Variable Annuities Explained

The variable annuity was the product of a search for a tool that would provide a guaranteed lifetime income that could never be outlived and also provide a relatively stable purchasing power in times of inflation by allowing for returns that may keep pace with (or even exceed) inflation. This can be contrasted with the level payments generally payable from fixed annuities, whose purchasing power will be eroded over time by inflation.

The variable annuity is based on equity investments. Purchasers pay premiums to the insurance company during the accumulation phase. The insurer places that money into one or more separate accounts as directed by the owner. The funds in these accounts are separate from the other assets of the insurer. Each year, the insurer takes some money out of the contract owner’s premium (or from the account value) for expenses. The insurer applies the balance to purchase units of credit in the separate accounts.

The number of credits purchased depends on the current valuation of a unit in terms of dollars. For example, if each unit was valued at $10 per unit based on current investment results, a $100 level premium (after expenses) would purchase ten units. If the value of a unit dropped because of investment experience, the premium would purchase more units. If the value of a unit increased, the same premium would buy fewer units. The price of a unit of a separate account is analogous to the NAV price of a share of a mutual fund. This unit purchasing continues until the maturity of the contract.

At the transition to the payout phase (annuitization) of the contract, the insurer credits the value of the contract owner’s total accumulation units to a retirement fund. A value of a given number of accumulation units will purchase so many retirement income units (based on actuarial principles). Note that a variable annuitization does not promise to pay a fixed number of dollars each month but rather a fixed number of retirement income units. In other words, the dollar amount of each payment depends on the dollar value of a retirement income unit (also called an annuity unit) when the payment is made. The dollar value of an annuity unit is in turn based on the investment results of the separate accounts. For example, assume an annuitant was entitled to a payment based on ten annuity units each month. If the dollar value of an annuity unit varied from $12.10 to $12.50 to $12.80 over three months, the annuitant would be paid $121, $125, and $128, respectively.

Under a variable annuity, the insurer assumes only the risk of fluctuations due to mortality and expenses (guaranteeing that the annuitant will not outlive his or her income and that internal expense fluctuations will be absorbed). This means the contract owner is assuming the entire investment risk. If the separate accounts are invested poorly or in the wrong investments, the annuitant could receive fewer dollars of income than would have been paid under a fixed annuity.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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