Variable annuity

From Bogleheads
Jump to navigation Jump to search

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.[1]

According to IRI (Insured Retirement Institute), investors held $1.8 trillion in Variable Annuities as of 12/31/2018.[2]

Variable annuity components

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:[3]

Variable Annuity Terminology
Variable Annuity Mutual Fund
Subaccount Mutual Fund
Accumulation Unit Mutual Fund Share
Accumulation Unit Value Net Asset Value
Accumulation Value Account Value

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.[3]

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.[4]
  • 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%.[4]

Variable annuity expenses

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% [4]
  • 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 2008 was 0.25%.
  • 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 2011 average VA subaccount ER as 0.96%.
  • Death benefit fees:The cost for enhanced death benefits ranges from .010% to 0.40%.[4]
  • Living benefit fees:
    • Guaranteed Minimum Income Benefit, average fee, 0.781%.
    • Guaranteed Minimum Accumulation Benefit, average fee, 0.76%.
    • Guaranteed Minimum Withdrawal, average fee, 0.836%.
    • Guaranteed Lifetime Withdrawal, average fee, 1.121%. [5]
  • 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.[3]
States With A Premium Tax on VA Investment
State Qualifying Non-Qualifying
Maine 0.00% 2.00%
South Dakota 0.00% 1.25%
Wyoming 0.00% 1.00%
States With A Premium Tax on Annuitized Contracts
State Qualifying Non-Qualifying
California 0.50% 2.35%
Nevada 0.00% 3.50%
West Virginia 1.00% 1.00%

The income phase

When it comes time to take income from a variable annuity you have three options:

  1. You can make aperiodic withdrawals from the VA. With aperiodic withdrawals you retain control of the annuity's capital.
  2. 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.
  3. 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. [6]
  • 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; [6]
  • 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.[6]
  • 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.[6]

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.[6]

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. [6]

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). [6]

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. The annuity option variables to include in a calculation are (quoting Milevsky):

  1. Lapse value. This captures the cash-flow that comes from liquidating or surrendering the policy – possibly after paying a contingent deferred surrender charge (CDSC) – and is tied to the evolution of the market value of the sub-accounts. Most investors purchase VAs exclusively for their lapse value since they view the instrument as a (tax-preferred) savings vehicle. Therefore, when contemplating an exchange, the policy holder should be cognizant of the discounted lapse value (DLV) of the new policy. All else being equal, the greater the contingent deferred surrender charges (CDSC) on the new policy and/or the greater the Mortality and Expense Risk Fees (from here, abbreviated M&E Fee) relative to the old policy, the lower the discounted lapse value, and the less likely it is that an exchange will add economic value to the investor.
  2. Death value. Most VA policies contain some form of guaranteed minimum death benefit. This guarantee comes in various shapes and flavors, but usually consists of a return-of-premium guarantee together with a minimally guaranteed interest rate and/or anniversary step-up feature, which periodically raises the minimum guarantee to market value. And, while these guaranteed minimum death benefits (GMDB)5 (as they are collectively known) have become a recent nuisance to the risk management and treasury departments within the insurance companies issuing these policies, the fact is that most consumers are more likely to lapse their VA than die and cash-in on the GMDB. Nevertheless, this embedded option must be priced in any transaction and we use the term discounted mortality value (DMV) to denote the current value of this guarantee.
  3. Guaranteed annuity rates. All variable annuity policies contain an option to annuitize – in the form of a guaranteed mortality table and interest rate -- which is poorly understood and usually ignored. Many older VAs contain annuity rate guarantees that are linked to outdated mortality tables and are thus more valuable, relative to updated mortality tables that assume a longer life expectancy. More recent VA policies offer optional guaranteed minimum income benefit (GMIB) riders which are a form of guaranteed annuity rate. In general, we use the term discounted annuity value (DAV) to denote the collection of options associated with the ability to annuitize the policy at a pre-specified mortality table and interest rate.

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.]

Inputs for the spreadsheet include:

  • The client's age;
  • The capital value of the Annuity. This allows one to account for any conditional surrender fees assessed upon transfer;
  • The death benefit value. For a client's current contract, this value can be either "in the money" or "out of the money." An "in the money" death benefit would potentially apply to contract values after a bear market, where the insured death benefit could be greater than the current market value of the contract. A transfer would negate this insured value since the new contract would, assuming the election of a death benefit, insure only the current market value of the portfolio. In most cases, the death benefit will be "out of the money", meaning that, assuming the election of a death benefit, the new contract will provide for a higher insured value for the transferred portfolio. Vanguard offers their VA with a zero death benefit at reduced cost. The program does not allow a zero input, so one should either input a nominal value or an estimated maximum downside risk value for this zero death benefit input.
  • The expense ratios of the two contracts;
  • The assumed volatility of the two portfolios (standard deviation);
  • The risk-free rate of return.

The output will provide the economic value of the proposed transfer. Positive values indicate that a transfer is economically suitable. Negative values indicate that a transfer is economically unsuitable.

See also


  1. SEC:Variable Annuities:What You Should Know Vanguard Variable Annuity Prospectus, 2008.
  2. IRI Issues 2018 Fourth Quarter Annuity Sales Report, Insured Retirement Institute
  3. 3.0 3.1 3.2 Vanguard Variable Annuity Prospectus, 2008.
  4. 4.0 4.1 4.2 4.3 Georgg D.Lambert. The Cost Of Variable Annuity Guarantees
  5. Kevin Loffredi, Carriers Settle In: Variable Annuity Product Development Slows in Third Quarter, Morningstar
  6. 6.0 6.1 6.2 6.3 6.4 6.5 6.6 Non-Qualified Annuity Tax Rules

External links

Internal Revenue Service

Regulatory cautions


  • Insured Retirement Institute


  • A tutorial series by forum member Mel Lindauer: