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Introduction to the Variable Annuity

When learning how different annuities work, the variable annuity (VA) is a great place to start. It has long been the best-selling form of annuity. Using the information on the Types of Annuities page, you can classify most VAs as flexible premium, deferred, variable accumulation contracts. In other words:

  • Funds can be added to the premium over time
  • Income payments are deferred to a later date, and taxes on gains are deferred until income is taken
  • Investment returns are variable in that they can go up or down over time

But how do variable annuity contracts really work? The simplest explanation is that they are clusters of mutual fund-like investments wrapped in one or more types of insurance. The owner must select which funds to invest in, so the investment risk is with the contract owner (as opposed to the insurance company).

This is one way that VAs differ from other types of annuities. Fixed or indexed contracts transfer assets to the insurance company, which then takes on the investment risk and pays interest to the client. As such, compared to other types of annuities, variable annuities have the highest return potential... but also the highest risk to the contract owner and the steepest annual fees.

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Insurance features vary from contract to contract, but can be generalized as either living benefits (longevity insurance) or death benefits (a form of life insurance). For an additional cost, these insurance features can be enhanced through optional add-ons called riders. This is what drives VAs' relative popularity among annuities.

Below are two major considerations for investors considering a VA.

1. Subaccounts -- The Investment Decisions are Your Responsibility

Subaccounts are mutual fund-like components of a variable annuity. They are closely related to the mutual funds available through 401k and retail brokerage accounts. Fund options will include stocks (both domestic and foreign), various bond funds, and capital-preserving (i.e., very low-risk) money market funds. In most cases, you'll be responsible for selecting which fund to invest in from a menu of anywhere from 10 to 300 options, possibly with some limitations imposed by the annuity company.

Subaccounts charge their own fees on top of annuity contract fees, including mortality and expense fees and any rider charges. This can cost you an extra 1.5% in fees per year.

Given these investment options and the layering of fees, it is crucial to read the prospectuses for all annuity subaccounts. Be sure to understand each and every individual fund’s goals, risks, fees, and limitations before investing. These subaccount prospectuses will be in addition to the insurance contract and prospectus, and can add up to several hundred pages.

Caution: Take the time to make sure you understand the subaccounts. Better yet, have an adviser walk you through each prospectus. An adviser that can’t or won’t help you understand the subaccounts may not be acting in your best interest. These are complicated, expensive, long-term contracts. Take as much time as needed to understand each aspect before signing. Our advisors are also available to help you with questions about your contract. Call them at 888-886-8546.

One more woe is that insurers may enforce asset allocation restrictions that limit the amount that can be invested in stocks to prevent contract holders from taking too much risk. While this does tend to smooth returns over time and reduce overall risk, it could also limit the total return that can be expected from the contract.

2. Variable Annuity Fees May Hide – Here’s how to find them

Annual fees for a VA contract can vary wildly. They range from less than 1% to greater than 4%. Some start with low base fees that grow to over three times the original amount when you add in riders and other management fees.

Indeed, VAs can carry additional fees for any optional rider benefits you elect to add to a policy. Within the contract, each subaccount fund may also charge a management fee. Funds also typically pass trading fees and other expenses on to the contract holder. What you end up with is a multi-layer contract with potential expenses at every level.

 
Annuity Fee Circular Diagram

*Source: Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36-38, 56.

Between the rider charges, contract fees, and subaccount fees, contracts with multiple riders have total annual expenses that can approach 4% per year1. Some financial advisers may also charge an additional fee for assets under management -- on top of the fees charged for the annuity product itself. Fees are an important part of the puzzle when learning how a variable annuity works. They can have a dramatic, compounding effect on your total returns, as illustrated below.

Compounding Effect of Variable Annuities
1 70% MSCI World Index/30% BofA Merrill Lynch US Treasury Index. Performance is presented inclusive of dividends and interest.
2 Hypothetical investment equivalent to the above blended index, less an assumed annual mutual fund expense of 0.81% (which is the average asset-adjusted expense ratio for balanced funds in 2011 per Morningstar).
3 Hypothetical investment equivalent to the above blended index, less assumed annual annuity expenses of 3.98%. The assumed annual expenses include Mortality & Expense Risk of 1.25%4, Administrative Fees of 0.15%4, optional Guaranteed Minimum Death Benefit (GMDB) of 0.61%4, optional Guaranteed Lifetime Withdrawal Benefit (GLWB) of 1.03%2, and Fund Expense for underlying funds in a variable annuity of 0.94%4.
4 Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36-38,56.


Doing proper due diligence can improve your confidence in understanding these complicated contracts. It can keep you from committing to the wrong retirement plan without understanding the details. We at AnnuityAssist want to help. We are available to answer your questions at 800-940-0182.

1 Industry averages estimate total annual expenses at 3.95% (Mortality & Expense of 1.25%, Administrative Fees of 0.15%, optional Guaranteed Minimum Death Benefit (GMDB) of 0.61%, optional Guaranteed Lifetime Withdrawal Benefit (GLWB) of 1.03%, and average expense for underlying funds in a variable annuity of 0.94%); Source: Insured Retirement Institute, 2011 IRI Factbook (Washington, DC: IRI, 2011), 36-38,56.

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