Variable annuities can provide a variety of benefits to clients who have both insurance and investment goals. However, variable annuities are complex products with unique features and risks. In order to better serve your clients, you need to have a thorough understanding of how variable annuities work and how they can help clients achieve their goals. This course provides an overview of variable annuities, including insurance and investment features, annuity phases, fees and expenses, and factors relevant to the selection of a variable annuity contract.

Definitions

A variable annuity is an annuity contract that allows the contract owner to allocate premiums among a number of different investment portfolios, or subaccounts. These subaccounts are pooled funds that operate much like mutual funds, investing in stocks, bonds, money market instruments, or some combination of the three.

Contract owners can typically choose from a wide range of subaccounts with different investment objectives as well as varying levels of risk. These subaccounts provide variable rates of return based on the investment performance of the underlying securities. However, this also means that the contract owner, rather than the insurance company, assumes the investment risk.

Annuity

A contract between a person (or a non-living entity, such as a trust) and an insurance company, where a premium or series of premiums paid to the insurance company is exchanged for the insurance company’s promise to make payments to the contract owner or some other designated annuitant for a specified period of time.

Contract Owner

The person or entity that owns the contract and funds the contract with premium payments. The contact owner retains control of the funds held in the variable annuity during the accumulation phase and designates the annuitant who will receive annuity payments during the annuitization phase.

During the accumulation phase, a variable annuity’s contract value will fluctuate in accordance with the market value of the underlying subaccounts. During the annuitization phase, the contract owner can choose to receive payments that are fixed in amount, payments that fluctuate in amount, or a combination of the two. If variable payments are chosen, the size of the periodic annuity payments will vary based on the performance of the underlying portfolio. If the value of the portfolio should increase, the increase will be reflected in a higher monthly payout to the annuitant. Conversely, a decrease in the portfolio’s value would cause the monthly payout to be lowered.

Once the contract is annuitized, the owner relinquishes control of the assets in the annuity in return for the guaranteed income stream. At this point, the owner no longer has access to the principal invested and he or she (or some other designated annuitant) will only receive periodic annuity payments as specified in the contract. For this reason, many variable annuity owners prefer to remain in the accumulation phase and often never annuitize the contract.

Accumulation Phase

The phase of an annuity that begins once the insurance company receives the first premium and continues until the time the contract is annuitized. Premiums are invested and accumulate tax-deferred until funds are distributed. During this phase, the contract owner retains control of the funds held in the annuity and can choose to withdraw these funds at any time.

Annuitization Phase

The phase of an annuity that begins once the contract is annuitized, at which time the current value of the contract is converted into a guaranteed income stream. During this phase, the insurance company makes periodic payments to the owner or other designated annuitant for a specified period of time, often the lifetime of the annuitant. The size of these payments is determined based on the value of the contract at the time of the annuitization, the length of the payout period, and the assumed return on underlying investments.

Annuitant

The person, designated by the contract owner, to whom annuity payments will be paid once the contract is annuitized. The annuitant must always be a living person and is often the same person as the contract owner.

As with other types of annuities, a variable annuity may be either an immediate annuity or a deferred annuity depending on when premiums are made and when the contract is annuitized. The contract owner could choose to purchase the annuity and immediately annuitize the contract and begin receiving annuity payments.

However, variable annuities are primarily designed for individuals looking to save for retirement or other long-term goals. For this reason, the vast majority of variable annuities sold in the U.S. are deferred variable annuities.

Immediate Annuity

An annuity, also known as Single Premium Immediate Annuity (SPIA), in which the contract owner pays a lump sum to the insurance company and the contract is immediately annuitized. After a short period of time following the payment of the lump-sum premium (usually 30 days), the contract owner or some other designated annuitant begins receiving an income stream from the contract.

Deferred Annuity

An annuity in which the contract owner pays premiums into the annuity contract and delays annuitization until some point in the future. Earnings on the premiums grow tax-deferred until distributed, at which time they are taxed as ordinary income. The contract owner can decide at any time to annuitize the contract and begin receiving periodic payments from the insurance company. Alternatively, the owner can choose not to annuitize and retain the right to withdraw funds from the annuity.

Investment and Insurance Features

Variable annuities combine features of both insurance and investment products. As investment products, variable annuities allow clients the opportunity to participate in the returns of the securities markets and choose how funds are invested. As insurance products, variable annuities offer a variety of insurance protections not found in other investment products, such as a guaranteed minimum death benefit and guaranteed lifetime income through annuitization of the contract.

While these insurance and investment features can make variable annuities very attractive to clients, both have costs and risks associated with them. As such, clients need to carefully consider their relative need for the investment and insurance features offered by a variable annuity in order to determine whether it is the product that will best help them achieve their goals.

Investment features of variable annuities include:

Variable Investment

Unlike fixed annuities, variable annuities offer clients the opportunity to participate in the potentially higher returns offered by investment in the securities markets. These returns are more likely to keep pace with inflation and can allow clients to accumulate a larger amount of assets for retirement or other long-term goals. However, along with this potential for higher returns comes a greater amount of risk and this risk is assumed by the client rather than the insurance company.

