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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.
Contents
What Is a Variable Annuity?
How Variable Annuities Work
The Death Benefit and Other
Features
Variable Annuity Charges
Tax-Free "1035" Exchanges
Bonus Credits
Ask Questions Before You Invest
For More Information
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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 important ways:
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
funds do. |
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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 year).
| 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 (discussed
below). |
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 charge.
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 withdrawals). |
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.
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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). |
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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:
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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 charge.
| 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. |
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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. |
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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. |
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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.
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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 surrender. |
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Bonus
Credits |
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:
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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. |
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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. |
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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 exchanged.
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| 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 charges. |
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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
following questions:
- 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 annuity)?
- Are you willing to take the risk that your account value may
decrease if the underlying mutual fund investment options perform badly?
- 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 money?
- If a variable annuity offers a bonus credit, will the bonus
outweigh any higher fees and charges that the product may charge?
- Are there features of the variable annuity, such as long-term
care insurance, that you could purchase more cheaply separately?
- 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 annuity?
| 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. |
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For
More
Information |
Other SEC Online Publications
Other Web Sites That May Be Helpful
- NASD Regulation,
Inc. – NASD Regulation, Inc., is the independent subsidiary of the
National Association of Securities Dealers, Inc., charged with regulating the
securities industry and the Nasdaq Stock Market, including sellers of variable
annuities. The NASD recently issued a release to its members
reminding them of their responsibilities to investors in selling variable
annuities (NASD Notice
99-35, "The NASD Reminds Members of Their Responsibilities Regarding the
Sales of Variable Annuities"). If you have a complaint or problem about
sales practices involving variable annuities, you should contact the District
Office of NASD Regulation, Inc., nearest you. A list of NASD Regulation
District Offices is available on the
NASD Regulation web site.
- National Association of
Insurance Commissioners (NAIC) – The NAIC is the national
organization of state insurance commissioners. Variable annuities are regulated
by state insurance commissions, as well as by the SEC. The NAIC's web site
contains an interactive
map of the United States with links to the home pages of each state
insurance commissioner. You may contact your state insurance commissioner with
questions or complaints about variable annuities.
How To Contact the SEC With Questions or Complaints
Office of Investor Education and Assistance
U.S.
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington,
D.C. 20549-0213
Fax: (202) 942-9634
E-mail:
help@sec.gov
Online Complaint Form.
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