An Explanation of Variable Annuities
With the responsibility for achieving financial independence resting more squarely on the individual's shoulders, it would be important to take a closer look at this unique, multi-tasking retirement vehicle. The best way to understand how a variable annuity works is to begin with an overview of how fixed annuities work.
How Annuities Work
Variable annuities were spawned from an established and highly coveted retirement vehicle called a fixed annuity. At its core, a fixed annuity is a contract between a life insurance company and a depositor that obligates the life insurer to protect the principal and guarantee a lifetime of income. In return, the depositor commits his funds for a long term which allows the life insurer to put his money to work in order to achieve a return on his investment.
The depositor, or annuity owner, is rewarded with a very competitive fixed yield for a period of time (5 to 10 years) and a guaranteed minimum rate on his deposit after that. In addition, the owner enjoys tax favored treatment on his earnings as the IRS won't collect ordinary income taxes until the earnings are withdrawn.
For the contract to work in favor of both parties, the owner must keep his obligation to the life insurer, which is to refrain from withdrawing his deposit too early. The life insurer recognizes that things do come up that may require the owner to withdraw a portion of his funds, so, the contract allows for 10% of the accumulated value to be withdrawn a year. In order to offset the loss of the use of those funds, the insurer will charge a surrender fee, as much as 10% of the withdrawal. After 5 to 10 years there are no more surrender fees. The IRS will also levy a penalty fee of 10% if the withdrawal occurs before age 59 1/2.
Further, when the owner decides to convert his accumulated funds into an income stream, the insurer is obligated to pay the owner a monthly come for as long as he lives. Since the insurer based its payout amount on the owner's life expectancy, should the owner live beyond it, the insurer is still obligated to pay the monthly amount. That's quite a contract.
With that overview of fixed annuities as a backdrop, it is much easier to see the distinctions and understand the inner workings of variable annuities. The primary distinctions are with the way your money is invested, your risk of principal, the expense structure, and the calculation of the income payout.
What Makes a Variable Annuity ‘Variable’
With a variable annuity, your funds are deposited in your own separate account which is comprised of several different investment options. The rate of return you earn is solely dependent on the performance of the subaccounts (similar to mutual funds) that you select for your portfolio. With as many as 10 subaccounts within a variable annuity, you have the opportunity to allocate your funds according to your investment goals, preferences and risk tolerance. As your financial situation and investment priorities change, you can switch between the subaccounts to achieve a different allocation.
The subaccounts are managed by professional investment managers and are tracked daily for performance. Many variable annuity providers team up with well known mutual fund managers to provide subaccount portfolios that are based on the proven track records of their mutual fund counterparts.
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Most variable annuity contracts offer a minimum death benefit guarantee that protects the principal from adverse market fluctuations so that, even if the markets decline, the beneficiary would receive the no less than the original principal. Some contracts include a ‘step-up’ that will lock in any accumulated value when it exceeds the principal so the beneficiary would receive the accumulated value if it is higher than the death benefit less any withdrawals. These step-up provisions are typically offered as an additional rider to the contract.
Minimum Withdrawal Benefit
When added as a rider the lifetime guaranteed minimum withdrawal benefit provides additional protection from the loss of values. Essentially it ensures that the annuitant will receive a minimum monthly payout amount even if the markets should decline. When a variable annuity is converted to a lifetime income stream, the calculation for determining the payout includes a guaranteed increase in the base account payout that acts as a floor. The guaranteed increase is typically 5% or 6%. This calculation is repeated each year to determine the new payout base. Should the account values increase beyond the guaranteed increase, then the actual account value becomes the new base for calculating the payout.
All of these guarantees do come at a cost. Variable annuities have garnered a reputation for being a high expense investment. The base contract fees typically run around 1.8% to 2.3% depending on the investment management fees. To add guarantees such as the minimum withdrawal and guaranteed benefit guarantees, the cost of the contract could reach 3.5% to 4%. Some would consider these expenses to be high compare with mutual fund expenses which average .5 to 1.3%. When you consider that a variable annuity provides for upside growth of your investment, without current tax consequences, without risk to principal, while providing a guaranteed increasing income at retirement, the additional expense is a small price to pay for financial security.
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