Diversification and Professional Management

Clients can typically choose from a wide range of professionally managed subaccounts with different investment objectives as well as varying levels of risk. This allows the client to construct a diversified portfolio that is consistent with his or her goals and risk tolerance.

Tax-Deferred Growth

Earnings on the premiums paid into a variable annuity grow tax-deferred until distributed. Over time, this tax-deferred compounding can provide significantly better returns than could be realized in a taxable account. This tax-deferral feature is particularly beneficial for clients who are currently in a higher tax bracket and expect to be in a lower tax bracket when earnings are distributed.

Flexibility

In a non-qualified annuity, there are no limitations on the amount of after-tax income that can be contributed to the variable annuity in any one year. This can allow clients to save more aggressively for retirement than they could with other tax-advantaged options such as IRAs or employer-sponsored retirement plans. In addition, clients do not generally need to begin taking withdrawals until age 85 or later.

Non-Qualified Annuity

An annuity contract purchased individually by a contract owner outside of a qualified retirement plan. Unlike qualified annuities in which contributions are made before-tax, contributions made to a non-qualified annuity are made with after-tax dollars. Non-qualified annuities do not place any limitations on the amount of annual contributions, and contract owners do not generally need to begin taking withdrawals until age 85 or later.

Insurance features of variable annuities include:

Lifetime Income

Variable annuities can be particularly beneficial to clients who are concerned about the possibility of outliving their assets. By annuitizing the contract, the client can ensure that he or she or some other designated annuitant will receive guaranteed income for the rest of his or her life or some other specified period.

Guaranteed Minimum Death Benefit

If the client dies before the contract is annuitized, the beneficiary or beneficiaries named by the client is guaranteed to receive a specified minimum amount. The guaranteed minimum death benefit typically guarantees that, at the owner’s death, his or her chosen beneficiary will receive the greater of the contract value on the date of death, or 100% of premium payments, minus withdrawals. Many variable annuities also offer enhanced death benefits at an additional cost.

Other Insurance Features

Most variable annuities offer a variety of contract riders or optional features that provide additional guarantees or benefits, such as enhanced death benefits or living benefits. However, these optional features also generally involve additional costs in the form of fees, charges, or higher expenses. For this reason, these features are generally only appropriate for clients who require additional protections and are likely to benefit from these protections.

Accumulation Phase

The manner in which a variable annuity functions differs depending on whether the contract is in the accumulation phase or the annuitization phase. While all variable annuities can be annuitized, many contract owners never annuitize the contract, instead remaining in the accumulation phase.

The accumulation phase begins once the insurance company receives the first premium and continues until the time the contract is annuitized. During the accumulation phase, premiums are allocated to the investment subaccounts chosen by the contract owner and the contract value fluctuates in accordance with the performance of the underlying subaccounts. This section provides an overview of the characteristics and features of variable annuities during the accumulation phase.

Separate Account

During the accumulation phase, variable annuity premiums paid to the insurance company are transferred into the insurance company’s separate account. The separate account is a segregated account set up by the insurance company that invests in the underlying investment funds offered through its variable annuity contracts.

The separate account’s assets are maintained separately from the insurance company's general account, so they cannot be used to pay claims associated with any other business of the insurance company. Unlike the general account, the contract owner, rather than the insurance company, assumes the investment risk associated with the separate account. The separate account generally must be registered with the SEC as an investment company.

General Account

The portfolio of investments that backs the guarantees the insurance company has contractually assumed. The portfolio is generally invested in fixed rate instruments, such as government and corporate bonds and commercial and residential mortgages. State insurance laws govern how insurance companies can invest their general account assets and mandate a conservative, risk-averse portfolio.

Subaccounts

The investment portfolios held within the separate account are referred to as subaccounts. These subaccounts are pooled funds that operate much like open-end mutual funds, and are managed toward a stated investment objective. Contract owners choose from among the available subaccounts offered by the variable annuity to establish their underlying portfolio. Since these subaccounts are held in the separate account, the performance of the contract owner’s investment does not depend on the insurance company's investment portfolio. Only the performance of the subaccounts the contract owner has chosen will affect his or her results. The value of each subaccount fluctuates daily, based upon the market value of the securities held in the subaccount’s portfolio.

Variable annuities typically offer a variety of subaccounts, including funds that invest in stocks, bonds, money market instruments, or some combination of the three. The number of subaccounts offered varies among different variable annuity contracts; however, most variable annuities offer a wide range of subaccounts designed to meet a variety of investment objectives and risk tolerances. A complete listing of available subaccounts, along with historical performance for each, can be found in the variable annuity prospectus.

