what is a variable annuity
(And why would you buy one?)
Variable annuities are a financial tool designed for two things: building wealth and creating a lifetime retirement income. There's no shortage of strong opinions for and against. And like everything else in the investment world, nothing is free. The features of variable annuities come at a cost. However, considering that Americans bought almost $93 billion in variable annuities in 2018, it's certainly worth finding out more about them.
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First Things First ... What’s a Variable Annuity?
Variable annuities are policies issued by insurance companies. They pay a regular income for life or for a period of years. You buy a variable annuity policy by making a single payment or a series of payments. Variable annuities are either deferred or immediate.
- Deferred variable annuities accumulate money for a period of time before the policy pays income.
- Immediate variable annuities start paying income right away.
Variable annuities are either qualified or non-qualified.
- Qualified variable annuities are part of a pension plan or IRA. They are purchased with before-tax dollars. Roth-qualified annuities are part of a Roth IRA or pension plan. They are purchased with after-tax dollars.
- Non-qualified variable annuities are personally owned and paid for with after-tax dollars.
How variable annuities work
Why It's Called Variable
Variable annuities have a selection of investments called subaccount funds. Subaccount funds are similar to mutual funds. Investors can choose from stocks, bonds, and other asset classes. The subaccounts accumulate money on a tax-deferred basis. Money can be transferred between subaccounts without any tax consequences.
The value of variable annuities is represented by units. The value of each unit rises and falls with the investment it represents. The account value of a variable annuity rises and falls based on the value of the units, not because there are more units or fewer units.
On the other hand, the value of fixed annuities is measured by dollars. When the value of a fixed annuity rises or falls, it's because there are more dollars or fewer dollars in the account.
Variable Annuity Features
- Tax-deferred growth: There is no tax on subaccount capital gains or dividends until there are distributions, and also no tax on transfers between subaccounts. There are, however, no additional tax benefits to purchasing a variable annuity in your IRA or employer-sponsored retirement plan.
- Downside protection: Living benefits offer a guaranteed minimum lifetime income regardless of market performance. Variable indexed annuities can protect retirement money from market losses.
- Lifetime retirement income: Variable annuities have income options that can pay for one lifetime or the longer of two lifetimes.
- A menu of investment options: Variable annuities offer a selection of professionally managed investments that suit many different objectives and strategies.
- Death benefit: Variable annuities offer death benefit protection for beneficiaries. The minimum death benefit is the account value. Some products offer enhanced minimum death benefits.
- Creditor protection: Most states offer annuities some form of creditor protection. In some cases, it is unlimited protection.
Who Can Benefit from a Variable Annuity?
If you have "maxed out" your contributions to your employer-sponsored retirement plan or your IRA, a non-qualified variable annuity may be a good option to supplement your retirement savings. There are no restrictions on contributions, and your investments grow tax-deferred.
Investors who are retired, or close to it, may benefit from the lifetime income options that variable annuities offer. There are options for fixed income payments, income that rises and falls with investment performance, and income that is provided for the longer of two lifetimes. Variable annuity downside protection features may also be attractive to "pre-retirees."
Some investors who change their portfolios on a regular basis by using rebalancing or other strategies may benefit from a low-cost variable annuity.
The Best Variable Annuity to Buy
Well, first things first. There are plenty of variable annuities on the market to choose from. Before you decide which one to buy, be clear about what your goals are. What features are important to you? Are you looking for a low-cost product for tax deferral and portfolio management? Do you want protection from down markets? If the variable annuity you are looking at doesn’t offer the features you want, the rest doesn’t matter.
Variable annuities are retirement products. They're designed to do two things, build wealth and create lifetime retirement income. They should fit into your retirement plan. If you haven’t done any retirement planning yet, that should be your first step.
What If the Insurance Company Goes Bankrupt?
Insurance companies that sell variable annuities are regulated by each of the 50 state insurance departments. These departments have financial standards for licensed companies. Each state has guarantee funds to reimburse policyholders if the insurance company fails. The limits for each state are different.
Variable annuity products are regulated by the states, the SEC, and the Financial Industry Regulatory Authority (FINRA). The subaccounts in variable annuities are separate from the insurance company, and not subject to the claims of their creditors. That said, strong financial ratings are important.
Financial strength ratings of insurance companies are available from A.M. Best, Fitch, Moody’s, and Standard & Poor. Financial strength ratings are the agency's opinion of the insurance company's ability to meet policyholder obligations.
