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The Following Is For Educational Purposes Only

Invest Wisely: Variable Annuities

What is a variable annuity?

An annuity in this context is simply a contract between you and an insurance company. You pay the insurer a specified amount of money and, in return, you’ll receive regular payments either for life or for a stated period of time. The money grows on a tax-deferred basis until you begin receiving it, usually after age 59 1/2. At that point, you can continue to postpone the tax bite by annuitizing the money - in other words, converting the assets into a monthly stream of income. There are two basic types of annuities: fixed and variable. If you choose a fixed annuity, it earns a fixed rate of return on your premiums. A variable annuity works more like a tax-deferred mutual fund. Your premiums could be invested in a variety of items, ranging from stock and bond funds to real estate investment trusts and certificates of deposit. Your return will vary depending on the success of the portfolio -- hence the term "variable."

What are the differences between a variable annuity and a fixed annuity?

If you choose a fixed annuity, the premiums you pay will be invested by the insurance company. The company board will declare a current rate of interest each quarter. If the rate declared is less than the guaranteed rate, the guaranteed rate will be paid. A variable annuity works more like a mutual fund. Your premiums will be invested in stock funds, bond funds, real estate funds or other kinds of cloned mutual funds that have no guaranteed rate of return. Instead, your return will vary based on the portfolio’s performance - hence the term "variable."

What are the benefits of tax-deferred variable annuities?

The key benefit of investing in a tax-deferred variable annuity is that the premiums you pay are used to make investments, and profits from those investments grow tax-deferred until you start making withdrawals. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), "The benefit of owning a tax-deferred variable annuity is the potential for above-average returns because your assets may be invested in the securities markets and assume actual risk. If the annuity contract meets certain conditions of the Internal Revenue Code, then the earnings, if left in the variable annuity, are not taxed. "Variable annuities are not normally purchased to provide current income, although partial withdrawals may be made. The objective is to let the annuity increase in value and accumulate tax deferred until you surrender the contract or annuitize it." You can also make partial withdrawals and never surrender or annuitize it, which for most is the preferable option.

What features should I examine when shopping for a variable-rate annuity contract?

An annuity is simply a contract between you and an insurance company. You pay the insurer a specified amount of money and, in return, you’ll receive tax-deferred growth and the possibility of regular payments either for life or for a stated period of time if you annuitize. It is usually better not to annuitize since you can access your money on an as needed basis. The money grows on a tax-deferred basis until you begin receiving it, usually after age 59 1/2. At that point, you can continue to postpone the tax bite by "annuitizing" the money -- in other words, converting the assets into a monthly stream of income. Fixed-rate annuities guarantee fixed monthly payments when you retire. A variable annuity works more like a tax-deferred mutual fund. Your premiums could be invested in a variety of items, ranging from individual stocks and mutual funds to real estate and certificates of deposit. Your return and future payments will vary depending on the success of the portfolio -- hence the term "variable." According to the second edition of "Ernst & Young’s Personal Financial Planning Guide" (John Wiley & Sons Inc., New York), here are some of the features that demand close inspection when you evaluate variable-rate annuities offered by different insurers: (1) The company’s financial strength. Using Bests Review and the Weiss Ratings, make sure the insurer is strong enough to be around when it’s your turn to start collecting payments instead of making them. (2) The variety of investment choices. Most annuities have several funds within them, so you can invest in stocks, bonds or choose other types of investments. (3) The track records of the various funds offered by the variable annuity. (4) An ability to switch from one investment inside the annuity to another quickly and cost-effectively. (5) Annual charges, as well as any fees levied when switching from one fund to the next.

How can I decide which insurer offers the best variable annuity policies?

Because a variable annuity is a security, each insurer who offers you an annuity contract must provide you with a prospectus. The prospectus includes important information about how the variable annuity works, the investment choices you can make and the risk those investments involve. Read each prospectus you collect to decide which insurer offers the policy that best meets your needs. Explore the performance of the funds offered and the annuities’ annual fees first. You want a good track record with low fees. Explore the fee issue thoroughly. Some are very high. A low fee may make all the difference.

Can variable annuities be used as part of an asset allocation strategy?

A variable annuity’s investment alternatives should have fundamentally sound objectives that seek long-term superior investment returns commensurate with the market risks assumed by an investor. For example, the Vanguard Variable Annuity Plan offers these investment choices: money market portfolio, high-grade bond portfolio, balanced portfolio and equity index portfolio. A variety of investment alternatives offered by variable annuities give you the flexibility to tailor your investment portfolio to meet your particular needs. You can allocate the investments in variable annuities to spread your risk across a balanced portfolio of stocks, bonds and cash reserves. There is no single answer to determining the best balance. According to Ibbotson Associates in Chicago, the long-term (70 years) return on cash reserves has been 3.7%, on bonds, 5.0% and on stocks, 10.3%, but your yield from investments in a variable annuity may be lower than similar investments held in an IRA or 401(k) account, both because of the related insurance costs and generally higher fees. The earnings do grow tax-deferred, and there may be a death benefit in excess of the cash value of the varible annuity. Also, some variable contracts have evidence to show their returns are slightly better than the retail fund counterpart because the manager does not have to keep as much of the fund in cash reserves to meet redemption requirements. With variable annuities redemptions occur much less frequently. It should be noted however that the asset allocation is the underlying investment mix associated with the variable annuity, not the annuity itself.

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