​​​​​​​Subaccounts – Management

Variable annuity subaccounts are managed by professional investment managers who buy and sell securities according to a stated investment objective. In return for managing the subaccount, the investment manager receives an annual investment management fee assessed as a percentage of total assets under management. In some cases, variable annuity subaccounts may be proprietary, meaning that they are managed by the investment managers of the company issuing the annuity or one of its affiliates. However, most variable annuities hire well-known mutual fund companies or investment advisory firms to manage their subaccounts.

In some instances, a variable annuity subaccount may even have a name that is quite similar to a mutual fund managed by the same investment manager. However, variable subaccounts are always managed separately from mutual funds and their portfolios are never mingled. In many cases, these similarly named portfolios have different investments making up their portfolio and have different fee structures. Consequently, they generally produce different results. For this reason, care must be taken when discussing variable annuities with clients to ensure that they do not confuse subaccounts with mutual funds.

Subaccounts – Diversification and Asset Allocation

Similar to mutual funds, each subaccount is comprised of a diversified portfolio of underlying securities chosen by the investment manager. This diversification spreads risk among many securities, reducing the impact of the underperformance of any single security.

In addition, the contract owner can achieve an even greater degree of diversification by allocating premiums to multiple subaccounts that invest in different types of securities. By allocating funds among the various subaccounts offered by the variable annuity, a contract owner can also implement an asset allocation strategy designed to further reduce risk and improve return.

Subaccounts – Transfers between Subaccounts

A variable annuity owner may transfer funds from one subaccount to another without incurring taxes at the time of the transfer. If such a transfer were to occur in a taxable account, any capital gains realized would be taxable in the year of the transfer. As such, variable annuities contract owners can transfer assets to react to changing market conditions, adjust their investment strategy, or rebalance their portfolio without having to worry about tax consequences. Over time, this ability to make tax-free transfers can prove to be a valuable benefit and can allow contract owners to accumulate a greater amount of assets.

While transfers between variable annuity subaccounts are always tax free, some insurance companies impose a transaction fee once the owner exceeds a certain number of transfers in a contract year. Any limitations on such transfers will be clearly identified in the variable annuity prospectus.

Subaccounts – Fixed Account

In addition to the variable investment options within a variable annuity, most contracts have a fixed account to which the contract owner may allocate all or a portion of premium payments. The fixed account in a variable annuity works similarly to a fixed annuity.

Premiums allocated to the fixed account are invested in the insurer’s general account, and the owner receives a fixed rate of return for a specified period of time. The variable annuity owner may elect one or more time periods over which the contract will pay a fixed interest rate. The length of the guarantee period selected will affect the amount of the guaranteed interest rate.

Accumulation Units

Accumulation units are the accounting measure used to determine the contract owner’s interest in the separate account and the underlying subaccounts during the accumulation phase. The contract owner contributes funds to the contract through either a single lump sum or a series of premium payments. A portion of each payment is deducted for charges and expenses and the remainder is used to purchase accumulation units in the subaccounts selected by the contract owner.

Once purchased, accumulation units fluctuate in value based upon the performance of the securities held in the subaccount’s portfolio. The current value of an annuity contract is equal to the total current value of all accumulation units in the various subaccounts owned by the contract owner. During the accumulation phase, the contract owner can withdraw amounts up to the current contract value. Similarly, if and when the contract owner wishes to annuitize the contract, it is this amount that will be used in the calculation of annuity payments.

The dollar value of each accumulation unit is determined at the end of each business day. As with open-end mutual funds, the value of an accumulation unit is stated in terms of Net Asset Value (NAV). The NAV per accumulation unit is calculated by dividing the total assets of the subaccount, minus any liabilities, by the total number of accumulation units issued.

NAV Per Unit =Total Assets – Liabilities / Total Units Issued

Similar to mutual fund shares, the contract owner will always receive the forward price when purchasing or selling accumulation units. For example, if an order is placed before the close of the market on Tuesday, the contract owner will receive the price as of Tuesday’s close. However, if the order is placed on Tuesday after the close of the stock market, he or she will receive the price as of Wednesday’s close.

Guaranteed Minimum Death Benefit

During the accumulation phase, the value of the annuity contract will fluctuate in accordance with the underlying performance of the subaccounts. However, if the owner dies during the accumulation phase, his or her chosen beneficiary is guaranteed to receive a certain minimum amount. This guaranteed minimum death benefit generally guarantees that upon the death of the owner, his or her beneficiary will receive the greater of:

• 100% of premium payments, less withdrawals, or
  
• The contract value on the date of death.
  

This death benefit can be attractive to contract owners who are concerned about the potential impact of market declines on the amount of assets that will be left to beneficiaries. This feature can also encourage risk-averse investors to invest more aggressively, knowing that a guaranteed minimum amount will be available for beneficiaries regardless of actual market performance.

Enhanced Death Benefits

Many variable annuities also offer owners enhanced death benefits that provide additional protections against declines in market value. Common types of enhanced death benefits include:

Step-Up

A step-up death benefit allows a contract owner to lock in investment gains periodically. The death benefit is “stepped up” every year, or some other pre-determined frequency, and the contract owner’s beneficiaries are guaranteed to receive at least that amount, even if the contract value later declines. The advantage of a step-up death benefit is that it allows the owner to lock in investment performance and prevent a later decline in contract value from eroding the amount that will be paid to beneficiaries.

