Variable Annuities - What to Know Before Your Purchase

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There are many aspects to a variable annuity that can be confusing to even the most sophisticated individuals.  Before you consider purchasing a variable annuity, make sure you fully understand all of its terms, features, costs and benefits. Carefully read the prospectus. Here are several factors you should keep in mind before purchasing:

1. Liquidity and Early Withdrawals

Deferred variable annuities are long-term investments. You will have to pay a surrender penalty if you take your money out before the surrender period ends.  Many variable annuities assess surrender charges for withdrawals within a specified period, which may be as long as 12 years.  However, most annuities will allow a free annual withdrawal up to a certain percentage that is free from surrender charges.

Also, any withdrawals before an investor reaches the age of 59 ˝ are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income (not the lower capital gains rate).

2. Sales and Surrender Charges

There are usually no front-end sales charges allowing 100% of your principal to go to work for you immediately.  However, they do impose back-end charges referred to as surrender charges. These charges normally decline over a certain period of time and are eventually eliminated.  For example, a surrender charge could start at 9% in the first year and decline to 0% over a 12-year period.  When purchasing an annuity, careful consideration should be given to both the surrender amount and surrender period which vary annuity to annuity.  Annuities with lower surrender charges and shorter surrender periods are preferred.  However, shorter surrender periods may be offset by higher fees.

3. Fees and Expenses

In addition to sales and surrender charges, variable annuities may impose a variety of fees and expenses, such as:

• Mortality and expense risk charges, which the insurance company charges for the insurance to cover:

• Guaranteed death benefits;
• Annuity payout options that can provide guaranteed income for life; or
• Guaranteed caps on administrative charges.

• Administrative fees, for record-keeping and other administrative expenses;
  
• Underlying fund expenses, relating to the investment subaccounts (similar to mutual funds); and
  
• Charges for special features that provide additional protection and flexibility unique to annuities adding to their appeal, such as:

• Lifetime Withdrawal Guarantee (LWG); 
• Guaranteed Minimum Income Benefits (GMIB);
• Guaranteed Withdrawal Benefit (GWB);
• Stepped-up death benefits; or
• Long-term health insurance.

Although these special features are attractive, the fees for them reduce the earning potential of your variable annuity.  Even a 1% annual reduction in return can be substantial in the long run (example).  To reduce costs, select the futures that are beneficial to you and eliminating those that are not.

4. Bonus Credits

To attract investors, many variable annuities offer a bonus credit that is immediately credited to your principal invested.  Bonus credits can range from 1% to 5% for each premium payment you make. For example, if deposited $100,000, you could receive a 5% credit adding $5,000 for a total value of $105,000.  Free money?  Not really.  The insurance company offsets the bonus credit by charging higher fees or expenses elsewhere.

5. Guarantees

Insurance companies issuing variable annuities provide a number of specific guarantees. For example, they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens. There are several credit rating agencies that rate a company's financial strength. Information about these firms can be found on the Companies that Rate Insurance Companies.

6. Variable Annuities within IRAs

Investing in a variable annuity within a tax-deferred account will provide no additional tax savings eliminating the tax-deferred benefit of an annuity.

Also, if the annuity is within a traditional (rather than a Roth) IRA, the government requires that you start withdrawing income no later than the April 1 that follows your 70˝ birthday, regardless of any surrender charges the annuity might impose.

7. Taxes

While earnings in a variable annuity accrue on a tax-deferred basis, they do not provide all the tax advantages of qualified plans (i.e. 401(k)) and IRAs.  Both qualified plans and IRAs allow for tax-deferred growth, but contributions can lower your taxable income, which lowers your current year's taxes -- annuities to not have this advantage    That's why most investors should consider annuity products only after they make their maximum contributions to their qualified plans and IRAs.  Annuities can be purchased within some qualified plans and IRAs.

Once you start withdrawing money from your variable annuity, earnings (but not principal) will be taxed at your ordinary income rate, rather than at lower capital gains rates that apply to other investments held for more than one year.  There are other complicated tax issues that should be addressed with both your Certified Financial Planner™ and your tax advisor.  Cash withdrawals before annuitization are taxed differently than income received from annuitizing an annuity contract.  There is also a potential estate tax issues that should be addressed.

Furthermore, proceeds of most variable annuities do not receive a "step-up" in cost basis when the owner dies. Other types of investments, such as stocks, bonds, mutual funds and real estate do provide a step up in tax basis upon the owner's death.  If you do not understand how a step-up in basis works or the tax benefit, consult your CFP^® and tax advisor.

8. IRDs: Income with Respect to a Decedent

9. Required Minimum Distributions...

10.  Exchanging or Replacing Your Current Annuity

Extreme caution should be taken when exchanging or replacing your current annuity contract with a new annuity contract.  Ask yourself if it is in your best interest or the salesperson best interest.  The competitive investment environment has pressured insurance companies to offer more attractive and competitive annuity contracts.  Many insurance companies will not pay an advisor commissions when one annuity contract is exchanged for another annuity contract offered by the same insurance company.

The new annuity contract may offer features an options that may be very beneficial to your unique needs.  However, you must be aware of the tradeoffs.  Although the exchange may be income tax free (1035 exchange), new surrender charges and surrender periods will apply.  Depending on your age and when the money will be needed, this may or may not be an issues.  The new variable annuity may have a lower contract value and/or a smaller death benefit.  Consult with your CFP^® to determine if exchanging or replacing your policy improves your financial plan.

You should specifically ask the person recommending that you exchange your variable annuity:

• What is the total cost to me of this exchange?
• What does the change in the surrender period or other terms mean for me?
• What are the new features being offered? Why do I need or want those features?
• Are those features worth the increased cost?
• Will you be paid a commission for the exchange, and if so, how much is it?

You should not sign any exchange form or agree to exchange or purchase an annuity until you study all of the options carefully, have all of your questions answered, and are satisfied that the exchange is better than keeping your current contract.

Protect Yourself

Ask the person recommending that you purchase a variable annuity:

• How long will my money be tied up? 
• Are there surrender charges or other penalties if I withdraw funds from the investment earlier than I anticipated?
• What are the risks that my investment could decrease in value?
• What are all the fees and expenses?

And remember to ask yourself:

• Am I already contributing the maximum amount to my 401(k) plan and other tax-deferred retirement plans?
• Do I have a long-term investment objective? Am I going to need the money before the surrender period ends (usually at least 7 to 10 years)? Will I need the money before I'm 59˝?
• Do I understand how the variable annuity works, the benefits it provides, and charges I have to pay?
• Have I read and understood the prospectus?
• Are there special features provided such as added long-term care insurance that I don't need?
• If I've decided to purchase a variable annuity, have I shopped around and compared the features of various variable annuities, such as sales loads and other fees and expenses?
• Do I understand the effect annuity payments could have on my tax status?
• If I'm considering purchasing a variable annuity within an IRA, do I understand that IRAs already provide for tax-deferred savings?
• Am I being pressured into making a quick purchase?

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