You call the shots on allocating your assets with a variable annuity.
Because they provide more individual control over retirement savings, variable annuity contracts are more flexible and as a result more complex than fixed contracts. In exchange for giving you more options and choices, they require you to make more decisions.
Managing risk and return
As with any equity investment, you risk loss of principal with a variable annuity. In some years, you also risk lower returns than you had anticipated. But equity investments also offer greater potential for long-term return and, equally important, better protection against inflation.
The key, of course, is the long-term commitment you make. While in some periods the value of a fixed annuity may increase faster than the value of a stock portfolio, historically the longer that money is in equities, the greater the potential for growth.
Using a diversification strategy, you can select investment funds that are invested in many different companies and industries. That variety helps protect you against sustained losses in a single stock or sector of the market. What it can’t protect you against, however, is a stagnant or falling market in which the majority of equities lose value for an extended period.
Traditionally, equity investments in variable annuities have outpaced inflation in two ways. Over time, equity investments inside and outside annuities have had stronger returns than other asset classes, though they have lost value in some periods. And because any annuity earnings are reinvested and no current taxes are due, annuity funds could gain value more quickly than funds earning a comparable rate if money was withdrawn to pay taxes. Second, with variable annuities you can leave some or all of your retirement savings in growth accounts even after you begin to take income. That means the payments you receive may increase over time — though of course they may also decrease if investment performance slows.
Understanding benchmark rate
If you choose a variable income option when you annuitize, the amount you’ll receive is based on an AIR, or assumed interest rate. It’s also referred to as a hurdle rate or a benchmark rate.
That rate is used to determine the amount of the first income check you receive and is the standard, or benchmark, that’s used to determine whether the checks that follow are more or less than the initial one. You may have the option of picking one of two interest rates. At the lower rate, the initial amount is less, but there’s the potential for larger payments over time. At the higher rate, the initial amount is larger and you can expect any increases to be more gradual and drops to be more likely.
If you choose a higher benchmark rate when you annuitize, and convert your account value to a stream of income, the amount of your first check will be larger than if you choose a lower rate. If your investment continues to produce the same return after annuity and investment expenses are subtracted (admittedly an unlikely prospect) your annuity income will stay the same. But any change, up or down, in the performance of your investment funds means you’ll receive different amounts of monthly income over the time you collect. In some variable annuitization plans, the amount is adjusted annually, and monthly payments throughout the year remain at the same dollar amount.
Your other choice — the lower benchmark — would produce a smaller initial payment. But you can anticipate larger increases in your monthly income when the performance of the investment funds you’ve chosen is strong, and you have more protection against a drop in income, since the market return may be less likely to drop below the lower rate.
While committing yourself to a choice such as this may seem difficult, you can ask your investment adviser to track what’s happened to variable incomes over the past ten years, and what a sustained drop in the underlying investments would mean to your income.
MVAs in variable annuities
Another major appeal of variable annuities is that you can make tax-free transfers among the funds your annuity offers. For example, if you’re convinced it’s time to increase the percentage of your retirement savings in more aggressive growth stocks, you can shift money from a balanced or money market fund. Or you might want to readjust your asset allocation from time to time. This flexibility lets you have continuing control over your retirement savings. No taxes are due on any gains in your investment funds when you reallocate within your variable annuity. But there may be a charge if you exceed the number of transfers your contract permits in a calendar year.
Sometimes there may be a market value adjustment (MVA) on transfers from the fixed-income account of a variable annuity, to adjust for increases and decreases in interest rates. For example, if you wanted to transfer $10,000 from a fixed account to an equity fund prior to the maturity date and after interest rates had gone up, you could move a portion of that amount but owe a contingent deferred sales charge, or back-end load. The terms of each contract can be different, so make sure you check what such an adjustment would be as part of your buying decision.
Understanding Variable Annuities Benchmark, Risks and Return by Inna Rosputnia
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