Roll-Up

A roll-up death benefit guarantees that the amount paid to beneficiaries upon the death of the owner will be equal to the greater of the current contract value or the premiums paid (less any withdrawals) compounded at a pre-determined annual growth rate. This allows contract owners to ensure a minimum rate of return on assets that will be paid to beneficiaries, regardless of actual market performance.

Step-Up or Roll-Up, Whichever Is Greater

Some enhanced death benefits guarantee that the beneficiary will receive, at the minimum, the greater of either the step-up benefit or the roll-up benefit.

Enhanced Death Benefits

In most cases, enhanced death benefits are offered as optional contract riders that can be included in the variable annuity contract at an additional cost. Since these costs are generally in the form of higher annual fees, they can have a negative impact on investment performance. For this reason, contract owners should only purchase an enhanced death benefit if they require additional protections and/or are likely to benefit from these protections.

Distributions

A contract owner has a number of options available when he or she wishes to begin taking distributions from a variable annuity. He or she can choose to withdraw funds from the variable annuity contract during the accumulation phase. Alternatively, he or she can choose to annuitize the contract and take distributions as a series of periodic payments from the insurance company. This lesson reviews both withdrawal and annuitization options.

Distribution Options

When the contract owner wishes to begin taking distributions from a variable annuity, he or she has two options available:

• Make withdrawals – During the accumulation phase, the contract owner can choose to withdraw funds from the annuity at any time, and these withdrawals are deducted from the annuity’s contract value.
  
• Annuitize the contract – Once annuitized, the contract enters the annuitization phase and the insurance company will make periodic payments to the contract owner or other designated annuitant for a specified period of time, often the lifetime of the annuitant. Once the contract is annuitized, the owner relinquishes control of the funds held in the variable annuity and can no longer make withdrawals from the annuity.
  

Many contract owners choose not to annuitize the contract, preferring to remain in the accumulation phase and withdraw funds from the annuity as needed. However, most variable annuities require owners to either annuitize the contract or take a lump-sum withdrawal of the contract value at a specified maturity date. While this date can vary, it is typically when the annuitant reaches a certain specified age (generally 85 years or older).

Withdrawals

Contract owners who wish to withdraw funds from the annuity during the accumulation phase have several withdrawal options available. These include:

• Lump sum – If the contract owner wishes, he or she can choose to surrender the contract and withdraw the entire current contract value of the annuity.
  
• Partial – The contract owner can choose to make partial withdrawals of funds from the annuity and these withdrawals are deducted from the annuity’s contract value.
  
• Systematic – Many variable annuities also allow contract owners to elect to take systematic withdrawals that are automatically distributed to the owner. For example, a contract owner could choose to have a certain percentage of the contract value liquidated and distributed to him or her on a monthly, quarterly, or annual basis. Alternatively, he or she could choose to have only investment earnings distributed while leaving principal intact. This systematic withdrawal option allows the contract owner a means of taking regular withdrawals to cover income needs without having to annuitize the contract.
  

Annuitization

The annuitization phase begins when the contract value is converted to an immediate annuity and the insurance company begins to make periodic payments to the contract owner or some other designated annuitant. The contract owner can choose to annuitize the contract at any time up until the maturity date of the contract. Once the maturity date has been reached, he or she must either annuitize the contract or take a lump-sum distribution of the contract value.

At the time of annuitization, the contract owner selects a payout option that will determine the length of time periodic payments will be made to the annuitant. The owner must also decide whether the annuity’s contract value will be allocated to one or more of the investment subaccounts, to the fixed account, or to both the investment subaccounts and the fixed account. Annuity payments coming from the fixed account are guaranteed and will remain constant throughout the payout period. However, annuity payments generated from the subaccounts will vary based on the investment performance of the underlying portfolio.

The payout option selected by the contract owner determines the length of time during which the insurance company will make periodic payments to the contract owner or other designated annuitant. The payout option also is an important factor in determining the relative size of these periodic payments. In general, the longer the anticipated payout period, the smaller the periodic payments will be. Some of the most common payout options include:

• Straight-Life - The annuitant receives periodic payments for the duration of his or her lifetime. Upon the death of the annuitant, all payments cease regardless of how much or how little has been paid out.
  
• Life with Installment Refund - The annuitant is guaranteed to receive periodic payments for the duration of his or her lifetime. However, if the total income payments made at the annuitant’s death are not equivalent to the premiums paid into the contract, income payments will continue to be made to the beneficiary until all premiums have been distributed.
  
• Life with Period Certain - The annuitant is guaranteed to receive periodic payments for the duration of his or her lifetime. However, if the annuitant should die prior to the end of a specified period, payments will continue to be made to a designated beneficiary for the balance of that period.
  
