How Do Variable Annuities Work? Part 1

Creating a portfolio

With variable annuities, lots of things can vary, or change: the rate of return you earn, the amount of income you receive if you annuitize, or convert your account value to a stream of income, and how your money is invested.

When you buy a variable annuity, you allocate your premiums among a number of investment funds, also called subaccounts or annuity funds. The accounts may be designed specifically for the annuity company or may be versions of existing mutual funds that are customized for exclusive annuity use. Although the names of the investment funds may be the same or similar to those of retail mutual funds, they are not the same funds.

Your job is to choose among the funds that the issuing company offers, much as you would with a 401(k) or 403(b) retirement plan. Typically, there will be a dozen or more, including stock portfolios, a money market account, a government bond portfolio, a corporate bond portfolio, and a guaranteed account, which is similar to a fixed annuity investment. Sometimes, you have an even wider choice drawn from a number of different investment management companies.

Making the investment

You can allocate your premiums however you like, usually on a percentage basis: 50% in a growth stock portfolio, for example, 25% in a balanced portfolio, and 25% in a guaranteed or bond account. Each time you add money, you buy a specific number of accumulation units, or shares, based on the net asset value (NAV) of the investment fund you’re putting money into, adjusted for the annuity’s mortality and expense risk fee (M&E). The accumulation unit value is the current value of the investment fund divided by the number of existing accumulation units.

Many investors are attracted by the death benefit variable annuities provide, which is based on the claims-paying ability of the insurance company that issues the contract. It means that if you die during the accumulation period, your beneficiaries will receive, at the minimum, the amount you put into the annuity. For an added fee, many contracts lock in investment gains regularly so that your beneficiaries receive more than your principal, even if the value has dropped at the time of your death below the amount you put into the account. In contrast, a mutual fund pays your beneficiaries whatever your account is worth at the time of your death, even if it’s less than the amount you invested.

Fixed vs variable annuities

Variable annuities differ from fixed annuities in another important way. The premiums you allocate to the subaccounts, or investment funds, go into individual accounts held in an issuer’s separate account, rather than into its general account. (The exception is any money you put in a fixed-income fund.) As a result, this part of your retirement savings may be shielded from the issuing company’s creditors.

 You can weigh the advantages of fixed and variable annuities.

Putting money to work

If you purchase a variable annuity by making payments over time, adding a set amount at regular intervals lets you take advantage of dollar cost averaging (DCA). This approach is designed to reduce the risk of trying to choose the best time to buy — though it can’t guarantee a profit or protect you against losses.

Because the prices of the underlying investments change regularly, DCA means you purchase a different number of units each time you make a premium payment. Over time, your cost per unit will be less than the average price per unit because you buy more units when the prices are down.

Remember, though, that if you’re dollar cost averaging, you must continue to buy annuity units when prices drop in order to reduce your overall cost per unit. If you stop buying in a falling market, you will have paid only the higher prices.

With many variable annuities, you can allocate a specific percentage of your purchase to each of your funds as you add money to your account. For example, if you invest $40,000 and have selected four investment funds, you might put $10,000 into each of the funds. Or, if you invest $400 a month, $100 would go to each of the funds.

Another approach is to put the investment amount in a fixed or money market account within the variable annuity and arrange to have the assets moved gradually into one or more of your investment funds. Transferring small amounts helps you avoid making a large purchase at what might turn out to be the highest price. But it does put your money to work accumulating earnings at a slower pace.

Making adjustments

Variable annuities let you diversify by creating asset mixes that you’re comfortable with at different stages of your life or in different economic climates. This allows you to share in the performance of a strong stock market or to shift the balance of your annuity from growth to income as you near retirement.

No one mix suits every investor, though the argument for emphasizing equity funds is that they have provided stronger returns over the long term and thus a greater opportunity for growth than fixed-income or stable value funds.

How Do Variable Annuities Work? by Inna Rosputnia

Wishing you a great week!