What is a variable annuity contract

what is a variable annuity contract

Annuities, General

What are the basic types of annuities?

An annuity is a contract, usually sold by an insurance company, that makes periodic payments to the holder at a future date, usually beginning at retirement. A fixed annuity pays a guaranteed rate and guarantees principal. A variable annuity produces investment returns based on the performance of the investments made through the annuity. An immediate annuity begins making payments right away, rather than several years from now. All annuities are tax-deferred, meaning that the income resulting from the growth of the assets within the annuity is deferred until withdrawals are made from the annuity. The term "tax deferred annuity" actually refers to certain pre-tax savings programs available to public school employees and the employees of nonprofit organizations defined in code section 403(b). Variable annuities typically offer mutual fund accounts that are managed identically to well known retail mutual funds. Such funds are called clones since they are patterned after other mutual funds and often have the same investment policy, name and manager.

What kinds of charges are involved when purchasing an annuity?

Be careful to ask about the many fees attached to every annuity contract. Many companies do not charge an initial commission, or load. Instead, they levy a substantial surrender charge of as much as 10% of your principal if you want to cash out or transfer your annuity to another company within the first five or 10 years of the contract. However, some annuities permit a free withdrawal after the first year and for every year thereafter that surrender charges apply. This allows you to withdraw a certain portion (usually 10%) of the accumulated account value. Note that withdrawals are subject to income tax and, prior to age 59 1/2 withdrawals would be subject to a 10% penalty tax by the IRS. Annuity surrender charges do not apply to immediate annuities because, once you have purchased the contract, it cannot be surrendered. There are also annual expenses to be considered. Most annuity sellers also charge annual maintenance fees of $25 to $50. Variable annuities have higher expenses than fixed annuities because of the various sub-accounts, often running up to 3% or more. In fact, many experts say that you need to own a variable deferred annuity for at least 15 years to make it a more worthwhile investment than doing so on your own with, say, a mutual fund. That number is somewhat less for fixed annuities, but it’s still something to consider. If you’re talking about immediate variable annuities, higher expenses mean lower monthly checks to you.

Who are the different parties in an annuity contract?

An annuity contract always involves at least three parties: the owner, the annuitant and the insurance company that issues the annuity. According to "The Investing Kit" (Dearborn Financial Publishing, Inc. Chicago), "An insurance company issues annuities. The company promises to invest your premium prudently and make payments to you or your beneficiary according to your selected income payment option. The owner is the individual who purchases the annuity and may change the beneficiary. "The annuitant can be the person who receives the payment when the annuity is annuitized (the point at which payments begin), or the person whose age is used to calculate payments to the annuitant. In many cases, the owner and the annuitant are the same individual. "The owner’s beneficiary generally is the individual who receives the death benefit of the annuity if the owner dies prior to the annuity starting date or becomes the owner upon the death of the owner(s) on or after the annuity starting date."

Are annuities a good retirement investment?

An annuity gives you the certainty of receiving an agreed-upon monthly income for the rest of your life, and for the life of your spouse in the case of a joint-and-survivor annuity.

A fixed annuity pays a regular stream of income while you live. An immediate annuity is purchased with a lump sum and begins to generate income immediately. Annuities offer many payout options. Each one is guaranteed by the insurance company. Generally, the longer you obligate the company to pay benefits, the lower your monthly check. Each company determines its payout scale by estimating survival rates and the company's expected earnings on investments.

A variable annuity provides an alternative should you seek an investment with the potentially higher return of equities or to be more involved with the investment decisions. For example, the Vanguard Variable Annuity Plan offers these investment choices: Money Market Portfolio, High-Grade Bond Portfolio, Balanced Portfolio and Equity Index Portfolio.

The investment alternatives offered by variable annuities give you flexibility to tailor your portfolio to meet your particular needs. Since variable annuities are not guaranteed, you're assuming a greater degree of risk, but your return is potentially higher than with a fixed annuity.

With a fixed annuity you're buying the guarantee of a fixed income, but you lose control of your capital. An alternative bond investment might pay you as much or more than an annuity, have lower expenses and commissions, and you would retain control of your money.

A fixed annuity offers a guaranteed rate of return, typically 3% to 4%. It also offers a current rate set by the company board of directors. The current rate is paid as long as it is equal to or greater than the guaranteed rate.

You can withdraw money from either a fixed or variable annuity as long as you have not annuitized it. Once the annuity is annuitized, the company pays only an income and no withdrawals may be made. You basically exchange the annuity value for an income stream that lasts, depending on the options you select, from a fixed number of years up to the remainder of your life.

