1. Introduction To Annuities: The History Of Annuities
  2. Introduction To Annuities: Basics of Annuities
  3. Introduction To Annuities: Advantages And Disadvantages
  4. Introduction To Annuities: Marketing And Regulation
  5. Introduction To Annuities: Fixed Contracts
  6. Introduction To Annuities: Indexed Annuities
  7. Introduction To Annuities: Variable Annuities
  8. Introduction To Annuities: Conclusion
In the last section, we examined indexed annuities and their components. In this section, we will examine the third major category of annuities. Traditionally, variable annuity investors have been subject to the same market risks as investors of taxable stock and bond funds, but in recent years many different features have become available within variable contracts that have reduced, or in some cases even eliminated, this risk.

Mechanics of Variable Annuities

Variable annuities are the most complex type of annuity in the market today. In fact, they are one of the most complex investments in existence, probably second only to variable universal life insurance. In a nutshell, these contracts consist of a bundled offering of mutual fund subaccounts that grow under a tax-deferred umbrella. The groups of subaccounts offered and the specific annuity products that they are in will vary according to the agreements made between the fund families and insurance companies. Most of their complexity resides in the various riders and other benefits that are commonly offered in modern contracts. These riders are aimed at reducing market risk through various means. For example, many variable annuities offer a rebalancing feature, where the initial asset allocation between the various funds offered within the contract is preserved by automatically reallocating the growth of each fund from the higher-yielding funds to the lower performing ones. Over time, this can be an extremely effective method of profiting from normal market cycles among various sectors. Dollar-cost averaging (DCA) programs are another method of increasing return while decreasing risk. Many companies will offer a high guaranteed rate of interest in a fixed account for a short period of time, such as six months or a year. The contract proceeds are initially invested in this fixed account and then moved into a preselected allocation of funds in equal shares over the prescribed period of time.

Many companies have gone even further in providing their clients with peace of mind while investing in the market. There are now riders available inside many of the contracts offered by major carriers that will guarantee not only the investor's principal, but also a set rate of growth. Furthermore, if the underlying funds outperform this rate, then the investor can reap the difference in growth between the two as well. However, this guarantee comes at a price, which will be examined more closely in an upcoming example.

The investor is not the only party privy to security features within the contract. If the annuitant dies, most beneficiaries in modern contracts will receive the highest of the current contract value, the highest anniversary value or a hypothetical amount based upon a fixed interest rate if the current value of the contract is less than that. Any withdrawals that the annuitant received are, of course, subtracted from the calculation of these amounts.

The various features that variable annuities offer come with corresponding charges that must be deducted from the contract value, either on an annual or quarterly basis. These fees cover a number of expenses, and can be broken down as follows:

Mortality and Expense ChargesThese are standard base fees found in all variable annuities. These fees covers the death benefit provisions commonly found in most contracts.

Contingent Deferred Sales ChargeThis is a back-end charge that declines to zero over time, usually by 1% per year over five to 10 years. This charge provides a substantial deterrent to an investor seeking to withdraw funds from the contract until a reasonable period of time has elapsed. However, most contracts today offer a free withdrawal window of 10% per year, as well as total liquidity provisions for such things as nursing home expenses. But if the contract owner is below age 59 ½, then the 10% early withdrawal penalty assessed by the IRS still applies.

Administrative Service Charge
This charge covers the money management features discussed earlier, such as asset rebalancing and dollar-cost averaging, as well as confirmation and monthly statements.

Contract Maintenance Charge
This cost is usually $15-$50 and is for the general maintenance of the contract. It covers the cost of issuing the contract, along with general administrative costs.

Fund Expenses – Fees charged by the mutual funds within the annuity contract and passed to the contract owner. They include
12b-1 fees and other management-related fees.

It is clear that the various features offered within today's variable annuity contracts do not come for free. Normally, the average contract owner can expect to pay 2-3% per year in combined fees, which are deducted on either a quarterly or annual basis from the contract value. The number of riders that are chosen will determine the exact percentage that is assessed.

To better illustrate this concept, let's examine a hypothetical annuity contract where the investor chooses a normal array of riders and benefits.