• Period Certain - The annuitant receives periodic payments for a specified period of time. After this period of time ends, payments will cease. If the annuitant dies before this time, a designated beneficiary will receive any payments that remain.
  
• Joint and Survivor Income - Two annuitants are designated for this type of payout option. Periodic payments are made to the primary annuitant for the duration of his or her life. Upon his or her death, payments will continue for the duration of a designated joint annuitant’s life.
  
• Fixed Amount - The annuitant receives periodic payments until a designated amount has been paid out. Once this amount has been exhausted, no further payments are made.
  

Annuitization – Fixed Payments

If the annuitant chooses to receive fixed payments, periodic payments are guaranteed and will not fluctuate in value. The size of these payments is determined based on:

• The contract value at the time of annuitization,
  
• The interest rate guaranteed by the insurance company,
  
• The anticipated length of the payout period, and
  
• The frequency of payments.
  

Choosing fixed payments allows the contract owner to ensure a guaranteed amount of income and avoid the risks associated with the market performance of underlying subaccounts. However, because these payments will remain the same throughout the payout period, inflation may diminish the real value of these payments over time. For this reason, contract owners must seriously consider the potential impact of inflation on fixed payments, particularly when the payout period will be long.

Annuitization – Variable Payments

When a variable payment option is chosen, the size of the periodic payments will vary based on the performance of the underlying subaccounts chosen by the contract owner. If the value of the underlying subaccounts increases, the size of the periodic payments will also increase. However, the contract owner also takes the risk that the size of any payment can be less than the previous one if the value of the underlying subaccounts declines.

Once the contract is annuitized, accumulation units are converted into annuity units. The number of annuity units received will depend on a number of factors, including the contract value at the time of annuitization, the anticipated length of the payout period, and the Assumed Interest Rate.

The Assumed Interest Rate (AIR) is a rate used by the insurance company to project the return on investments made in the separate account. Once determined, the number of annuity units remains constant. As the value of each annuity unit increases or decreases, so does the size of the periodic payment.

The amount of the first income payment is calculated using the AIR and actuarial assumptions made by the insurance company. Subsequent payments will be made based on the actual investment results of the underlying subaccounts. If the return on the subaccounts is higher than the AIR, payments will increase. However, if the return on the portfolios is lower than the AIR, payments will decrease. The exact amount of each periodic payment is determined by multiplying the current value of each annuity unit by the number of units. Depending on the contract, payments may be recalculated on a monthly or annual basis.

Variable Payments – Example

Joe Andrews has recently retired and wishes to annuitize his variable annuity contract to supplement his retirement income. Joe is 65 years old and his current contract value is $100,000. Joe selects a straight life payout option with an AIR of 3.25%. Based on Joe’s age, the payout option he has selected, and the AIR, the insurance company determines that Joe’s first monthly payment will be $554. The value of an annuity unit at the time of Joe’s first monthly payment is set at $10 and he is credited with 55.4 annuity units ($554/$10).

Once the contract is annuitized, the number of annuity units is fixed and will remain constant for as long as Joe continues to receive income. However, the value of each unit will fluctuate based on the performance of the underlying subaccounts. For example, if the annual net return on the underlying subaccounts exceeded the AIR by 5.5%, the value of Joe’s annuity units would increase to 10.55 ($10 x 1.055). Based on this new value, Joe’s monthly payment will increase to $584.47 (55.4 x $10.55). However, the value of the annuity units will continue to fluctuate and could decrease if the performance of the underlying subaccounts is less than the AIR, resulting in smaller monthly payments.

Tax Treatment – Withdrawals

Earnings on the premiums paid into a variable annuity grow tax-deferred. However, once these earnings are distributed, they are subject to taxation. The tax treatment of distributions from a variable annuity differs depending on whether distributions are made during the accumulation or annuitization phase. Important factors with respect to the taxation of earnings withdrawn from a variable annuity during the accumulation phase include:

Taxable Amount

When a contract owner makes a withdrawal from a variable annuity, he or she will owe income taxes on the portion of the withdrawal that is considered earnings. For tax purposes, earnings are always considered to be withdrawn before principal. This means that withdrawals will be fully taxable until all earnings have been withdrawn and principal begins to be exhausted.

Ordinary Income

Once a contract owner begins withdrawing money from a variable annuity, all earnings that are distributed will be taxable at ordinary income rates rather than at lower long-term capital gains rates or qualified dividend rates. For this reason, variable annuities may be less appropriate for individuals who prefer a buy and hold investment strategy.

Early Withdrawal Penalties

Variable annuities are allowed to grow tax-deferred in order to encourage individuals to save for retirement. For this reason, earnings withdrawn from a variable annuity contract before the contract owner reaches age 59½ are generally subject to a 10% early withdrawal penalty in addition to regular income taxes.

Tax Treatment – Annuity Payments

Once the contract is annuitized, the insurance company makes periodic payments to the owner or other designated annuitant in accordance with the selected payout options. As with withdrawals made during the accumulation phase, all earnings distributed as part of regular annuity payments are taxable to the annuitant. For tax purposes, annuity payments are treated as being comprised of part tax-free return of principal and part taxable earnings.