Are death benefits typically provided in annuities?

Fixed annuities provide death benefits (prior to annuitization) in the form of the guaranteed return of principal or the cash value of the annuity, whichever is greater. According to the National Network of Estate Planners in Denver, "In the case of fixed annuities, there is no life insurance benefit involved. In the event of the owner’s death, the beneficiary is simply entitled to the accumulated value (principal and interest) of the annuity. Because the owner of a variable annuity is making deposits to bond and/or stock portfolios, the value of his or her account can increase or decrease based upon the value of the underlying securities." Conversely, most variable annuities include a provision for death benefits. Although the value of the annuity may rise and fall over time, at least some death benefit will usually be paid to the beneficiaries. This death benefit is expressed in terms of the total premium paid to the time of death. Many variable annuities will pay the value of the accounts or the total premium paid, whichever is greater. Some annuities will pay an enhanced death benefit by adding a percentage each year to the death benefit, determined by total premium paid, measure that new sum against the value of the accounts at time of death, and pay the greater amount.

What is the accumulation phase of an annuity?

The accumulation phase of an annuity is the time during which the value of the annuity is growing. This phase ends when the annuitization or payout phase begins (the day you start receiving payments).

What is annuitization?

When an insurance company begins paying out the proceeds of an annuity on a monthly basis, the annuity is said to be annuitizing. The process is called annuitization. A person should not annuitize their annuity without careful thought. Once an annuity is annuitized, the annuitization cannot be reversed. Also, withdrawal of the funds within the annuity is no longer possible. Annuitization effectively exchanges the cash in the annuity for a guaranteed income stream, and as a result, it is quite inflexible.

Why is the decision of when to annuitize an annuity so important?

Once an annuity is annuitized (you start taking regular income payments), there are no other options. The income is distributed as the contract requires, but there is no flexibility to increase or decrease the payments or to make cash withdrawals from the principal.

What’s the difference between the current rate and the guaranteed rate on an annuity?

The guaranteed rate of an annuity contract is the rate defined in the contract. Typically this is the minimum rate the contract will pay. The current rate is the rate, higher than the guaranteed rate, paid by the company when the company chooses to pay a higher rate. The current rate is not contractual and is established by the insurance company board of directors. It varies as the board decides to vary it, depending on the purpose the board has for paying a higher rate, typically related to marketing.

Annuities, Fixed

What are the differences between a variable annuity and a fixed annuity?

If you choose a fixed annuity, the premiums you pay will be invested by the insurance company. The company board will declare a current rate of interest each quarter. If the rate declared is less than the guaranteed rate, the guaranteed rate will be paid. A variable annuity works more like a mutual fund. Your premiums will be invested in stock funds, bond funds, real estate funds or other kinds of cloned mutual funds that have no guaranteed rate of return. Instead, your return will vary based on the portfolio’s performance - hence the term "variable."

What is a tax-deferred fixed annuity?

All annuities sold by insurance companies are tax deferred. The term, "tax-deferred annuity" refers to a tax-favored savings program available under code section 403(b) to public school employees and the employees of nonprofit organizations. A fixed annuity contract is a contract between you and an insurance company in which the company, in exchange for a single or flexible premium, guarantees a fixed payment at a future date. Fixed annuities are "fixed" in two ways: (1) The amount you invest earns tax-deferred interest at a guaranteed rate (typically 1% to 3% under long-term U.S. government bonds) while your principal is guaranteed not to lose value. (2) When you withdraw or opt to annuitize (begin taking monthly income) you receive a guaranteed amount based on your age, sex, and selection of payment options. Be careful to ask about the many fees attached to every annuity contract. Most companies do not charge an initial commission, or load. Instead, they levy a substantial surrender charge of up to 10 percent of your principal if you want to cash out or transfer your annuity to another company within the first five or 10 years of the contract. However, some annuities permit a free withdrawal provision after the first year and for every year thereafter that surrender charges apply. This allows you to withdraw a certain percent (usually 10 percent) of the accumulated account value. Note that prior to age 59 1/2 these partial withdrawals would be subject to a penalty by the IRS unless you meet an exception. Most annuity sellers also charge annual maintenance fees of $25 to $50. Most annuity charges do not apply to so-called immediate annuities because once you have purchased the contract, it cannot be surrendered.

What features should I look for when shopping for a fixed-rate annuity?