Billy Bones buys a $100,000 contract with a major insurance carrier. He decides to participate in the dollar-cost averaging special which pays 7% in the fixed account over a one-year period during which $12,500 is moved monthly into the allocation of funds that he has selected. He has also opted for the 7% guaranteed minimum benefit rider, which guarantees that he will receive at least 7% growth over the life of the contract as long as he adheres to certain withdrawal provisions. Finally, he adds the asset rebalancing feature as a growth and safety measure. Here is a breakdown of what these features will cost him:
Mortality & Expense Charge
Contract Maintenance Charge

Waived for contracts of $100,000 or more
Mutual Fund 12-1 fees
Minimum Income Rider
This total is fairly high in terms of relative fee structure. For example, most professional money managers (meaning Registered Investment Advisors, who trade individual securities directly for clients) charge less than this (often less than half this amount, in fact) per year.

Purchasing the minimum income rider should also have an effect on the investor's investment strategy. Since the rider guarantees a rate of 7%, the mutual fund portfolio should therefore be invested aggressively. The reasoning is that since a conservative rate is already guaranteed, there is nothing to be gained by investing in funds that will yield that amount or less.

Plus, the funds already have a 3.4% annual charge to overcome as it is, so a 10.4% return is needed just to break even with the guaranteed rate. This should direct the investor to look at funds that have historically yielded 12-14% per year over time, such as small cap funds, some international funds or perhaps a developing sector fund, like a healthcare fund. That way, there is at least some chance of reaping excess growth above and beyond the 7% guarantee.

But investors should carefully weigh the income withdrawal provision against their income needs during the payout phase. Guaranteed income riders often require annuitization, which irrevocably locks the contract into a set payment schedule that cannot be altered. This means that if the investor's income needs change after payout begins, he or she cannot alter the income from the annuity to accommodate those needs. Therefore, guaranteed income riders need to be considered carefully from several angles by an investor before being chosen.

It should be noted that some insurance carriers are now starting to offer unbundled benefits within contracts, thus allowing investors to choose the riders and benefits that they think they will need and not be forced to pay for other provisions that they think are unnecessary.

Use of Variable Annuities in Retirement Plans
This issue deserves special attention for two main reasons. First, a substantial percentage of all retirement plans, qualified or otherwise, are invested in annuity contracts. Second, there is some controversy about whether annuities belong within a tax-deferred retirement plan to begin with.

Many retirement planners and insurance advisors use annuities as the de facto investment vehicle for funding any type of retirement plan, regardless of whether it is group or individual, qualified or nonqualified. Virtually all 403(b) plans are invested in Tax Sheltered Annuities. But what is to be gained by doing this? Annuities are inherently tax-deferred by nature, just as retirement plans and accounts are. There is no such thing as double tax-deferral! So why is this practice so common? This question has more than one answer. The response usually given by the insurance industry is that annuities offer many other features and benefits besides tax-deferral, such as money management features and insurance protection. This latter feature has been substantially developed over the last five years via the guaranteed contract riders discussed earlier. Admittedly, these options do allow for a guaranteed stream of retirement income that conventional retirement plans and accounts alone cannot duplicate, but they come with a cost that must be borne by all participants, and not just those whose need for income happens to fit the guaranteed option riders offered within the annuity contract.

It is important to note that inside a retirement plan, when all possible investment choices are offered within a variable annuity, then all plan participants are forced to pay the commensurate contract fees. Many participants do not need or want a guarantee of principal, and while it is of course possible to waive many of the protection riders, there are certain mortality and expense fees that cannot be avoided. As stated previously, these fees effectively reduce the overall return that participants will realize from their plans over time. Furthermore, most plan participants do not understand enough about the plans they participate in to separate the plan from the annuity contract or the investment. Most advisors will simply tell participants that they are investing in mutual funds. They are, of course, but within the variable annuity contract that the plan has been placed in. In reality, there is a large percentage of plan participants who do not even know that their retirement plan is contained within an annuity contract at all, thinking that the fees and expenses are just part of the plan's administration costs. It must also be noted that both the SEC and FINRA are taking an increasingly dim view of annuities within tax-deferred accounts. In fact, FINRA recently gave notice to all financial, retirement and insurance planners, brokers and agents that they are now required to notify plan participants that the annuity contract within their retirement plan is technically unnecessary. It is likely that this issue will continue to receive attention from both regulatory bodies and the financial media for some time to come.

For more information on this topic, see Are You Buying Annuities or Mutual Funds?

Introduction To Annuities: Conclusion
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