Benefits Of A Variable Annuity

Do you remember the old radio commercials that featured a guy with an odd voice who asked, "Hey Bunky" and then went on with a series questions like, "Are you tired of that old jalopy? Do you want ...." Well, the question of the day would be, "Hey Bunky, are you tired of losing money in your investment portfolio?" Most people who have investments in the stock market would have no choice but to answer an arousing "Yes!"

Some life insurance companies have attached some interesting bells and whistles onto their variable annuity products. Before describing the features of a variable annuity, let’s get basic and describe an annuity. Were you to look up the meaning of "annuity" in a dictionary, you might find the following: 1. a. The annual payment of an allowance or income. b. The right to receive this payment or the obligation to make this payment. 2. An investment on which one receives fixed payments for a lifetime or for a specified number of years.

If you continued to research the meaning of annuity you would come to a tontine, named for a 16 th century Italian born French banker who created an investment plan in which participants buy shares in a common fund and receive an annuity that increases every time a participant dies, with the entire fund going to the final survivor or to those who survive after a specified time. And, that is not the end of the meanings.

Yet another example is, if you are receiving a pension, you are the recipient of an immediate annuity. However, this column is about deferred annuities which are vehicles that build up money prior to paying it out, e.g., saving for retirement. There are two kinds of deferred annuities: one is fixed, the other variable. With a fixed annuity, you receive a guaranteed rate of return from an insurance company. With to-day’s 40-year low interest rates, fixed annuities are paying between 3% and 4%. When you take into account taxes and inflation, you are losing money on fixed annuities.

Variable annuities are contracts that have their underlying investments in mutual funds. These funds include stocks, bonds and cash: all of the elements needed for a diversified portfolio. "Yeah," you would say, "but I don’t want to lose any more money in the stock market." The insurance companies who issue the variable annuities are now offering guarantees, even though the investments are in the stock market. But these "gua-rantees" require some scrutiny.

Without giving any insurance company a free commercial, I will outline some of the options currently available. One company guarantees that you get your investment back in seven years no matter which investment option you choose. It works as follows. They re-serve the right to move your money from whatever fund you have chosen into a money market account when they believe the stock market is going down.

If they make the right calls, they will preserve the money that they are guaranteeing. However, if they are in a money market when the stock market goes up, you are losing the upside potential of your investment. This is a risk to you. Additionally, this benefit is not a gift. It has a cost.

The cost is 40 basis points, a term that is often bandied about in the financial business yet seldom defined. There are 100 basis points in I%, so 40 basis points is 40% of I% or .004. It works in total return as follows: let’s say your investment in the variable annuity earned 10% in a given year. If you had purchased the guarantee rider, your net return would be 9.6% (10% - 40 basis points).

Another insurance company offers a different deal. They will guarantee that you can withdraw 7% annually from the contract for 14 years until you get your investment back, no matter what happens in the market. For example, let’s say that you deposited $100,000 into a contract and began withdrawing $7,000 per year. Let’s further assume, although it’s highly unlikely, that the investments you chose in the contract become worthless after eight years. The company is guaranteeing you withdraw-als of 7% per year until you receive your investment back.

If you do the math, at 7% per year, you will receive 98% of your money back in 14 years, so in the beginning of the 15th year, you will have received all of your money back. The insurance company is betting that the stock, bond or money market fund that you invest in will not stay down for 14 years. Since they are the one who selects the funds available within their variable annuity, they will attempt to replace any losers with winners. This insurance company charges 35 basis points for this guaranty.

Variable annuities are complex in-struments. They have other benefits, such as a guaranteed death benefit, which works as follows. You invest $100,000 into the contract, you choose a fund that drops to $80,000, and you die. Your beneficiary will receive $ 100,000. There is a cost for this benefit. On the other hand, assume that you invest $100,000 into a variable annuity, the value goes up to $120,000 and you die. Your beneficiary receives $120,000.

Variable annuities also offer the benefit of having gains tax deferred. Are they right for you? That depends on your tax position, cash flow, risk tolerance and everything that’s part of your financial plan.