A fixed-rate annuity is a contract between an investor and an insurance company. The investor agrees to make a lump-sum payment or series of contributions now in exchange for the insurer’s promise to provide the investor with a much larger lump sum or monthly payments several years from now-usually after the investor retires. "Ernst & Young’s Personal Financial Planning Guide" (John Wiley & Sons Inc. New York) suggests you look at these issues when evaluating fixed-rate annuities: 1) The company’s financial strength. You want to make sure the insurer is strong enough to be around when it’s your turn to start collecting payments instead of making them. 2) Surrender charges. Find out how much you will be charged if you prematurely end, or "surrender," the annuity contract. Also determine the conditions under which you can withdraw money without a surrender charge. 3) The company’s crediting history. This tells you whether the insurer has consistently paid reasonable rates to annuity holders over the years. More important, compare the rate to others. You should examine both the current rate history and the guaranteed rate for several companies. Find the three to five best rates, then choose the best contract and company among them, based on Ernst & Young’s method.

Are there any guarantees involved in a fixed annuity?

When an insurance company sells you a fixed annuity, it will make two basic guarantees. According to "The Investing Kit" (Dearborn Financial Publishing, Inc. Chicago), "The insurance company guarantees both the principal, excluding surrender charges, and interest based on the terms of the contract. The interest earned may vary over time, depending on the insurance company’s earnings and what rate the contract guarantees." Keep in mind however that there is no guarantee the insurance company will remain an ongoing concern. That is why it is best to deal only with those insurance companies of the highest rating.

What is the floor of a fixed annuity?

Fixed annuities guarantee you a minimum interest rate. What you are looking for is a company that always pays a competitive yield. Annuities guarantee a "floor" below which your interest rate won’t fall. The floor is low, usually 3% to 5%. Your risk is in selecting a company that won’t pay a competitive current rate. It may offer an initially high rate to lure you in, but then drop the rate once you are "locked in" to the contract. A typical scenario: you start out with a fat 11 percent yield the first year, a leaner 8 percent the second year, then down to 6.5 percent, and a huge surrender charge if you want out. The bigger the surrender charge, and the longer it lasts, the freer the company is to drop your rate.

If a fixed annuity carries a guaranteed rate of return, then why does the rate sometimes change?

With a fixed, group annuity, the premiums are invested in fixed-rate instruments

such as bonds or mortgages. Your money earns a guaranteed fixed rate of return only for a certain period of time, usually for one to five years. After the guarantee period is over, the assets of the annuity are automatically rolled over for a new time period at a new rate. The new rate may be higher or lower than the initial rate paid on the annuity, depending on the overall direction of interest rates.

Annuities, Immediate

What is an immediate annuity?

Younger workers often purchase tax-deferred annuities, but you may want to purchase an immediate annuity if you are about to retire. When you buy an immediate annuity, payouts from the annuity will begin shortly after you purchase the contract, i.e. it annuitizes immediately. The size of the monthly payouts will primarily be based on how much you paid for the annuity. Part of each payment you receive will be considered a return of your original investment; the rest will reflect interest earned during the payout period. Remember, you won’t be able to withdraw any cash other than the payments because the annuity was annuitized at inception.

Annuities, Tax Issues

What costs are involved if I invest in a tax-deferred annuity?

Some tax-deferred annuities are annuities purchased by the employees of school districts or nonprofit organizations under a 403(b) plan sponsored by their employer. The eligible employees use pre-tax salary deferrals to purchase their annuities. Other tax-deferred annuities are simply those annuities bought by people who want their investments to grow tax deferred for many years, then convert to a payout schedule once they retire. When purchasing such an annuity, be particularly wary of potentially high fees and expenses. Many companies do not charge an initial commission, or load. Instead, they levy a substantial surrender charge of as much as 10% of your principal if you want to cash out or transfer your annuity to another company within the first five or ten years of the contract. However, some annuities permit a free withdrawal provision after the first year and for every year thereafter that surrender charges apply. This allows you to withdraw a certain percent (usually 10%) of the accumulated account value. Note that prior to age 59 1/2 these partial withdrawals would be subject to a penalty tax by the IRS. Most annuity sellers also charge annual maintenance fees of $25 to $50 to cover the administrative costs of maintaining an account. Most annuity charges do not apply to immediate annuities because once you have purchased the contract, it cannot be surrendered. One way to get around high fees is to purchase a low- or no-load annuity. Variable Annuities Online offers a listing of the 25 lowest-cost variable annuities available.

How are the proceeds of an annuity taxed to the beneficiary?

