Variable income means the amount of your payments will change to reflect investment performance.
The point of choosing variable income when you annuitize your contract is the potential for the income to increase over time. Such increases are dependent on growth in the value of the underlying investments in the annuity funds you’ve selected. For example, if you’ve invested primarily in equity funds and the stock market gains value, your account should gain value.
Of course, growth isn’t guaranteed. So your income could be less in one year than it was the year before if investment markets lost value or the funds you chose didn’t provide a strong return.
The air factor
Whether or not you realize an increase in income in any year also depends on another factor: the contract’s assumed interest rate, or AIR. The AIR is a benchmark against which the annual return on your annuity funds, minus expenses, is measured. If the net return is equal to the AIR or exceeds it, the return will translate into higher income. But if the net return is less than the AIR, your income will decrease.
For example, if the AIR was 3.5% and the net gain in the value of your investment funds is five percentage points, your income will increase. But if the AIR was 5.5% and the net gain was the same five percentage points, your income would drop despite the increase in your account value.
In some contracts, the AIR is set by the annuity issuer and in others you may have a choice of two rates that vary by one and a half to three percentage points, such as 3.5% and 5% or 3% and 6%. If you choose the lower rate, your initial income payment will be lower than it would have been with the higher rate. But the performance of your investment funds can meet or exceed the benchmark more easily than if the AIR were higher.
Finding the initial payment
Once the benchmark has been set, you can compute the minimum amount you’ll receive in your first payment by using the tables included in your contract. There’s a different table for each of the AIRs and payment options the contract offers.
For example, assume you owned a variable annuity contract whose payment tables showed that a life annuity with an AIR of 3.5% would pay $5.94 for each $1,000 of accumulated contract value if you annuitized at age 65. If your contract was worth $100,000, your first monthly check (or direct deposit) would be $594 ($5.94 times 100, the number of 1,000s in $100,000).
In the balance
Variable annuities are complex products, and the process involved in determining the ups and downs of variable income can be particularly confusing.
But investors are typically attracted by their potential, based on past performance, to offset the impact of inflation during retirement, although that’s no guarantee of future results.
Once the amount you’re receiving increases, any decreases in value are based on the most recent payments, not the amount of your first payment. For example, if over several years the amount you received increased from $267 to $400 and then values declined for a time, your payments might go down to $350 or even less. It is less likely, based on historical figures, that your payment amount will drop below $267, though in a serious downturn, or in a downturn occurring soon after your income stream began, it could.
How variable income works?
After the first payout, the amount you receive can go up or down depending on the performance of your investment portfolios. The first step in the process is to convert your first payment into a set number of annuity units. This is done by dividing the initial payment by the annuity unit value at the time of the payment. Next, this constant number of units is multiplied by the annuity unit value at the time of each future payment to determine the amount of that payout in dollars. Here’s how it works:
Step one: Determining Annuity Units
In the example in the box on the previous page, the first payment was $594. If the annuity unit value at the time of the payment was $10, you would be credited with 59.4 units (594 ÷ 10 = 59.4). The number of annuity units is then fixed so you always have the same number of annuity units as long as you continue to receive income.
Step two: Assessing Portfolio Performance
The company determines the value of an annuity unit for your next payment, which can increase or decrease based on the performance of your investment portfolios. If the net return on your investment portfolios is greater than the benchmark rate, the value of the annuity unit increases. For example, if the annual net return on your investment portfolio results in a 6.3% increase over the benchmark, the unit value would increase to $10.63 ($10 x 1.063). But the net return is less than the benchmark, the value declines.
Step three: Calculating New Income Amount
Finally, the company multiplies the new unit value times the number of annuity units to arrive at the amount of your payment. In this example, the new monthly payment would be $631.42 (59.4 x $10.63 = $631.42). Of course, the amount could go down as well as up in any given period.
Understanding Variable Annuity Income by Inna Rosputnia
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