Packaged Securities - Purchasing Variable Annuities

A variable annuity has two phases; accumulation and payout.

Accumulation Phase
During the accumulation phase, your client makes purchase payments, which can be allocated to a number of investment options.

  • For example, you could advise your client to designate 45% of purchase payments to a bond fund, 45% to a U.S. stock fund and 10% to a money market fund.

  • The money allocated to each investment option will increase or decrease over time, depending on the performance of the funds.

  • In this phase, your client can typically transfer money from one investment option to another without paying tax on investment income and gains, although he or she may be charged by the insurance company for transfers.

Your clients will pay several charges when he or she invests in a variable annuity. Be sure he or she understands them before investing:

  • Surrender charges: If a client withdraws money from a variable annuity within a certain period after a purchase payment - typically six to eight years - the insurance company usually will assess a charge to pay a commission for selling the variable annuity to the advisor.
    • Generally, the surrender charge is a percentage of the amount withdrawn, and it declines gradually over a period of several years, known as the surrender period.

    • A 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on.

    • Often, contracts will allow investors to withdraw part of their account value, say 10%, each year without paying a surrender charge.

    • Your client can exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in the current variable annuity account. These tax-free exchanges are known as 1035 exchanges. Surrender charges on the old annuity would still apply, and a new surrender period would begin.

    • A variable annuity contract typically has a "free look" period of 10 or more days, during which an investor can terminate the contract without paying any surrender charges and get back all purchase payments, adjusted to reflect charges and performance of the investment.

  • Mortality and expense risk charge: This charge is equal to a percentage of your client's account value - usually 1.25% per year - to compensate the insurance company for insurance risks it assumes under the annuity contract. Proceeds from this charge are sometimes used to pay the insurer's costs of selling the variable annuity - in other words, to pay the registered representative.

  • Administrative fees: The insurer may deduct charges annually to cover record-keeping and other administrative expenses. This may be charged as a flat account maintenance fee of $25 or $30 or as a percentage of the account value in the range of 0.15%.

  • Underlying fund expenses: The investor indirectly pays the fees and expenses imposed by the mutual funds that are the underlying investment options for the variable annuity.

  • Charges for other features: Such features as a stepped-up death benefit, a guaranteed minimum income benefit, or long-term care insurance carry additional fees.

Front-end sales loads, fees for transferring money from one investment option to another, and other charges may also apply. All charges need to be detailed in the variable annuity's prospectus.

At the beginning of the payout phase, your client may receive his or her purchase payments plus investment income and gains as a lump-sum payment or, more typically, as a stream of monthly payments.

  • If he or she chooses to receive a stream of payments, there are a number of choices regarding how long the payments will last.

  • Under most annuity contracts, investors can choose to have their annuity payments last for a period that they set - such as 20 years - or more typically for an indefinite period.

  • During the payout phase, the annuity contract may permit investors to choose between receiving payments that are fixed in amount or payments that vary based on the performance of mutual fund investment options.
Valuing a Variable Annuity Contract
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