In 1952, the Teachers Insurance and Annuity Association, College Retirement Equities Fund (TIAA-CREF), introduced the first variable annuity in the United States, thereby complicating the options for shoppers but also adding flexibility to the annuity market.
Like the annuities we already covered, variable annuities may be immediate or deferred, can create a lifelong income stream for an annuitant, may feature a death benefit and will involve surrender charges for early withdrawals. Nevertheless, these products are significantly different from their fixed cousins.
When shopping for a variable annuity, a person has much more to think about than just the insurance company�s financial strength. This is true because premiums for a variable annuity do not become part of an insurer�s general account and, therefore, are not accessible to the company�s creditors. Instead, premiums go into �custodial accounts� or �sub-accounts� and are put to work by fund managers who invest the money in the stock market, bond market or other parts of the financial world. The annuity owner, and no one else, bears responsibility for placing his or her money in profitable places. The issuing company merely provides investors with a set of investment options and performs administrative duties.
Unlike the fixed annuity, a variable annuity contract does not need to guarantee a return of principal or any interest rate. The annuity�s value at any given time may depend entirely on the owner�s specific investment strategy. The abundance of market risk and responsibility assumed by the owner explains why some financial experts refer to variable annuities as �self-directed� annuities.
Variable annuities can lead to investment gains that tower over those created through fixed annuities or CDs, or could become worthless if the wrong choices are made. These products might satisfy clients who are interested in a long-term investment that might keep up with or exceed inflation and who feel reasonably comfortable putting their money in mutual funds. People who have had success with variable life insurance policies might also find variable annuities to their liking. However, it might be hard or even inappropriate to sell a variable annuity to someone who prefers security over growth or has little knowledge of how the financial markets work.
Fixed and Variable Accounts in Variable Annuities
The number of investment options for the owner of a variable annuity can usually be counted on at least two hands, and some issuing companies let clients invest their premiums in any of several dozen different mutual funds. The annuity owner has the right to allocate the principal investment as he or she sees fit. Nearly all of the owner�s investment can go into a single fund, or the principal may be disbursed relatively evenly among funds that involve foreign and domestic stocks and foreign and domestic bonds. Other options might include funds that go up or down in value depending on various indexes, such as the S&P 500.
Most of the money invested in variable annuities becomes part of �variable accounts,� which offer no guarantees of principal or interest. Many insurers also allow owners to invest a portion of their premiums in one or several �fixed accounts.� A fixed account acts like a fixed annuity within the variable annuity. Investors receive a guaranteed return of principal on all money put into fixed accounts and also earn a minimum interest rate on that money.
The option to put some principal in a fixed account can appeal to owners of variable annuities who have lost money in higher-risk funds or who are experienced enough to recognize when a booming financial market is close to becoming a sluggish one. These accounts also allow insurance companies to occasionally guarantee a full return of principal if the owner adheres to strict investment guidelines for at least a few years after purchasing the variable annuity. It is worth noting, however, that the guarantees available through the fixed accounts will end up being lower than the guarantees available in a traditional fixed annuity contract. This difference in guarantees exists because the owner of the variable annuity will pay various annual fees that do not factor into a fixed contract.
Like a variable life insurance policy, a variable annuity contract will give owners the opportunity to transfer invested funds from one mutual fund to another within contractually mandated limits. The owner might have an opportunity every month to move money from a domestic stock fund into an international stock fund, for example, and the insurer might require that all transfers involve a minimum number of dollars. Moving money in and out of a fixed account is much trickier and more limited. All transfers within a variable annuity will avoid taxation, but the contract may allow the insurance company to charge surrender-type fees if transfers occur too frequently or involve movement between fixed and variable accounts.
The mechanics of the variable annuity tend to make it a seemingly costlier product than the fixed annuity. As the reader might recall, owners of fixed annuities often have no idea exactly how much money an insurance company is making from a sale. Since the insurer is the party doing all the investing in a fixed setup, it merely calculates a spread for itself and credits the excess interest to owners� accounts. The insurer may credit less interest from one year to the next, but it generally does not subtract fees from the owner�s account balance. On the other hand, since variable annuities put the owner in charge of investing principal and do not guarantee a rate of return every year, companies that issue these annuities must charge clients directly for products and services.
Owners of variable annuities pay flat fees as well as percentage-based �asset charges� that will be linked to the amount of money in an account. In most cases, these fees will remain the same as long as the contract is in force. Annuitants who opt for variable payouts, which we will study in the next section of this course, will continue to be charged these fees during annuitization. The various fees can lessen investment gains during good times and possibly contribute to a financial loss during rough times.