Once you begin receiving payouts from an annuity, you must pay income tax on a portion of those payouts. Each payment is considered part investment earnings and part return of your original principal. You are required to pay tax on the investment earnings but not on the return of your capital. Your insurance company will inform you how much of each payment constitutes earnings and principal. Distributions from a deferred annuity contract before you reach age 59 1/2 are usually subject to an additional tax of 10% unless you qualify for an exception. The tax applies only to the taxable part of the distribution.

How are payouts from an immediate annuity taxed?

An immediate annuity is an annuity you purchase from an insurer that begins generating monthly payments to you immediately rather than several years down the road. This format results in some important tax issues. According to "The Investing Kit" (Dearborn Financial Publishing, Inc. Chicago), "Because each payment you receive is part income and part return of principal, only the income portion is taxed as ordinary income. The insurance company will calculate the the portion of your payment (return of principal) that is not taxed as ordinary income." Check with your accountant or tax attorney for a comprehensive explanation of taxation for annuities.

What is a tax-deferred fixed annuity?

All annuities sold by insurance companies are tax deferred. The term, "tax-deferred annuity" refers to a tax-favored savings program available under code section 403(b) to public school employees and the employees of nonprofit organizations. A fixed annuity contract is a contract between you and an insurance company in which the company, in exchange for a single or flexible premium, guarantees a fixed payment at a future date. Fixed annuities are "fixed" in two ways: (1) The amount you invest earns tax-deferred interest at a guaranteed rate (typically 1% to 3% under long-term U.S. government bonds) while your principal is guaranteed not to lose value. (2) When you withdraw or opt to annuitize (begin taking monthly income) you receive a guaranteed amount based on your age, sex, and selection of payment options. Be careful to ask about the many fees attached to every annuity contract. Most companies do not charge an initial commission, or load. Instead, they levy a substantial surrender charge of up to 10 percent of your principal if you want to cash out or transfer your annuity to another company within the first five or 10 years of the contract. However, some annuities permit a free withdrawal provision after the first year and for every year thereafter that surrender charges apply. This allows you to withdraw a certain percent (usually 10 percent) of the accumulated account value. Note that prior to age 59 1/2 these partial withdrawals would be subject to a penalty by the IRS unless you meet an exception. Most annuity sellers also charge annual maintenance fees of $25 to $50. Most annuity charges do not apply to so-called immediate annuities because once you have purchased the contract, it cannot be surrendered.

What are the benefits of tax-deferred variable annuities?

The key benefit of investing in a tax-deferred variable annuity is that the premiums you pay are used to make investments, and profits from those investments grow tax-deferred until you start making withdrawals. According to "The Investing Kit" (Dearborn Financial Publishing, Inc. Chicago), "The benefit of owning a tax-deferred variable annuity is the potential for above-average returns because your assets may be invested in the securities markets and assume actual risk. If the annuity contract meets certain conditions of the Internal Revenue Code, then the earnings, if left in the variable annuity, are not taxed. "Variable annuities are not normally purchased to provide current income, although partial withdrawals may be made. The objective is to let the annuity increase in value and accumulate tax deferred until you surrender the contract or annuitize it." You can also make partial withdrawals and never surrender or annuitize it, which for most is the preferable option.

What tax form will I receive if I receive pension plan, annuity or insurance distributions?

If you receive a distribution from a pension plan, annuity or insurance contract, the company that makes the payment will send you a Form 1099-R. This form also is sent when your receive payments from a profit-sharing plan, Individual Retirement Account (IRA), or other tax-favored retirement program.

Annuities, Variable

What is a variable annuity?

An annuity in this context is simply a contract between you and an insurance company. You pay the insurer a specified amount of money and, in return, you’ll receive regular payments either for life or for a stated period of time. The money grows on a tax-deferred basis until you begin receiving it, usually after age 59 1/2. At that point, you can continue to postpone the tax bite by annuitizing the money - in other words, converting the assets into a monthly stream of income. There are two basic types of annuities: fixed and variable. If you choose a fixed annuity, it earns a fixed rate of return on your premiums. A variable annuity works more like a tax-deferred mutual fund. Your premiums could be invested in a variety of items, ranging from stock and bond funds to real estate investment trusts and certificates of deposit. Your return will vary depending on the success of the portfolio -- hence the term "variable."

What are the differences between a variable annuity and a fixed annuity?

If you choose a fixed annuity, the premiums you pay will be invested by the insurance company. The company board will declare a current rate of interest each quarter. If the rate declared is less than the guaranteed rate, the guaranteed rate will be paid. A variable annuity works more like a mutual fund. Your premiums will be invested in stock funds, bond funds, real estate funds or other kinds of cloned mutual funds that have no guaranteed rate of return. Instead, your return will vary based on the portfolio’s performance - hence the term "variable."

