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Variable annuities may be the least understood investment option in an individual's retirement arsenal. Yet, by enabling individuals to accumulate tax-deferred savings toward a regular stream of income at retirement, VAs may provide investors some reassurance that they will not outlive their nest eggs. Brian Dobbis, Retirement Analyst—Lord Abbett Institutional Investor Services, answers some frequently asked questions about them.
Q: Let's start with the basics. What exactly is a variable annuity (VA), and why should investors consider this investment option?
A: A variable annuity is a retirement vehicle that allows individuals to save money on a tax-deferred basis and protect those assets in the event of an untimely death. Newer VAs allow individuals not only to protect their assets in the case of death but also to provide different forms of guaranteed accumulation and income during retirement. More specifically, a VA is an insurance agreement that can help provide those lucky enough to live a long life the peace of mind that they will not run out of money. A VA does this, first, by helping investors accumulate money for retirement through tax-deferred savings (often with no investment limitations) and, second, by providing them with monthly income that can be guaranteed to last as long as they live.
Q: Let's talk about some of the distinctive features of VAs, namely their tax advantages and potential for tax-free growth. What are some of these advantages, and how do they work?
A: As with a 401(k) plan, earnings and gains on assets held in a VA are not taxed until they are withdrawn, which allows the assets to compound and grow more rapidly than if they were regularly reduced by taxes. Moreover, nonqualified VAs have no limit on how much one can invest. In essence, they are a limitless 401(k).
Q: What about qualified VAs—why would they be advantageous to anyone?
A: Qualified VAs, which are products offered within defined contribution plans, such as 401(k)s, are gaining popularity because of the need for retirement income. Some might question the value of including a VA within another vehicle that already is tax-deferred, such as a 401(k) or IRA. However, many people desire a guarantee that they will have a certain amount of income throughout their retirement. Other types of retirement-plan investments, such as mutual funds, don't offer such predictability.
Q: What happens when the owner of an annuity dies?
A: The impact of death on a VA will depend on the type of VA and the type of options—called "riders"—that the owner purchased. Typically, if the annuity holder dies before receiving any lifetime income or other annuity payout option, his or her beneficiaries will receive at least the amount originally invested, minus an adjustment for any withdrawals—regardless of how the underlying investments have performed.
Q: How much should an individual contribute to a VA?
A: Investors should always consult with an investment professional when making financial decisions, including those concerning individual retirement income needs. Variable annuities often are used to fund and insure the fixed costs that people will have in retirement. Increasingly, VAs are being viewed as another piece of an asset-allocation puzzle that can help people plan their overall retirement income needs, including both essential and lifestyle expenses.
Q: At what age should clients start thinking about investing in a VA?
A: It is never too early to start planning for retirement; however, the appropriate age to first invest in a VA should be discussed between a client and his or her financial advisor. If purchased early enough, a VA can help increase an individual's odds of success in retirement and can protect the VA owner against longevity risk—that is, the possibility of an individual outliving his or her money. People should be aware that withdrawing money from certain VAs before specified age or time limits are reached could result in surrender charges and potential tax implications.
Q: Is there a minimum investment to buy a VA?
A: Insurance companies typically have minimums for initial investments, as well as for additional investments. As there are many VA providers, an individual should consult a specific provider for any minimum requirements.
Q: Do clients have access to their money at any time?
A: If a VA is purchased within a qualified retirement plan, such as a 401(k), access will be limited by retirement or service separation guidelines. If a VA is purchased on a nonqualified basis, access to the principal amount paid for the annuity often will depend on the type of annuity purchased. Generally, deferred annuity contracts allow for complete or partial withdrawals during the accumulation phase, although withdrawal penalties and/or tax ramifications might apply.
Q: Variable annuities can offer loss protection and the ability to capture market advances while not participating in market declines. That sounds too good to be true. What's the catch?
A: You get what you pay for. An individual purchases an insurance contract to protect his or her nest egg, the same way that someone would insure a life, a house, or a car. To get certain benefits from a VA, the account owner might be required to purchase benefit-specific riders, which would entail an additional expense. In any case, the purchaser has options.
Q: Individuals can create income streams by setting up a systematic withdrawal plan (SWP)1 from their 401(k) balance or a laddered bond portfolio2; so why would anyone need a VA?