• Return of principal – This portion of the payment represents the after-tax premiums paid by the contract owner into the annuity and is not subject to taxation.
  
• Earnings – This portion of the payment represents tax-deferred earnings and is taxable as ordinary income for the year in which the payment is received.
  

The tax-free portion of each annuity payment is calculated by dividing the total premiums paid into the variable annuity by the total number of anticipated monthly payments. For an annuity that is payable for the life of an annuitant, this number is based on the annuitant’s life expectancy as determined by IRS calculation.

Once all after-tax premiums have been distributed, all future annuity payments will be entirely taxable. Generally, insurance companies will provide annuitants with information on an annual basis that identifies the taxable portion of annuity payments made during the year.

Living Benefits

Many variable annuity contracts now offer optional “living benefits” which provide enhanced protections against market loss at an additional cost. Unlike a death benefit, which only comes into effect upon the death of the contract owner, a living benefit guarantees a certain minimum contract value during the life of the contract owner provided certain requirements are met. Some examples of living benefits include:

Guaranteed Minimum Accumulation Benefit

A guarantee that, after a stated period of time, the contract value will not be less than the total premiums paid, or, in some cases, the total premiums paid plus a minimum rate of interest less any withdrawals. However, the insurance company may place limitations on how this guaranteed minimum amount can be withdrawn, such as requiring that the amount be systematically withdrawn over a period of time.

Guaranteed Minimum Income Benefit

A guarantee that, after a stated period of time, the owner can annuitize the contract based on the greater of actual contract value or an amount equal to premiums compounded at a specified interest rate or a periodically stepped-up value. However, the owner must generally wait a specified number of years and annuitize the contract in order to receive this benefit.

Guaranteed Minimum Withdrawal Benefit

A guarantee that allows an owner to take minimum withdrawals from a guaranteed withdrawal amount without having to annuitize the contract. The owner can withdraw up to a specified percentage of the contract each year until the guaranteed withdrawal balance is depleted. If the owner withdraws more than the specified amount, the guarantee may terminate or, depending on the contract, reset to a lower amount. In some cases, this benefit may be structured to provide a guaranteed minimum withdrawal payment for the life of the owner.

Fees and Expenses

While variable annuities can provide clients with a variety of benefits, they also generally have higher fees and expenses than mutual funds and other investment products that do not provide insurance features. In addition, most variable annuities have surrender charges that are assessed on withdrawals made during the early years of the contract. This section reviews the fees and expenses typically associated with variable annuities.

Surrender Charges

Most variable annuities impose a surrender charge on withdrawals from the annuity before a specified period—generally 5 to 10 years. Surrender charges usually start at around 6%–8% of the amount invested and decline gradually over a period of several years. Surrender charge schedules can be either contract-based or rolling.

• A contract-based surrender charge period begins on the date the contract is established and ends on the same date, a specified number of years later. In this type of contract, surrender charges on withdrawals are calculated using the date of the initial premium payment, regardless of additional premium payments made after the contract is established.
  
• A rolling surrender charge period begins every time a premium payment is made into the contract and ends a specified number of years after the date of each premium payment. In this instance, the surrender charge period “rolls” with each new premium payment.
  

Most variable annuities also allow a small percentage of the contract value to be withdrawn each year without assessing a surrender charge, and some also waive surrender charges under certain specified circumstances (e.g., terminal illness). All information relevant to the surrender charge schedule, including information regarding any exceptions, can be found in the variable annuity prospectus.

Recently, some insurance companies have begun to offer annuities with reduced surrender charges or, in some cases, no surrender charges at all. While these annuities do provide greater liquidity, they also typically have higher annual expenses. Since these higher expenses can have a negative impact on investment performance, the contract owner must carefully consider his or need for greater liquidity relative to the costs involved. If the owner does not anticipate the need to access funds in the short term, he or she may be better suited to an annuity with a traditional surrender charge period but lower annual expenses.

Mortality and Expense Risk Charge

The mortality and expense (M&E) risk charge compensates the insurance company for the insurance risks it assumes under the contract. This charge is set in the contract and usually cannot be changed throughout the life of the contract. The mortality risk portion of the M&E charge compensates the insurance company for the risk associated with guaranteeing a minimum death benefit and the risk of paying out more in annuity payments than actuarially predicted. The expense risk portion of the charge is assessed in return for the guarantee that contract expenses will not increase.

The M&E charge is typically assessed as an annual percentage of the separate account assets, with an industry average of approximately 1.25%. It is important to keep in mind that the investment returns published by an insurance company for its annuity subaccounts may or may not reflect the impact of M&E charges. The prospectus will identify whether or not these charges are reflected in the performance data.