What are the benefits of tax-deferred variable annuities?

The key benefit of investing in a tax-deferred variable annuity is that the premiums you pay are used to make investments, and profits from those investments grow tax-deferred until you start making withdrawals. According to "The Investing Kit" (Dearborn Financial Publishing, Inc. Chicago), "The benefit of owning a tax-deferred variable annuity is the potential for above-average returns because your assets may be invested in the securities markets and assume actual risk. If the annuity contract meets certain conditions of the Internal Revenue Code, then the earnings, if left in the variable annuity, are not taxed. "Variable annuities are not normally purchased to provide current income, although partial withdrawals may be made. The objective is to let the annuity increase in value and accumulate tax deferred until you surrender the contract or annuitize it." You can also make partial withdrawals and never surrender or annuitize it, which for most is the preferable option.

What features should I examine when shopping for a variable-rate annuity contract?

An annuity is simply a contract between you and an insurance company. You pay the insurer a specified amount of money and, in return, you’ll receive tax-deferred growth and the possibility of regular payments either for life or for a stated period of time if you annuitize. It is usually better not to annuitize since you can access your money on an as needed basis. The money grows on a tax-deferred basis until you begin receiving it, usually after age 59 1/2. At that point, you can continue to postpone the tax bite by "annuitizing" the money -- in other words, converting the assets into a monthly stream of income. Fixed-rate annuities guarantee fixed monthly payments when you retire. A variable annuity works more like a tax-deferred mutual fund. Your premiums could be invested in a variety of items, ranging from individual stocks and mutual funds to real estate and certificates of deposit. Your return and future payments will vary depending on the success of the portfolio -- hence the term "variable." According to the second edition of "Ernst & Young’s Personal Financial Planning Guide" (John Wiley & Sons Inc. New York), here are some of the features that demand close inspection when you evaluate variable-rate annuities offered by different insurers: (1) The company’s financial strength. Using Bests Review and the Weiss Ratings (company financial ratings from can be found on the Web at Insure.com ), make sure the insurer is strong enough to be around when it’s your turn to start collecting payments instead of making them. (2) The variety of investment choices. Most annuities have several funds within them, so you can invest in stocks, bonds or choose other types of investments. (3) The track records of the various funds offered by the variable annuity. (4) An ability to switch from one investment inside the annuity to another quickly and cost-effectively. (5) Annual charges, as well as any fees levied when switching from one fund to the next.

How can I decide which insurer offers the best variable annuity policies?

Because a variable annuity is a security, each insurer who offers you an annuity contract must provide you with a prospectus. The prospectus includes important information about how the variable annuity works, the investment choices you can make and the risk those investments involve. Read each prospectus you collect to decide which insurer offers the policy that best meets your needs. Explore the performance of the funds offered and the annuities’ annual fees first. You want a good track record with low fees. Explore the fee issue thoroughly. Some are very high. A low fee may make all the difference.

Can variable annuities be used as part of an asset allocation strategy?

A variable annuity’s investment alternatives should have fundamentally sound objectives that seek long-term superior investment returns commensurate with the market risks assumed by an investor. For example, the Vanguard Variable Annuity Plan offers these investment choices: money market portfolio, high-grade bond portfolio, balanced portfolio and equity index portfolio. A variety of investment alternatives offered by variable annuities give you the flexibility to tailor your investment portfolio to meet your particular needs. You can allocate the investments in variable annuities to spread your risk across a balanced portfolio of stocks, bonds and cash reserves. There is no single answer to determining the best balance. According to Ibbotson Associates in Chicago, the long-term (70 years) return on cash reserves has been 3.7%, on bonds, 5.0% and on stocks, 10.3%, but your yield from investments in a variable annuity may be lower than similar investments held in an IRA or 401(k) account, both because of the related insurance costs and generally higher fees. The earnings do grow tax-deferred, and there may be a death benefit in excess of the cash value of the varible annuity. Also, some variable contracts have evidence to show their returns are slightly better than the retail fund counterpart because the manager does not have to keep as much of the fund in cash reserves to meet redemption requirements. With variable annuities redemptions occur much less frequently. For historical returns and information on variable annuity plans, see "Grow Rich With Mutual Funds Without a Broker" by Stephen Littauer (Dearborn Financial Publishing, Chicago). It should be noted however that the asset allocation is the underlying investment mix associated with the variable annuity, not the annuity itself.

Source: www.winthers.com

Category: Credit

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