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Variable Annuities Explained

Variable annuities are, once again, climbing back into the spotlight as a popular alternative to mutual funds and other taxable investments. While their resurgence is due, in part, to the recent surge in the stock market, much of the renewed attention is a result of several key changes made in the product which have increased their appeal for long term investors. For people who haven’t considered variable annuities in recent years, a fresh look at variable annuities may be worth their while.

Variable Annuity Overview

Variable annuities were introduced in the 1950s as an alternative to fixed annuities which provided savers with a way to accumulate funds for retirement in a tax deferred account. Instead of an accumulation account which earned a fixed rate tied directly to the life insurer’s general investment account, variable annuities were given separate accounts that were tied to stock and bond investment portfolios giving investors the opportunity to earn unlimited returns on a tax deferred basis. In the high tax bracket years of the 1950s, 1960s, and 1970s, this proved to be a major attraction for variable annuities and their sales skyrocketed.

The Separate Investment Accounts

The separate investment accounts of variable annuities are very similar to mutual fund accounts. They are professionally managed portfolios that invest in various segments of the stock and bond markets. A variable annuity usually offers a selection of five to 12 accounts that enable investors to devise an allocation strategy around their specific objectives and risk tolerance. Most variable annuities allow for several transfers among the various accounts each year so the allocation can be rebalanced or changed as needed.
As with mutual funds, past performance is no indication of future performance; however, established variable annuities with long track records for their separate account can provide some measure of management’s capabilities in up markets and down markets. The more important indicator of a separate accounts future prospects is the soundness and continuity of the professional management team. Separate accounts are selected largely based on their stated investment objective and philosophy which is established by the management team. If the separate account has a revolving door of management teams, it may be an indication of internal problems, and changing management teams are likely to change the investment objective over time.

Information on the separate accounts, the management teams, their investment objective, performance history and management expenses can all be found in the prospectus which can be obtained before any investment decision is made.

Fund Access

Many people steer clear of variable annuities because they are considered to be illiquid investments. While they are more likely to perform better if left untouched for the long term, variable annuities are liquid to the extent that the funds inside the separate accounts can be accessed each year. Investors are able to withdraw up to 10% of their account values each year without any fees. For someone with $100,000 invested, that means $10,000 can be accessed for any use.

Amounts withdrawn over 10% will be charged a fee if the withdrawal is made within the surrender period which can last for five to 10 years (some variable annuity products don’t have a surrender period, however, they may charge a high front-end sales load). The fee can be high at first, but then it gradually declines each year of the surrender period until it drops to zero. At the end of the surrender period, funds can be withdrawn without charge, however, if the withdrawal occurs prior to the age of 59 1/2, the IRS may levy a penalty of 10%.

Death Benefit

One of the distinguishing features of variable annuities is the guaranteed death benefit that is common with all annuities. The death benefit assures investors that, no matter how their separate accounts perform, their heirs will receive no less than the original investment. If you can imagine those unfortunate investors who died after losing half the value of their 401k accounts in the last market crash, you will realize how valuable this benefit can be. Many contracts have a step up provision that ratchets up the basis to include the prior year’s gain, so the guaranteed death benefit will increase along with the value of the separate accounts.

Minimum Rate Guarantee

Many variable annuities now include an option (at an additional cost) that ensures that, even in a market decline, a minimum rate of return will be credited. For an investment that offers the opportunity for market returns, this would seem to be counterintuitive as higher rewards usually come in the face of higher risk. Many investors, who suffered through painful years in the market over the last decade, may find that this “insurance premium” is worth the cost.

Minimum Income Guarantee

Like all annuities, variable annuities can be converted into an income annuity. Unlike a fixed annuity in which the payout rates are fixed, the payout rates of a variable annuity are linked to the underlying investment portfolios. So, when the markets perform well, the payout can increase, and, when the market declines, so too can the payout. For investors who believe that the overall trajectory of the stock market is up, they would expect that their payout will rise over time. Investors can purchase an added layer of protection through a minimum income guarantee which will create a floor below which the payout cannot fall.

At What Cost?

One of the complaints that spew from variable annuity critics concerns their high expenses. While it’s hard to argue that their expenses run a little high, it is important to place these costs in the overall context of what the investment provides. All annuities provide a guaranteed death benefit, and for variable annuity owners, this can be a very important benefit. Mortality costs of approximately 1% of the account value are deducted each year to cover the insurance risk.

As with mutual funds, variable annuities have investment management expenses. These fees can vary from as low as .5% to as high as 1.5%. The difference lies in how actively the accounts are managed. Aggressive stock accounts that invest in high growth stocks will usually have a higher turnover than a government bond account, hence the difference in fees. These fees aren’t any higher than those found in mutual funds, however, they are added on top of the mortality expenses.

Once extra options, such as the minimum income rate or income guarantees, the fees climb higher. It’s not inconceivable that the total annual expense fee could run as high as 4% depending on how many options and extra guarantees are added. Many critics focus on the impact such a high expense rate will have on investment returns, which is a reasonable concern. What they tend not to focus on is the amount of capital that is preserved during extended down markets. If, after all expenses, your separate account values netted 0% return in a down market, would that be worth the expense?


Variable annuities are complex investments, and the marketplace is vast consisting of a seemingly unlimited variety of products offering many different bells and whistles. For a long term investor, concerned about taxes and capital preservation, they can a great addition to an overall investment portfolio. But, it would be important to study the prospectus carefully, compare all fees and sales charges, and try to limit your search to well established variable annuity providers.