Variable annuity

A variable annuity is an insurance contract that delays payments of income (periodic or systematic withdrawals, or annuitized payouts) until the investor elects to receive them. This type of annuity has two main phases, the savings phase in which you invest money into the account, and the income phase in which the plan is converted into income and payments are received. Earnings within the contract are tax deferred, and are taxed upon withdrawal at income tax rates (similar to qualified retirement plans) and share with these plans the 10% early penalty tax for withdrawals made prior to age 59 and 1/2. If the annuity is held within a retirement plan it is known as a "qualified" annuity and distributions are totally taxable. If the annuity is purchased in the taxable account it is known as a "non-qualified" variable annuity and only the earnings are subject to tax. Variable annuity withdrawals are made on an earnings first, basis last principle. Variable annuities come with an array of insurance options, all of which add to the cost of investment in the contract. These guarantees are subject to the continuing claims paying solvency of the insurer.

According to NAVA investors held $1.397 trillion in Variable Annuities as of 3/30/2008.

History of the Annuity in the United States 1759 -  The first annuity in America is offered by a Pennsylvania company to Presbyterian ministers and their families.

1912 -  The Pennsylvania Company for Insurance on Lives and Granting Annuities is the first American company to offer annuities to the general public.

1930s  -  Annuities become popular as concerns about the overall health of the financial markets prompt many to purchase products from insurance companies, which are seen as stable institutions.

1930s -  New Deal programs encourage individuals to save for their own retirement. The group annuity market for corporate pension plans begins to develop.

1952 -  The first variable annuity is issued by TIAA-CREF for use in college and university qualified retirement plans.

1959 -  In SEC v. Variable Annuity Life Insurance Company, the Supreme Court holds that variable annuities are subject to federal securities regulation.

1960  -  The first non-qualified variable annuity policy becomes available through the Variable Annuity Life Insurance Company (VALIC).

1977  -  Revenue Ruling 77-85 is issued stating that individual investments in an annuity cannot be directed by the owner.

1979 -   Revenue Ruling 79-335 is issued eliminating the tax-free step up in basis at death for variable annuity contracts.

1980 -   Revenue Ruling 80-274 is issued ruling that bank CDs cannot be wrapped in an annuity.

1980 -   The guaranteed minimum death benefit (GMDB) is introduced.

1981 -   Revenue Ruling 81-225 is issued stating that publicly traded mutual funds cannot be the underlying investments in a non-qualified annuity.

1982 -   The Tax Equity and Fiscal Responsibility Act of 1982 allows annuities to keep their valuable tax-deferred status, retains the exclusion ratio which treats annuitization payments as part return of principal and part return of taxable earnings, and changes the taxation of withdrawals from principle first to income first.

1984 -   The Tax Reform Act of 1984 eliminates the double taxation of realized capital gains of separate accounts at the insurance company level.

1986 -   The Tax Reform Act of 1986 disallows non-natural owners of annuities unless they are held by a trust acting as agent for an individual. The capital gain preference tax is eliminated and tax shelter investments are greatly curtailed.

1991 -   The National Association for Variable Annuities (NAVA) is formed.

1994 -   Variable annuity sales figures are published on a regular basis in the National Underwriter.

1995  -  Indexed annuities and the maximum anniversary value (ratchet) death benefit are introduced.

1995 -   Annuity industry sales top $100 billion.

1996 -   The guaranteed minimum income benefit (GMIB) is introduced.

1997 -   Total annuity assets top $1 trillion.

1998 -   Bonus variable annuities are introduced.

1999 -   Variable annuity sales top $100 billion.

2000 -   Variable annuity assets top $1 trillion.

2000 -   Enhanced earnings benefits (EEBs) and L-share variable annuities are introduced.

2002 -   The guaranteed minimum withdrawal benefit (GMWB) is introduced.

2002 -   The guaranteed minimum accumulation benefit (GMAB) is introduced.

2002 -   The variable annuity industry standardizes net flows (net sales) reporting.

2002 -   Fixed annuity sales top $100 billion.

2004 -   The guaranteed lifetime withdrawal benefit (GLWB) is introduced.

2005 -   Indexed annuity sales top $25 billion.

2006 -   The Pension Protection Act of 2006 overhauls the federal pension plan and tax laws which, among other provisions, allows annuities to include long-term care riders, and makes it easier for traditional defined contribution plans to offer annuities to workers by clarifying the “safest available annuity” standard under ERISA.

2007 -   Total annuity assets top $2 trillion.