The Best Variable Annuity Companies
Companies that sell variable annuities have to be licensed as insurance companies by the states where they are selling, and registered with the SEC as investment companies.
Out of the 773 life insurance and annuity companies in the US, 20 sell 95% of the variable annuities. That makes it a little easier to decide who to buy from.
One good thing to know is whether other people are buying from this company. Are they a leader? While it doesn’t tell you about the company, it’s a good indication that financial professionals have some confidence in them.
It’s true that Mom says, “If your friend jumped off a bridge, would you do it too?” While that’s good advice, it doesn’t apply here.
How does the company treat its customers? One way to find out is the J.D. Power consumer satisfaction survey of annuity companies. They use a rating system of Among the Best, Better than Most, Average, and The Rest.
We’ve put together a handy chart to show you the sales rankings, financial strength ratings, and J.D. Power satisfaction ratings (where available) of the top 20 variable annuity companies.
Claims-Paying Ability Tier
|Rank By Premium Sales *||Company||A.M. Best||S&P||Moody's||Fitch||J.D. Power Satisfaction**|
|2||AXA US||Highest||Highest||Highest||Highest||Better than Most|
|3||TIAA||Highest||Highest||Highest||Highest||Better than Most|
|7||Brighthouse Financial||Highest||Highest||Medium||Medium||The Rest|
|9||Riversource||Highest||Highest||Highest||N/A||Among the Best|
|13||N.Y. Life||HIghest||Highest||Highest||Highest||Among the Best|
|14||Thrivent Financial||Highest||N/A||N/A||Highest||Not Rated|
|15||Fidelity Investments Life||Highest||N/A||N/A||N/A||Not Rated|
|16||Northwestern Mutual||Highest||Highest||Highest||Highest||Not Rated|
|17||CMFG Life||Highest||Highest||Medium||N/A||Not Rated|
|18||Principal Financial||Highest||Highest||Medium||Highest||Not Rated|
|19||Great- west Financial||Highest||Highest||Highest||Highest||Not Rated|
* Source: LIMRA Secure Retirement Institute U.S. Individual Annuities Sales Survey 2nd Quarter 2019
** Source: JD Power 2019 U.S. Life Insurance Study
How to Compare Variable Annuities
Variable annuity features come at a cost. Like anything else, it's important to know what you're buying, what you're paying, and what you're getting. The best variable annuity products offer the features you are looking for at the lowest cost. The chart below shows fees and expenses to look at for comparison purposes.
|Mortality & Expense||1.25% of the account value||Cost of providing insurance|
|Management Fees||.25% - 2% of subaccount value||Fees paid to subaccount investment managers|
|Administrative Fees||$25.00 - $50.00 per transaction||Cost of transactions and record keeping|
|Surrender Charges||7%, 6%, 5%, 4%, 3%, 2%, 1%, 0||Charge declines over a period of years, usually 5 - 7. Withdrawals up to 10% of the account value are usually free of surrender charges|
|Guaranteed Minimum Income Benefit (GMIB), Guaranteed Lifetime Withdrawal Benefit (GLWB)||1% and up of benefit base||Charges for guaranteed minimum income riders|
|Guaranteed Minimum Accumulation Benefit (GMAB)||1.4% and up of the benefit base||Charge for optional GMAB|
|Enhanced Death benefits||.65% and up of the benefit base||Charges for stepped-up death benefit option|
|Premium Tax||Premium-based||8 states charge a premium tax, CA, FL, ME, NV, SD, WV, WY, along with the US territory of PR|
Again, your objectives are important. Be sure to comparison shop the total cost as well as the features that you are looking for. Don't overlook the subaccount management fees. Many variable annuities have low-cost options available.
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What Happens to the Money in a Variable Annuity When You Die?
If you die during the deferral period, your beneficiary will receive the account value. If you die during the distribution period, the income option that you selected will determine what the beneficiary will receive.
Some companies offer a minimum guaranteed death benefit equal to the purchase payment. There are also optional riders to step up or increase the death benefit based on a formula. The formula can be the purchase payments accumulated at an interest rate, or the highest previous account value.
Variable annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone. Talk to an independent insurance agent. They can help you decide if a variable annuity is right for you.
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TrustedChoice.com Article | Reviewed by Paul Martin
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Insured Retirement Institute 2018 sales results
J.D. Power 2019 life insurance study