An �account maintenance fee� is perhaps the most common flat fee found in variable contracts. The charge generally covers the cost of paperwork and amounts to roughly $30 each year. In terms of asset charges, owners can at least expect to pay a �mortality and expense risk charge,� which will typically amount to somewhere near 1.25 percent of the annuity�s value each year. This annual fee is like a life insurance premium and helps pay for any applicable death benefits. The typical variable annuity contract calls for beneficiaries to receive the greater of the principal investment, minus any previous withdrawals and the annuity�s value at the time of death. For an additional fee, the insurer might guarantee a larger death benefit.
Beyond those two common fees, the owner might also need to reimburse the issuing company and its affiliates for investment-related services, such as fund management, and might need to pay yet another fee for any desired financial advice.
When owners of variable deferred annuities determine that the time is right to start receiving periodic or lifetime income from the insurance company, they may put a stop to market risk and request fixed payouts that will be based on the insurer�s benefit rate and the accumulated funds. In a sense, their variable annuity can transform into a fixed annuity during annuitization.
Other people will not be intimidated by continued market risk and will want their money to retain its growth potential even as they receive an income for life. Variable annuities make this latter option possible through the process of �variable annuitization.�
At first, this concept might seem illogical. If the owner�s investment remains in volatile places like the stock market, how can an insurer begin to offer periodic payouts that will continue in some form until the annuitant dies? For both deferred and immediate variable annuities, the answer to that question involves the �assumed interest rate� (AIR). Along with such important factors as the account balance and the annuitant�s life expectancy, the AIR helps the insurer arrive at a statistically fair, initial payout. The company will then base subsequent payouts on the invested funds� performance in relation to the AIR. When investments in the annuity outperform the AIR, income received from the insurance company will be larger than the initial payout. When investments in the annuity under-perform and fail to earn interest equal to the AIR, income received from the insurance company will be smaller than the initial payout.
Variable annuitization is a complex settlement option that will result in a regularly timed but inconsistently sized income for the annuitant. Even if the invested funds always outperform the AIR, they will almost certainly not outperform it by the same margin every month or every year. So, variable annuitization turns budgeting into a bit of a guessing game. A sudden market downturn can cause someone who received a perfectly adequate income for one month to receive a largely inadequate income for the following month.
Financial advisers and insurance professionals have come up with at least two suggestions for people who want the inflation-beating potential of variable annuitization but who shudder at the thought of unpredictable payouts. One option is to accept a low AIR from the insurance company, which means initial payouts will be small but that subsequent ones will be more likely to equal or exceed the initial payouts. Conversely, a large AIR will give the annuitant a lot of money at first, but subsequent payouts will be less likely to equal or exceed that early amount. Concerned consumers might also be interested in riders that can temporarily guarantee that income will not drop below a certain amount. This kind of guarantee and most other promises within variable annuity contracts will still affect the account balance by way of annual fees.
In spite of the risks involved with variable annuities, consumers can secure various guarantees from the insurance company if they are willing to pay annual fees, sacrifice more liquidity or follow a strict investment plan. These optional guarantees may cater to the owner�s desire to provide additional funds for beneficiaries in the event of a death or can create a relatively reliable income stream for the annuitant. Because we are already familiar with the general concept of an annuity�s death benefit, we will quickly focus first on those optional guarantees related specifically to beneficiaries and then turn our full attention to different kinds of contract provisions called �living benefits.�
The reader will recall that the standard annuity death benefit grants beneficiaries the greater of the annuity�s value at the time of the death and the principal, minus any previous withdrawals. This may seem like a reasonable benefit as far as fixed annuities are concerned because the fixed annuity�s value will do nothing but grow over time unless the owner makes premature withdrawals. But with a variable annuity, there is always a chance that all or a portion of the owner�s investment gains will vanish during a market downturn. Pretend, for a moment, that a man bought a variable annuity for $100,000 and opted for a standard death benefit. After 15 years, investment gains pushed the man�s account value up to $130,000. After five more years, some of the man�s investments went poorly, and his account value dropped to $125,000. The man died, and the standard death benefit entitled his beneficiaries to $125,000. On the positive side of things, his heirs received $25,000 more than the principal investment. But the drop in the annuity�s value from $130,000 to $125,000 meant that $5,000 was lost along the way.
