitant will receive an income for his or her lifetime. If the annuitant dies before the guarantee period is over, the beneficiary will receive the payments remaining per the original guarantee period, also know as a “period certain.”
  • Lifetime Income for Two People - (Usually referred to as “Joint and Survivor”) Income payments will be received as long as one of two designated people is alive (frequently husband and wife). Upon death of either person, income will continue to the survivor until his or her death. At the death of both people, payments cease unless the option was accompanied by a set guarantee period, in which case, the beneficiary will receive payments remaining per the original guarantee period.
  • There are two types of annuities in the payout period: Fixed (in which each payment is a fixed dollar amount) or Variable (in which the amount of each payment reflects changes in the market value of underlying stock and/or bond portfolios).
  • Fixed Income Payments - The annuitant will receive a fixed dollar amount at regular pre-determined intervals. The amount received will depend on the annuitization option selected. The amount of each payment will always be known, but over time this choice may not keep pace with inflation.
  • Variable Income Payments - Payments will vary based on the performance of the underlying investment. This means that income payments may decline in periods of market decline. The possibility of increased payments in rising markets also exists which may provide the opportunity for income to keep pace with inflation during retirement.

What are the Tax Implications Associated with an Annuity?

The tax rules that apply to variable annuities can be complicated. Before investing, a tax advisor should be consulted about the tax consequences of purchasing a variable annuity. While there may be other circumstances that impact the tax implications of investing in a variable annuity, some common characteristics of annuities are:

  • Annuities accumulate tax deferred.
  • Taxation of gains (at ordinary income tax rates), occurs only when money is withdrawn from the contract or when the proceeds from the contract are paid to a beneficiary.
  • Prior to annuitization, the value of the contract is included in the estate of the contract owner at death.
  • Distributions made prior to age 59 1/2 may be subject to a 10% federal.
  • Income tax penalty (on earnings).
  • Annuitization provides tax-advantaged income payouts.
  • At death, variable annuity values avoid probate.
  • At death, proceeds of variable annuities do not receive a “step-up” in cost basis.

Variable Annuities in Qualified Accounts

Investing in a variable annuity in a tax qualified retirement account (such as a 401(k) plan or IRA) does not provide any additional tax deferred treatment of earnings beyond the treatment provided by the tax qualified retirement plan itself.

Under these circumstances, a variable annuity should be purchased only if it makes sense because of the annuity’s other features such as lifetime income payments, living benefits, or death benefit protection. Purchasing a variable annuity in a tax qualified account may increase the expense of the tax qualified account.

Summary

Before investing in a variable annuity, read the prospectus and any company product literature thoroughly. Consider:

  • Investment objectives and investment time horizon.
  • The investment choices offered and their long-term historical performance.
  • The reputation of the portfolio managers of the different subaccounts.
  • The financial strength of the insurance company.
  • How the death benefit is determined.
  • The ability to withdraw money during the accumulation period.
  • The income payout options offered.
  • Total fees and expenses (including withdrawal charges) associated with the variable annuity.

Additional information may also be obtained on the Securities and Exchange Commission website and the Financial Industry Regulatory Authority website at the following addresses:

To learn more about variable annuities and to decide if this type of investment vehicle is right for you, please contact us today.


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