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Morningstar.com's Interactive Classroom

Course 401
Variable Annuities

Introduction

Up until now, we've talked about how to use reasonably run-of-the-mill investments--stocks and mutual funds--in your portfolio.

In the 400 level of Investing Classroom Portfolio, we'll explore other types of investments that you might choose for your portfolio.

This lesson will focus on annuities. Many people own them but few people understand them.

What's a Variable Annuity?

All annuities are contracts with an insurance company, whereby you pay in with the understanding that the company will send you a stream of income. But that's where the similarities end and an often-bewildering parade of features and benefits begins.

You can choose to receive the income within the first 13 months of your contract (an immediate annuity) or at some point in the future (a deferred annuity). With a fixed annuity, you earn a predetermined rate of interest on your investment. If you invest in a variable annuity, you'll have control over how your assets are invested, and the size of your account will vary based on how those investments perform.

Equity-indexed annuities, which have grown in popularity in recent years, promise to be kind of a hybrid between a variable and fixed annuity. They allow you to earn returns that are higher than you'd be able to get with a fixed annuity but provide a measure of downside protection not available with a variable annuity.

Here's an overview of some of the key annuity types, as well as the pros and cons of each.

Fixed Immediate Annuity

Pros

  • Helps provide protection against outliving your assets.
  • Can be a cost-effective way to obtain a predictable income stream.

Cons

  • Annuity rates are loosely correlated with interest rates. Because interest rates are currently low, annuity payouts are also pretty low right now and go lower as you add more features.
  • Once you've bought one of these contracts, it can be difficult to get out of it.

The most straightforward type of fixed immediate annuity is a single premium immediate annuity, or SPIA. With a SPIA, you give the insurance company a slice of your assets, and in exchange you receive an income payment, usually monthly, for the rest of your life, much as you would with a pension.

With the most basic type of SPIA, you receive income during the course of your own lifetime, and your income payments cease when you die. That can be a good deal if you're in good health and have longevity in your family. On the flip side, if a retiree were to die early in the life of his contract, the insurance company would go home the winner, pocketing more than it ever paid out.

In addition to buying an annuity to cover your life and your spouse's, you can also add on features that provide benefits to your children or other beneficiaries after you've died. You can also buy a fixed immediate annuity with inflation protection, so that your payment steps up along with prices. But the costs of those extra features can quickly erode your payout.

Fixed Deferred Annuity

Pros

  • Offers many tax benefits of a traditional nondeductible IRA but has no income, contribution, or withdrawal limits.
  • Allows purchasers to spend down their portfolio of traditional assets during their expected life spans and then kicks in to help cover living expenses later in life.

Cons

  • Although fixed deferred annuities sometimes entice with high teaser rates that are attractive compared with certificates of deposit or other short-term vehicles, those rates often reset to lower levels. Fixed deferred annuities typically offer a guaranteed minimum interest rate, but that can be quite low after the teaser period ends.
  • Fixed deferred annuities, unlike CDs, don't offer FDIC protection, and you can't tap them for short-term income needs before you're age 59 1/2. You also may owe a surrender charge if you need access to your money early on in the life of your contract. (Annuities typically offer a "free look" provision, however, that lets you get all of your money back if you cancel the contract within a set number of days.)

Unlike a fixed immediate annuity, you don't begin taking payments from a fixed deferred annuity right away. Instead, the fixed deferred annuity functions something like a savings vehicle, where you can sock away money for retirement and earn a predetermined rate of interest. Fixed deferred annuities are sometimes called longevity insurance because you begin taking payouts later in life, after you've spent down your traditional portfolio of stocks, bonds, and mutual funds.

A fixed deferred annuity is somewhat (but not entirely) like putting a CD inside of an IRA. Like CDs, these vehicles guarantee you a fixed--albeit relatively low--interest rate. They also offer some of the same tax treatment as a traditional nondeductible IRA receives: Your contributions are nondeductible, but your investment increases on a tax-deferred basis. You will also owe a penalty if you take your assets out before you're 59 1/2, as is the case with a traditional IRA. The key differences versus an IRA are that the IRS doesn't impose any limits on how much you can stash in one, and you don't have to take assets out by age 70 1/2. Some fixed deferred annuities also include a death benefit, payable to your heirs, if you die before you begin taking income from your annuity.

Variable Annuity

Pros

  • For those with long time horizons, the ability to enjoy equity market participation is valuable.
  • Variable annuities also offer tax-sheltered growth and unlimited contributions for those who have maxed out their tax-deferred options.
  • Those who layer on guaranteed withdrawal and income benefits also buy themselves income and a measure of principal protection.

Cons

  • Variable annuities often have several layers of costs, including mortality and expense charges, underlying fund costs, administrative expenses, and fees for option benefits. Surrender charges may also apply if you need to withdraw assets early in the life of your contract, usually within the first five years.
  • Tax treatment upon distribution is also unattractive relative to stocks and stock mutual funds held in taxable accounts for at least a year.