If the fellow in our example wanted to maximize death benefits for dependants or other loved ones, he could have purchased a rider that allowed for a �stepped-up� death benefit. This contract feature, which usually involves an annual fee, allows the owner to lock in the minimum death benefit once or every few years during the accumulation period if the variable annuity increases in value. When the annuitant dies, beneficiaries receive the greater of the stepped-up amount and the account value at the time of death. So, if the owner buys an annuity for $100,000 and invokes a stepped-up provision when the annuity is worth $130,000, beneficiaries are guaranteed to receive at least $130,000 if death occurs prior to annuitization and the owner makes no premature withdrawals. If the owner is worried about losing money in a variable annuity and leaving nothing but the principal amount for beneficiaries, he or she can purchase a modestly enhanced death benefit. For an annual fee, the insurer will guarantee that beneficiaries will at least receive a return of the principal plus a pre-set rate of interest if death occurs prior to annuitization.
If annuity sales professionals ever stopped emphasizing death benefits and stuck to explaining the variable annuity as a handy tool for asset accumulation and retirement planning, they would still have many add-ons to discuss with their prospective clients. These remaining add-ons are called �living benefits� because they help preserve a potential lifelong income for the annuitant regardless of poor market conditions and serve no purpose after the annuitant dies. Essentially, when insurers attach living benefits to their variable annuities, they are adding fixed elements to the contracts and selling minimum guarantees.
Perhaps the most common living benefit is the �guaranteed minimum income benefit� (GMIB), which, in some ways, entitles the annuitant to a modest immediate fixed annuity if investments in the variable sub-accounts prove to be ultimately disastrous. In exchange for keeping the variable annuity with the issuing company for several years (usually 10), the annuitant will receive no less than the GMIB upon annuitization. In exchange for that extra security, the owner must invest premiums temporarily in a manner chosen by the insurance company. When owners surrender their variable annuities, they also surrender this non-transferable living benefit.
The fact that the GMIB only applies during annuitization distinguishes it from the �guaranteed minimum accumulation benefit� (GMAB), which, in some ways, entitles the owner to a minimum rate of return. In exchange for keeping the variable annuity with the issuing company for several years, the owner will end up with an annuity that can be worth no less than the GMAB, which is usually equivalent to the principal investment. Like the GMIB, this benefit might force the owner to invest premiums temporarily in a manner chosen by the insurer. However, the owner might have the right to take advantage of the GMAB without needing to annuitize with the issuing company. Another optional pre-annuitization feature is the �guaranteed minimum withdrawal benefit� (GMWB), which guarantees that the owner may take out a set percentage of the principal each year even when the initial funds become battered in the financial markets. A basic GMWB allows for withdrawals up to a certain percentage until the owner has withdrawn a cumulative amount equal to the principal investment.
Another kind of GMWB may extend the benefit beyond the principal investment and through the annuitant�s lifetime. Suppose a woman buys an annuity for $100,000 along with a GMWB that allows for 4 percent withdrawals for life. She could then receive $4,000 annually without annuitizing. If her annuity�s value ever dips below $4,000, she could still receive annual checks, equal to the GMWB, from the insurance company.
All these guarantees are usually associated with significant annual fees. An owner who chooses these benefits should expect to pay an asset charge of 0.5 percent or so to the insurance company each year. The asset charge for each benefit might not seem like much at first, and the benefits might end up paying for themselves in a threatening financial environment. But prospective buyers should be made to understand that, just like the annuity itself, a living benefit represents a long-term commitment between the insurer and the contract owner. If buyers have second thoughts after purchasing a living benefit, they may find it hard or even impossible to cancel the add-on provision and its accompanying fees without having to surrender the whole contract.
Regulation of Variable Annuities
Variable annuities present considerable market risk to buyers and do not typically balance that risk with free guarantees of interest or even a return of principal. This imbalance explains why the federal government and state regulators treat variable annuities like securities.
Security-level status puts the variable annuity market under the rule of the Securities and Exchange Commission (SEC), which aims to protect consumers at a national level, and the Financial Industry Regulatory Authority, a non-government entity that oversees security firms� market conduct. These various regulatory bodies make rules that affect annuity salespersons and the products they promote. Anyone interested in selling variable annuities should keep in mind that he or she must be licensed to sell variable products. A basic license to sell life insurance policies will not, on its own, satisfy all security-related regulatory requirements.
Regulations also require that all variable annuity contracts come with a prospectus, which discloses all fees associated with the annuity and summarizes the investment history of all the mutual funds associated with the annuity. The prospectus should be simple yet informative enough to help people make educated decisions regarding their potential purchases.