Variable Annuities: How They Work

Variable annuities—lots of choices.

Variable annuities and fixed annuities provide many of the same benefits—including:

Tax-deferral of any earnings
A choice of payouts
Plus the opportunity to make unlimited contributions if the annuity is non-qualified.

In addition, a variable annuity offers the potential for greater returns and the opportunity to make your own decisions about how to allocate your assets among a variety of investments.

There are lots of things that can change with variable annuities; the rate of return, the amount of income you receive if you annuitize, and how you allocate your investments. In other words, the risk of variable annuities is that the principal and return are not guaranteed and variable annuities are subject to market risk, including the potential loss of principal. What remains constant with all fixed or variable annuities, is the opportunity to select an income stream that is guaranteed to last for your lifetime.

Allocations
With a variable annuity, you choose how to allocate your money among a number of investment portfolios. The investment portfolios, called subaccounts or investment accounts, are similar to mutual funds, which are either designed specifically for the annuity company or similar versions of existing funds designated for retirement accounts. Although the names of the investment portfolios may be similar to those of mutual funds available to the public, they are not the same funds.

Your job is to choose among the ones that the issuing company offers, much as you would with a 401(k) or 403(b) retirement plan. Typically, there will be a dozen or more, including a variety of stock portfolios, a money market account, a government bond portfolio, and a guaranteed account, which is similar to a fixed annuity investment. The performance of the investment portfolios is not guaranteed and is subject to market risk.

Guaranteed Death Benefit
A major attraction of variable annuities to many investors is the guaranteed death benefit they provide, which is based on the claims-paying ability of the insurance company that issues the contract. This means that if you die before you begin to receive income, your beneficiaries will receive, at the minimum, the amount you put into the annuity. However, with most variable annuity contracts, investment gains are locked in regularly so that your beneficiaries receive more than your principal, even if the value has dropped back down at the time of your death. In contrast, the value a mutual fund is based on the value at the time of redemption which may be more or less than the original investment.

The assurance the guaranteed death benefit provides can help alleviate your fear of losing money and encourage you to invest in stock portfolios, thus increasing your chances of building a larger annuity value. The death benefit may also reassure people otherwise reluctant to invest in equities that they can afford to do so.

Dollar Cost Averaging
With many variable annuities, you can take advantage of dollar cost averaging.

The principle is that by making equal purchases on a regular schedule, your average price per unit is never the highest price and you actually end up paying less than the average price per unit for the purchase. That happens because you buy more units when the price is lower.

With variable annuities, you can dollar cost average two ways:

1. You can put your money into your annuity on a regular schedule, or what’s known as an incremental purchase.

2. You can put a lump sum in a fixed or money market account within the variable annuity and arrange to have it moved gradually into one or more of your investment portfolios.

Dollar cost averaging does not assure a profit and does not protect against loss in a declining market. Since dollar cost averaging involves continuous investment in securities regardless of fluctuating price levels, you should consider your financial ability to continue to make purchases through periods of low price levels.

Tax-Free Transfers
Another major appeal of variable annuities is that you can make tax-free transfers among your investment portfolios. For example, if you’re convinced it’s time to increase the percentage of your retirement savings in more aggressive growth stocks, you can shift money from a balanced or money market portfolio. Or you might want to readjust your asset allocation from time to time. This flexibility lets you have constant control over your investment accounts.

Variable Annuities A Brief History Lesson
CREF, the first variable annuity, began on July 1, 1952. It was created to compliment TIAA's traditional annuity. The variable annuity's history, like that of mutual funds and self-directed pension plans, is directly related to the increasing responsibility individuals have for making their retirement financially secure. During the 1990s, as the stock market boomed, and people became increasingly aware of the need to save for retirement, variable annuities attracted even more attention.

Terminology of Variable Annuities
Variable annuities have certain special terms. Keep in mind that your premiums are allocated to "subaccounts" which are divisions of the insurance company's "separate account." These subaccounts, in turn, invest in shares of corresponding "investment portfolios." Your interest in a subaccount is measured in "accumulation units," the value of which varies up or down depending on the performance of the corresponding investment portfolios.

Added Protection
Deferred variable annuities differ from fixed annuities in another important way. Your retirement savings go into individual accounts held in an issuer's separate account, rather than into its general account (except for any money you put in a fixed account). Your money in these individual accounts is invested in the investment portfolios you choose. As a result, your retirement savings are shielded from the issuing company’s creditors. As an extra bonus, some states protect your savings from your creditors as well.

Underlying Investments
The portfolios you choose in variable annuities are called your underlying investments because the performance of your annuity as a whole is based on how these investment portfolios perform. And the portfolios have underlying investments as well: the stocks or bonds they own. It is the collective performance of those stocks or bonds that determines the performance of the portfolio.

MVAs in Variable Annuities
Sometimes there may be a market value adjustment (MVA) on transfers from a fixed account of a variable annuity to adjust for changes in interest rates. For example, if you wanted to transfer $10,000 from a fixed account to an equity portfolio (prior to the maturity date). After interest rates had gone up, you could move a portion of that amount, and the balance would go to the annuity provider. The terms of each variable annuity contract can be different, our planners and financial specialists can help you to evaluate the terms, as part of your buying decision.

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