More info on variable annuities

A variable annuity shares similar tax deferral treatment to its cousins - fixed and equity indexed annuities - in that gains during the accumulation period are not taxed, and it is only when monies are removed that income taxes are levied. Tax legislation in 1986 made changes to annuity taxation, but the tax deferral remains.

In my opinion, it makes no sense to purchase a variable annuity within a qualified plan, such as an IRA, because you would negate the tax deferral advantage, since all qualified plans are tax deferred. There are other more appropriate investment vehicles for qualified plans than variable annuities.

In the infancy of variable annuities, the appeal of their use as investment vehicles were the tax deferral, and the very real possibility of greater returns than could be realized from fixed annuities, both in the accumulation phase and the payout phase.

Early on, the equity accounts in the variable annuity were managed by the life insurance company and were held in investment accounts that were not part of the company's general assets, or general account. The reason for this separation was due to the fact that insurance companies are not allowed to invest more than 5 percent of their general account in stock market investments.

This payout phase was nothing more than annuitization, which means that the funds were paid out over the lifetime of the annuitant. This annuity payout would continue for as long as the annuitant were alive and guarantees of duration (10 years, 20 years, joint and survivor, etc.) were also available. The computation of the amount of each monthly income was based on an assumed interest rate of, say, 3 percent. Each month that the invested funds within the variable annuity earned more than 3 percent net, the monthly income would go up. Conversely, if the fund values earned less than the assumed interest rate, the monthly income would decrease.

This fluctuation of monthly income became a disadvantage over time as purchasers became wary of the stock market in the late '70s, and guarantees were needed, even though annual sales of variable annuities were in the billions. The ever creative life insurance industry responded, and many of the features that are available today were introduced to provide income guarantees.

One such feature provides a guaranteed accumulation rate each year to your account, but only for income purposes. There is a charge for this feature, usually in the 1 percent range each year. This feature means that your variable annuity will have two different current account values: the actual investment account that may be invested in a myriad of ways, using as many as 90 or more investment choices; and the "income" account.

One company will credit 10 percent simple interest each year to your income account, and this means that if you make a lump-sum payment of $100,000 when you purchase the product, at the end of 10 years, your income account will be worth $200,000.

Your actual investment account may be worth more or less, but when it comes time to take out your monies, the values in your income account may only be removed at a specified rate, say 5 percent each year.

So, in this example, at the end of 10 years, you could take out $10,000 for a long as you live. Some companies offer a death benefit option, for a separate fee, that would allow your spouse to continue receiving the $10,000 each year for as long as he or she lived.

If the actual investment account values were greater, you could annuitize those dollars or remove the money as you saw fit.

One company has an interesting wrinkle in that it captures the highest investment account amount each day and then re-computes the income account value, using a 5 percent compounded interest rate. For example, if you invested $100,000 and your actual investment account during the first year reached $110,000, the company would reset your income account to that amount and then increase that value by 5 percent each year.

All of the additional features come with a price, but depending on your risk profile, they may be worth it. Investors must think the features are worth it, since sales of variable annuities were over $140 billion in 2010.

One final piece of advice: Variable annuities are not short term investments, so if your investment horizon is less than 10 years and the income feature is not important, you may want to look elsewhere.

Got a financial planning question for Greg? You may email him at greg@lifesolutionsonline.net.