Investment Management Fees

In addition to the various fees charged directly by the insurance company, contract owners must also pay the fees and expenses assessed by the investment funds that comprise the annuity’s underlying subaccounts. This investment management fee covers the costs of managing and operating the subaccount, including investment advisory fees, custodial fees for the custodian bank, and other costs related to the investment management of the subaccount.

These fees are typically assessed as an annual percentage of assets under management and generally range from 0.15% to 2.00% and vary based on the type of subaccount and its investment strategy. For example, index subaccounts tend to have lower expenses than actively managed subaccounts. Management fees are identified in the prospectus, and are sometimes broken down into a separate investment advisory fee and an operating expense fee. The historical returns provided in the variable annuity prospectus for annuity subaccounts are the net returns after all underlying subaccount expenses have been deducted.

Administrative Fees

Many variable annuities also assess administrative fees that compensate the insurance company for expenditures, such as the cost of issuing the contracts, recordkeeping, and the publishing and mailing of statements and other communications.

The administrative fee can be charged as a flat account maintenance fee, sometimes called the annual contract fee (typically between $25–$35 per year), or as a percentage of the value of the subaccounts (generally in the range of 0.15% annually), or both. The annual contract fee is often waived if the contract value is over a certain amount. Administrative fees may be added to the M&E charge by the insurer, or broken out as a separate expense.

Charges for Optional Features

Many variable annuities offer a variety of contract riders or optional features that provide additional guarantees or benefits, such as a guaranteed minimum income benefit or enhanced death benefit. However, these optional features also generally involve additional costs in the form of fees, charges, or higher expenses.

These fees are disclosed in the prospectus with the charges generally assessed as a percentage of the variable annuity’s contract value. Given the additional costs associated with these features, they are generally only appropriate for clients who require additional protections and who are likely to benefit from these protections.

Selecting a Variable Annuity Contract

Once you determine that a variable annuity is the product that will best help your client achieve his or her goals, you still must identify and select a particular contract. While all variable annuities are similar in structure and function, they can differ significantly in terms of investment options, insurance features, and costs. As such, you and your client will need to carefully evaluate and compare the features and costs of various variable annuity contracts in order to determine which will best meet his or her needs.

This section reviews factors that should be considered when helping clients select an appropriate variable annuity contract.

The Prospectus

Insurance companies are required to issue a prospectus for each variable annuity contract they offer. A current copy of this prospectus must be provided to the client at the time of sale or concurrent with the confirmation of sale. In addition to providing important disclosures, the prospectus also serves as a valuable information resource for both you and your client. Important information regarding the variable annuity contract provided in the prospectus includes:

• Product features
  
• Surrender charges
  
• Fees and expenses
  
• Death benefits and other guarantees
  
• Subaccount information, including historical performance
  
• Payout options
  

The prospectus should be your primary tool in both helping the client understand the features and risks of the annuity and in determining if a particular contract is the best one to achieve his or her goals.

Investment Options

Variable annuities are designed to help individuals accumulate assets to achieve retirement and other long-term goals. As such, one of the most important factors in selecting a variable annuity is the quality and range of investment options offered by the contract. This should include careful consideration of:

Available Subaccounts

Variable annuity contracts can differ greatly in terms of the number and types of subaccounts they offer. As such, you will want to verify that the contract offers subaccounts that are consistent with the investment objectives and risk tolerance of the client. In addition, most variable annuities offer a variety of subaccounts that invest in different asset classes and have different investment objectives. You will want to verify that the contract offers a sufficient range of options for the client to effectively diversify and implement an asset allocation strategy.

Management

Most variable annuities hire well-known third-party investment managers to manage their subaccounts. While name recognition is important to many clients, a recognizable name does not necessarily ensure the best management. As such, you will want to carefully consider each manager’s experience, expertise, and track record when evaluating the quality of subaccount management.

Performance

The historical performance of subaccounts is also an important factor when evaluating the investment options offered by a variable annuity contract. Performance issues are discussed in more detail on the following screens.

Exchange Privileges

Some variable annuities charge transaction fees on exchanges between subaccounts that exceed a specified number in any one year. You will want to verify that the client is comfortable with any limitations and that these limitations are consistent with his or her investment strategy.

Investment Options – Subaccount Performance

One of the areas most commonly compared when evaluating variable annuity contracts is the past performance of subaccounts. While past performance is no guarantee of future results, it does provide important information about how well a subaccount has been managed over a period of time. When comparing investment performance between subaccounts, comparisons should only be made of subaccounts with similar investment objectives and over identical time periods. For example, comparing the ten-year historical return for one subaccount to the five-year historical return for another subaccount would not provide a valid comparison.

Regulators require that the variable annuity prospectus provide subaccount performance information for periods of one year, five years, ten years, or for the life of the subaccount if it has not been in existence for any of the full time periods. As a rule, data from the longest historical time period available should be used when examining subaccount performance. With the exception of money market funds, most subaccounts are intended to be long-term investments. For this reason, it is generally best to focus on long-term historical performance.

