How variable annuities work

In last week's column, I started to define some of the basics about variable annuities, which have become a part of the retirement and investment plans of many Americans. This week's column will examine how variable annuities work.

A variable annuity has two phases: an accumulation phase and a payout phase.

During the accumulation phase, you make purchase payments, which you can allocate to a number of investment options. For example, you could designate 40 percent of your purchase payments to a bond fund, 40 percent to a U.S. stock fund, and 20 percent to an international stock fund.

The money you have allocated to each mutual fund investment option will increase or decrease over time, depending on the fund's performance. In addition, variable annuities often allow you to allocate part of your purchase payments to a fixed account. A fixed account, unlike a mutual fund, pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum (e.g., 3 percent per year).

Example: You buy a variable annuity with an initial purchase payment of $10,000. You allocate 50 percent of that purchase payment ($5,000) to a bond fund, and 50 percent ($5,000) to a stock fund. During the following year, the stock fund has a 10 percent return, and the bond fund has a 5 percent return. At the end of the year, your account has a value of $10,750 ($5,500 in the stock fund and $5,250 in the bond fund), minus fees and charges (discussed below).

Your most important source of information about a variable annuity's investment options is the prospectus. Request the prospectuses for the mutual fund investment options. Read them carefully before you allocate your purchase payments among the investment options offered. You should consider various factors with respect to each fund option, including the fund's investment objectives and policies, management fees and other expenses that the fund charges, the risks and volatility of the fund, and whether the fund contributes to the diversification of your overall investment portfolio.

During the accumulation phase, you can typically transfer your money from one investment option to another without paying tax on your investment income and gains, although the insurance company may charge you for transfers. However, if you withdraw money from your account during the early years of the accumulation phase, you may have to pay "surrender charges," which are discussed below. In addition, you may have to pay a 10 percent federal tax penalty if you withdraw money before the age of 59 1/2.

At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump sum payment, or you may choose to receive them as a stream of payments at regular intervals (generally monthly).

If you choose to receive a stream of payments, you may have a number of choices of how long the payments will last. Under most annuity contracts, you can choose to have your annuity payments last for a period that you set (such as 20 years) or for an indefinite period (such as your lifetime or the lifetime of you and your spouse or other beneficiary).

During the payout phase, your annuity contract may permit you to choose between receiving fixed-amount payments or payments that vary based on the performance of mutual fund investment options.

The amount of each periodic payment will depend, in part, on the period that you select for receiving payments. Be aware that some annuities do not allow you to withdraw money from your account once you have started receiving regular annuity payments.

In addition, some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and you will start receiving annuity payments right after you purchase the annuity.

Coming Next Week

Features of the variable annuity death benefit.

Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer based in Silver Spring, Md. He specializes in taxes, investing, business and government workplace issues. He is a certified internal auditor and a registered investment adviser. He can be reached at milt.zall@verizon.net.

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