-- NAVA 2008 Annuity Factbook 

The Variable Account
Investments in a variable annuity are placed in what is termed a Separate Account, which is an account segregated from an insurer's general account and is exempt from the insurer's creditors. The assets in the account are thus safe from an insurer's default. Investors are provided with a menu of subaccounts, pooled investment vehicles analogous to mutual funds, offering access to stocks, bonds, and money market instruments. The annuity investor's capital will fluctuate with the returns of the underlying subaccount investments. The terminology used in connection with a subaccount, along with the analogous mutual fund terminology is provided in the following table:

Dividends and capital gains distributions do not add accumulation units to your subaccount; they are added into the accumulation unit value.

The Death Benefit
The basic insurance benefit associated with a variable annuity is the death benefit. The benefit assures the beneficiaries of the annuity a guaranteed payment if the contract owner dies prior to annuitizing the contract. The benefit is usually offered with variations. Fees for these benefits will be discussed later.
 * Return of Premium:The return of premium death benefit guarantees that the beneficiary will receive either the current market value of the contract or the premiums (net of any withdrawals) paid into the contract.
 * Stepped Up Death Benefit: This death benefit guarantees the beneficiary will receive either the full account value at the time of death or the highest account value on any contract anniversary prior to death, whichever is greater.
 * Stepped Up Benefit with Accumulation: This option guarantees the beneficiary will receive either the greater of the stepped up death benefit or the total contributions accumulated at a certain annual percentage rate, less any withdrawals.

Living Benefits
Many variable annuities offer guarantee options to insure a given level of retirement income, or accumulation value. These guarantees come at an added cost. The main Living Benefit options include:
 * Guaranteed Minimum Income Benefit: This option ensures that if you purchase a variable annuity during one of the financial market peaks and end up requiring retirement payments during one of the market’s troughs, you will still receive a predictable minimum level of retirement payments after a certain agreed-upon date. Should the underlying investments perform well, then your payments may be higher than this guaranteed amount.  To initiate the guaranteed minimum income benefit, you must annuitize the contract.
 * Guaranteed Minimum Accumulation Benefit: This optional feature protects your contribution against market volatility. Typically, a portion of your original contribution is invested in a fixed interest account that is guaranteed to grow to the size of your principal after a specified period of time, while the remainder is invested in variable investment portfolios. Some versions of this benefit, in addition to guaranteeing your principal or original contribution, also guarantee a certain minimum level of accumulation.
 * Guaranteed Minimum Withdrawal Benefit: This optional benefit guarantees that regardless of market performance, you will be able to receive at least the entire amount of your total principal investment through a series of annual withdrawals – provided that you do not withdraw more than a specified percentage of your total investment in any given year. Some variable annuities are now offering this benefit with the guarantee that you can make withdrawals for as long as you live.
 * Guaranteed Lifetime Withdrawal Benefit (GLWB):The GLWB guarantees that you can withdraw a minimum amount throughout your lifetime - regardless of the subaccounts' performance - and you don't have to annuitize your contract. The guarantee is a set percentage of your investment, which increases the longer you delay taking payments. For example, the company might agree to pay you 5% at age 55. But if you wait until you are 70 to begin taking income, the company might increase that to 5.5%. At age 80, it could be 6%.

Variable Annuity Expenses
Each of the above features and options are available for a fee. The fees associated with a variable annuity include the following charges.
 * Mortality and Expense Risk Charge: This charge covers the insurer's costs for guaranteeing an annuity payout rate, as well as other insurance and administrative charges. This charge often contains the cost for providing a basic death benefit.The average basic death benefit costs between 0.15% and 0.35%
 * Account Maintenance Fee This is usually a flat fee ($25-$35) assessed annually to the contract to cover the costs maintaining the account. The fee usually is waived at a certain account size level. The average VA asset based administrative and recordkeeping fee for 2006 was 0.313%
 * Underlying Subaccount Fees: Subaccounts have expense ratios just as do mutual funds. Average variable annuity subaccount expense ratios are lower than average mutual fund expense ratios. Morningstar reports the 2006 average VA subaccount ER as 0.821%.
 * Death Benefit Fees:The cost for enhanced death benefits ranges from .010% to 0.40%.
 * Living Benefit Fees:
 * Guaranteed Minimum Income Benefit,fees range from 0.50% to 0.75%.
 * Guaranteed Minimum Accumulation Benefit, fees range from 0.25% to 0.75%.
 * Guaranteed Minimum Withdrawal Benefit, fees range from 0.40% to 0.65%.
 * Guaranteed Lifetime Withdrawal Benefit, fees range from 0.50%-0.60%
 * Surrender Charges: Most variable annuities impose a surrender charge for withdrawals from or exchanges out of the contract. The percentage charge usually declines over time (usually 7 or 8 years) until it disappears. Some VA's impose a surrender charge on each investment you make in the contract. Many contracts allow you to withdraw a certain percentage of the account value (often 10%-15%) per year without incurring the surrender charge..
 * Premium Taxes Some states assess a regulatory tax on each variable annuity investment payment; other states assess a tax on accumulated annuity values which are annuitized and not taken as a lump sum.