Unlike fixed annuities, variable insurance products give you a level of control over your investment selections--including the opportunity to invest in stocks. The account value of a variable annuity fluctuates with the direction of your investments. The ability to own stocks makes a variable annuity a better choice when asset growth is a priority, though it can be a mixed blessing when stocks are dropping. Variable annuities also come with insurance components, including a death benefit payable to your heirs if you die before you annuitize. VA investors can also layer on other so-called living benefits, such as guaranteed minimum withdrawal benefit riders, which allow VA owners to withdraw a fixed percentage of the benefit base each year until death.

As with the fixed deferred annuity discussed above, a deferred variable annuity (by far the most common type of VA) functions something like an IRA, though you must choose your investments from a set menu of mutual funds, called subaccounts. VAs receive generally the same tax treatment as fixed deferred annuities: Your contributions aren't tax-deductible, but your investments can compound on a tax-deferred basis. You'll also owe ordinary income taxes upon withdrawal. (More on this in a moment.)

The biggest knock against VAs is their several layers of costs. The management costs associated with running the investments are, in some cases, even lower than mutual fund management fees. But because annuities offer a death benefit--usually guaranteeing to provide your heirs with an amount equal to your initial investment if you die before you annuitize--they charge an additional expense called a mortality and expense charge. That element of protection can provide peace of mind.

But in reality, few VA owners end up using their death benefits, and the associated costs can be a drag on your long-term returns. You'll also pay additional fees for any features you layer on, such as guaranteed minimum withdrawal benefits. When all of those expenses are factored in, you can easily pay much more than you would for a comparable mutual fund coupled with separate insurance coverage. Finally, some VA policies have onerous surrender charges if you need your cash early in the life of your policy. (VAs also typically have a free look provision, however.)

Equity-Indexed Annuity

Pros

  • Equity-indexed annuities give holders equity participation as well as some safeguards if the stock market performs poorly.
  • Offers tax-deferred growth.

Cons

  • In a strong up market, investors in these vehicles will see their gains muted.
  • These vehicles are also complicated and can carry significant surrender charges, as well as a tax penalty if you need to sell before age 59 1/2.
  • Withdrawals are taxed as ordinary income.

These vehicles, often pitched as a happy medium between fixed and variable annuities, have exploded in popularity during the past several years. Although there are many different variations, the basic idea is the same: Equity-indexed annuities typically promise some guaranteed rate of return, much like a fixed annuity, but they also offer participation in equity market returns.

Under a typical scenario, an equity-indexed annuity will offer a minimum return that amounts to 90% of the premium paid at a 3% interest rate. In an up market, it will also offer a percentage of the return of a stock market index, usually the S&P 500. Some equity-indexed annuities cap the equity gains you're eligible to receive.

As with the other annuities, earnings in equity-indexed annuities increase on a tax-deferred basis, and holders pay income tax on their distributions. Equity-indexed annuities also typically include a death benefit. Additionally, when stocks were going up, critics bemoaned that owners of equity-indexed annuities would receive only a fraction of the stock market's gains. But as the stock market tanked from 2007 through early 2009, owners of these annuities were able to limit their stock market-related losses.

Still, there are a couple of persistent issues with equity-indexed annuities. The first is that they're complicated. Insurers use different methods of calculating the index return that holders pocket, and you need to read the fine print to determine how your own return will be calculated. Moreover, equity-indexed annuities don't typically include reinvested dividends when calculating index returns, yet dividends have historically accounted for nearly 40% of the market's total return. Finally, equity-indexed annuities often carry steep surrender charges, though some insurers waive them for medical reasons or other emergency expenses.

Quiz 401
There is only one correct answer to each question.

1 What is an annuity?
a. A contract with a mutual-fund company, whereby you pay in with the understanding that the company will send you a steady total return
b. A contract with an insurance company, whereby you pay in with the understanding that the company will send you a stream of income
c. A pension
2 What is the difference between a fixed annuity and a variable annuity?
a. You can select from among a variety of investments in a fixed annuity; you cannot in a variable annuity
b. Fixed annuities allow you to invest in stocks; variable annuities do not.
c. You can select from among a variety of investments in a variable annuity; you cannot in a variable annuity
3 Which statement below is true?
a. An immediate annuity allows you to receive the income within the first 13 months of your contract
b. A deferred annuity allows you to receive the income within the first 13 months of your contract
c. Neither an immediate nor deferred annuity allows you to receive the income within the first 13 months of your contract
4 Which statement below is false?
a. If you invest in a variable annuity, you'll have control over how your assets are invested, and the size of your account will vary based on how those investments perform.
b. If you invest in a fixed annuity, you will not have control over how your assets are invested, but you will be sent a guaranteed rate of return some time in the future
c. Equity-indexed annuities do not promise any guaranteed rate of return, but they also offer participation in equity market via index funds.
5 What is a “con” of variable annuities?
a. Costs
b. Taxation
c. Both A and B
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