As with other investment products, the use of industry benchmarks, or indices, can be a valuable means of assessing variable annuity subaccount performance. Subaccount performance should generally only be compared to a benchmark relevant to the investment objective of the subaccount and the type of securities in which it invests. In addition, comparisons should only be made over similar periods of time.

For example, if you are helping your client evaluate the performance of a broadly diversified equity growth subaccount, comparing its five-year returns with the five-year returns of the S&P 500 Index would give you an accurate idea of how management performed relative to an appropriate equity index. Relevant benchmark comparisons are typically included along with subaccount performance figures in the prospectus.

Insurance Features

In addition to investment features, you will also need to compare insurance features when selecting a variable annuity contract. This includes careful evaluation of the benefits and costs of insurance features relative to the client’s needs and objectives. Insurance features that should always be considered include:

Annuitization

While all variable annuities offer clients the ability to annuitize the contract, annuitization options and limitations can vary from contract to contract. Important factors to consider include the annuity payout options offered under the contract, the mortality date at which the contract will have to be either surrendered or annuitized, and the availability of fixed and variable payment options.

Death Benefits

All variable annuities offer some form of guaranteed minimum death benefit. However, the costs and options associated with the death benefit can vary significantly among different contracts. Important factors to consider include the minimum amount guaranteed under the death benefit, the availability of enhanced death benefits that offer additional protections against declines in market value, and the costs associated with the various options.

Living Benefits

Many variable annuity contracts also offer optional living benefits that provide enhanced protections against market loss at an additional cost. Important factors to consider with respect to living benefits include the conditions under which the client can receive the guaranteed amount, any limitations on the client’s ability to access guaranteed amounts, and the costs associated with these benefits.

Insurance Features – Optional Features

Many insurance companies offer a variety of optional features or contract riders that can provide clients additional protections or benefits. However, these features typically also involve additional costs in the form of higher annual fees.

While it is important to consider the availability of such features when evaluating a variable annuity contract, they should only be a factor when the client has a need for the feature and he or she is likely to benefit from it. For example, a living benefit that guaranteed a minimum contract value upon annuitization would be completely useless for a client who never plans on annuitizing the contract.

Fees and Expenses

In addition to comparing the features and benefits of variable annuity contracts, it is also essential to carefully consider the costs involved. This includes surrender charges as well as other fees and expenses.

Surrender Charges

Surrender charge schedules can vary significantly among variable annuity contracts. Some variable annuities now also offer contracts with reduced surrender charge periods. However, these contracts often have higher annual fees. The surrender charges associated with a variable annuity contract should always be considered relative to the client’s need for liquidity and the costs involved.

Fees and Expenses

The fees and expenses charged by variable annuities are generally higher than those associated with other investment products. Over time, these fees and expenses can have a significant impact on investment returns. As such, all fees and expenses should be carefully considered and compared against industry averages (currently around 2.3%) as well as other available contracts. However, just because a contract has lower fees does not necessarily mean that it is the better contract for a particular client. The fees associated with a contract must always be considered relative to the benefits the contract provides the client.

Insurance Ratings

The guarantees included in a variable annuity contract are only as good as the claims-paying ability of the insurance company that issues it. As such, it is important to consider the strength and reliability of the issuing insurance company when selecting a variable annuity. A number of agencies rate insurers on their ability to meet their claims. The table below lists the largest insurance rating agencies and their highest ratings. An insurance company may have a lower rating than one identified below, however, it is generally best to work with an insurance company that has one of these top ratings.

Asset Allocation Programs

The wide range of subaccounts offered by most variable annuities allow clients to implement asset allocation strategies that can help reduce overall portfolio risk and maximize portfolio return. In order to help contract owners take advantage of the benefits of asset allocation, many variable annuities now offer asset allocation programs. These programs can help clients design and maintain an asset-allocated portfolio tailored to their specific investment goals and risk tolerance. These programs also typically provide assistance in maintaining and adjusting this portfolio as necessary over time.

Once the initial asset allocation is implemented, most asset allocation programs will automatically rebalance the portfolio at periodic intervals. This portfolio rebalancing makes the necessary adjustments to bring the portfolio back to its original allocation and ensures that the portfolio retains the appropriate weightings over time. Any exchanges that occur as a result of portfolio rebalancing do not count against limits on the number of exchanges in any given year.

Dollar Cost Averaging

In some cases, a client may wish to make a large contribution to a variable annuity but would prefer not to invest all funds in subaccounts immediately due to concerns about short-term market fluctuations. Many variable annuities offer dollar cost averaging programs that allow clients to automatically transfer a set amount of money from a fixed or money market subaccount to variable subaccounts over time. This feature allows clients the ability to allocate funds to their chosen subaccounts over a period of time.

The theory behind dollar cost averaging is that purchases made with equal dollar amounts will buy more units of a subaccount when its price is low and fewer units when the price is high. The result is that the overall average cost of the subaccount units will be less than the average price on the purchase dates. However, dollar cost averaging does not protect against losses in market value or necessarily ensure a higher return.