The accumulation of all these fees and surrender charges make the average VA a prohibitively expensive investment vehicle. Investors can reduce the costs associated with a VA by directly investing in a no-load, no surrender fee VA with low insurance and subaccount cost loadings.

The Income Phase
When it comes time to take income from a variable annuity you have three options:
 * You can make aperiodic withdrawals from the VA. With aperiodic withdrawals you retain control of the annuity's capital.
 * You can make systematic withdrawals from the VA. A systematic withdrawal can be either a fixed percentage of the account balance, or a fixed regular withdrawal of a set dollar amount. With systematic withdrawals you retain control of the annuity's capital.
 * You can annuitize the VA. The decision to annuitize is irrevocable. With this option, you usually surrender control over the VA capital in return for an income stream. An annuitization can be either a fixed immediate annuity, or a variable immediate annuity, or a combination of the two.

Variable Annuity Taxation
If a variable annuity is held within a qualified plan, the annuity is taxed according to the tax rules governing the qualified plan. Non-qualified variable annuities are subject to the following tax rules. All income is taxed at an individual's marginal income tax rate.


 * The VA, similar to other retirement vehicles, is subject to a 10% early withdrawal penalty for withdrawals made prior to age 59 and 1/2. Exceptions to the penalty include:
 * The owner is over age 59½;
 * The owner is disabled after contract purchase;
 * The owner, not the non-owner annuitant, dies;
 * Pre-TEFRA (prior to 8/14/82 contributions) nonqualified money;
 * Immediate nonqualified annuity (Note: An exchange from a deferred to an immediate annuity does not qualify as an immediate annuity for the purposes of avoiding tax penalty);
 * Substantially Equal Periodic Payments.


 * Non-qualified VAs are not subject to the required minimum distribution rules. This allows you to potentially continue to defer taxes past the 70 and 1/2 age required distribution date that applies to traditional IRAs and qualified plans (if you are not still working). Most VAs do have a point (frequently age 85) where you are required to annuitize the contract.


 * VA withdrawals are made on an earnings first, basis last principle. An exception applies to pre-TEFRA contributions to an annuity made prior to 8/14/82. Withdrawals from these contracts are on a basis first, earnings last principle.


 * VA ownership transfers such as:
 * Addition/deletion of joint owner;
 * Transfer to another individual or entity;
 * Assignment;
 * Can have the following tax consequences:
 * Earnings are subject to income tax at time of transfer;
 * 10% penalty may apply;
 * Gift taxes may apply;
 * Exceptions to tax:
 * Transfers between spouses;
 * Transfers incident to divorce;
 * Transfers between an individual and his/her grantor trust;


 * Upon annuitization each VA income payment represents a return of non-taxable investment in the contract with the balance of each payment considered taxable income. The taxable and non-taxable portions of the payments are determined by an exclusion ratio, determined for a variable annuity by dividing the investment in the contract by the total number of expected payments. Once the total amount of the investment in the contract is recovered, the annuity payments are fully taxable. If the owner dies before the total investment in the contract is recovered, and annuity payments cease as a result of his death, the un-recovered amount is allowed as a deduction to the owner on the final tax return.


 * For variable annuity contracts issued on or after 10/29/79 there is no "step-up" in basis for income tax purposes and the beneficiary pays income tax on the earnings. If the annuity is subject to estate tax, the beneficiary is entitled to deduct a portion of estate tax paid on the annuity for income tax purposes. For variable annuity contracts issued prior to 10/21/79, there is a "step-up" in basis for income tax purposes and no income tax is payable on the earnings.

Distributions Upon the Death of the Variable Annuity Owner
A surviving non-spouse joint owner or beneficiary of a non-qualified VA must select one of the following distribution options for a VA inherited during the accumulation phase of the contract:
 * immediate lump sum;
 * according to the five-year rule with complete withdrawal(s) within 5 years of the contract owner's death;
 * annuitization (over the life of the new owner) to start within one year of the contract owner's death.

A spousal co-owner or beneficiary has the option of assuming the variable annuity as his or her own.

The income over basis in a variable annuity is considered Income in Respect of a Decedent. This means that the increase in value inside a deferred variable annuity does not receive stepped up valuation upon the death of the contract owner. The beneficiary assumes both the decedent's basis in the annuity, as well as the same tax character of the income. Should a decedent's estate pay estate tax the portion of the tax attributable to the estate's IRD is deductible as a miscellaneous itemized deduction (not subject to the 2% AGI exclusion) to the beneficiary receiving the IRD. The deduction is figured by computing the estate tax due on the entire estate and computing the estate tax due on the estate minus all IRD. The difference between the two provides the deductible amount. The deduction is realized on the IRD as the IRD is paid out to the beneficiary.

The beneficiary's right to income after the death of the annuitant during the annuitization phase of a variable annuity will depend on the annuitization option selected (single life, joint life, or the selection of a guaranteed period).

The 1035 Exchange
The IRS allows you to make tax free transfers of annuities through what is known as a 1035 exchange. Since variable annuities are typically burdened with high insurance costs and stiff back end surrender fees, a tax-free exchange of high cost contracts to no-load, no surrender fee, low cost annuities is clearly warranted for most non-qualifying annuities. Low cost VA's are offered by Vanguard, Fidelity and TIAA-CREF. The 1035 transfer decision can be quantified using a spreadsheet template similar to the one offered by Dr. Moshe Milevsky as an adjunct to his paper Exchanging Variable Annuities: An Optional Test for Suitability. A full explanation of the variables and inputs for this calculation are available at the Fiduciary Transfers Page.

The spreadsheet program for quantifying the 1035 exchange can be downloaded here. [Please note that this spreadsheet is made available for educational purposes, not for commercial use.]

Links

 * SEC Variable Annuities: What You Should Know
 * FINRA Variable Annuities: Beyond the Hard Sell
 * IRS Publication 575 Pension and Annuity Income
 * IRS Publication 939 The General Rule

Academic Papers

 * Brown, Jeffrey R. and Poterba. James M. "Household Ownership of Variable Annuities" (October 2005). Available at http://www.nber.org/~confer/2005/tpe05/poterba.pdf
 * Burns, William J., and Utkus, Stephen P. "“DB in DC”: Deferred Annuities in Defined Contribution Plans" Research Note. Available at https://institutional.vanguard.com/iam/pdf/CRRREA.pdf
 * Dai, Min, Kwok, Yue Kuen and Zong, Jianping, "Guaranteed Minimum Withdrawal Benefit in Variable Annuities" (February 12, 2007). Available at SSRN: http://ssrn.com/abstract=964083
 * Devine, Colin, Hunt, Heather L. and  Walsh, Keith, "The New Variable Annuity" Smith Barney (September 14, 2004). Available at http://www.peterkatt.com/newsletters/SmithBarney.pdf
 * Evans, Richard B. and Fahlenbrach, Rudiger, "Do Funds Need Governance? Evidence from Variable Annuity-Mutual Fund Twins" (November 5, 2007). Fisher College of Business Working Paper No. 2007-03-18 Available at SSRN: http://ssrn.com/abstract=1030022
 * Goodman, Benny, and Tanenbaum, Seth, "	The 5% Guaranteed Minimum Withdrawal Benefit: Paying Something for Nothing? " TIAA-CREF Institute, Research Dialogue, Issue 98 (April 23, 2008). Available at http://www.tiaa-crefinstitute.org/pdf/research/research_dialogue/89.pdf
 * Milevsky, M.A. and Kyrychenko, V., "Portfolio Choice With Puts: Evidence from Variable Annuities" (November 23, 2007). Available at SSRN: http://ssrn.com/abstract=1032627
 * Milevsky, M.A. and Panyagometh, Kamphol, "Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options" (September 2001). York-Schulich-Finance Working Paper No. MM10-1. Available at SSRN: http://ssrn.com/abstract=289549 or DOI: 10.2139/ssrn.10.2139/ssrn.289549
 * Milevsky, Moshe and  Posner, Steven "The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds" The Journal of Risk and Insurance, 2001, Vol. 68, No. 1, 91-126. Available at http://www.yorku.ca/milevsky/Papers/JRI2001A.pdf
 * Milevsky, Moshe A. and Salisbury, Thomas S. "Static and Dynamic Valuation of Guaranteed Minimum Withdrawal Benefits" (August 25, 2004). Available at http://www.ifid.ca/pdf_workingpapers/WP2004Aug25.pdf
 * Milevsky, Moshe A. and Salisbury, Thomas S. "Asset Allocation and the Transition to Income: The Importance of Product Allocation in the Retirement Risk Zone" (September 27, 2006). Available at http://www.ifid.ca/pdf_workingpapers/WP2006OCT3.pdf
 * Reichenstein, William, "Who Should Buy a Non-Qualified Tax-Deferred Annuity" Financial Services Review 11 (2002) 11-31, (January 17,2002). Available at http://www.rmi.gsu.edu/FSR/abstracts/v11_arts/Vol11_A02.pdf
 * Reichenstein, William, "Retirement Planning: Annuities and When They Make Sense" AAII Journal (July 2003). Available at http://www.aaii.com/journal/200307/portstrategies.pdf
 * Reichenstein, William, "Non-qualified Annuities in After-tax Optimizations" (May 11, 2005). Available at http://www.ifid.ca/Conference_Material/Reichenstein_paper.pdf