A: Although SWPs and laddered bond portfolios can distribute income, they cannot guarantee a lifetime income. It's important to note that such income-distribution schemes are subject to sequence-of-returns pressures on the underlying portfolios. Sequence of returns addresses the order in which investment returns occur, and negative market returns—particularly early in retirement—can greatly decrease an individual's retirement assets and reduce his or her income. With people living longer in retirement, the margin of error is continually narrowing, which puts greater stress on nonguaranteed income programs. With a VA, the potential sequence-of-returns impact to a portfolio can be muted, thereby increasing an individual's odds of not running out of money in retirement.
Q: Investors unfamiliar with VAs may have the perception that VAs offer only limited choices. What sorts of investment options are commonly available within VAs today?
A: Variable annuities provide essentially the same investment choices that investors can purchase through retail investments; however, purchasing those same investments in a VA allows an investor to do so in a tax-deferred vehicle with an option that can also guarantee an income stream.
Q: Variable annuities offer a unique level of certainty for retirement and, potentially, some peace of mind. Yet VAs are seen as extremely complex, which puts off some investors. How can advisors help clients overcome this hurdle?
A: The VA story is rather simple: tax-deferred growth and the option to receive guaranteed, lifetime income. It is true that the features and benefits offered by different providers can be confusing; however, we have seen that advisors who use VAs the most tend to keep the industry jargon to a minimum and instead focus on what these investment solutions do rather than what they are or are not. It also would help advisors to look at VAs not as stand-alone investment solutions but as essential parts of a well-planned retirement income strategy. Every individual needs some level of retirement income, and VAs are suited uniquely to guarantee some or all of that income need.
Q: How can Lord Abbett help?
A: While we don't sell annuities, Lord Abbett has multiple ways to support advisors, including strategies geared to helping advisors build their VA business, such as a powerful web-based, data-mining tool called Insights and Intelligence, which can help advisors locate investible assets, and offers tips on how to capture them. Advisors may also glean useful information guidance from our video tutorial, "Ideas into Income," which is our prospecting program that gives advisors all they need to identify and connect with annuity candidates, as well as to close the sale.
Brian Dobbis is a Retirement Analyst within Lord Abbett's Institutional Investor Services. His areas of expertise include IRAs, 401(k), 403(b) and 457 retirement plans. Mr. Dobbis began his career in the financial services industry in 1996. He joined Lord Abbett in 2002, and held the positions of Retirement Consultant and Retirement Research Associate. Mr. Dobbis is recognized by the American Society of Pension Professionals and Actuaries (ASPPA) as a Qualified 401(k) Administrator (QKA), a Qualified Plan Administrator (QPA), a Tax-Exempt & Governmental Plan Consultant (TGPC), and a Qualified Plan Financial Consultant (QPFC). He earned a BA in communications from Rowan University, and also is a holder of the Series 6, Series 63, and Series 65 licenses.
Important Information: By definition, a variable annuity is a contract between an investor and an insurance company. Annuities are considered a form of life insurance, although they function more like retirement vehicles. An investor agrees to pay an upfront sum or annual premiums. The principal generated by these payments is invested in an underlying investment vehicle such as a mutual fund, and the investor is able to make income withdrawals at retirement. A variable annuity's most popular feature allows an investor to receive periodic payments for the remainder of their life. This guarantees that an investor's cash flow remains constant.
Variable annuities are suitable for long-term investing, particularly for retirement. They are subject to market risk, including the loss of principal. There are fees and charges associated with variable annuities, including mortality and expense charges, administrative fees, and annual contract fees. In addition, annuities can offer certain features and benefits, called riders, at additional costs that can usually only be elected at issue date. Variable annuities are subject to risks including the potential for principal loss. Investors should consult their investment professional and/or tax advisor for specific questions related to their particular situation.
Withdrawals of earnings will be subject to ordering income tax and, if taken prior to age 59½, may be subject to a 10% federal tax penalty. Excess withdrawals may significantly reduce some of the guaranteed benefits associated with a variable annuity. Withdrawals may also be subject to surrender charges. Any earnings in a variable annuity contract are subject to ordinary income tax at withdrawal. Investment options are subject to principal fluctuation and are not guaranteed.
Any guarantees are based on the claims-paying ability of the issuing insurance company. Guaranteed benefits have costs/fees, limitations, and penalties for certain triggering events, such as early withdrawal.
Additional fees are imposed annually on optional benefits. Investors should be sure they understand the charges and carefully consider whether these optional benefits are appropriate for them, as variable annuity contracts may vary.
Guaranteed minimum income benefit (GMIB)—Guarantees that retirement income payments will be based on whichever is greater: the actual contract value or a minimum payout base (which is equal to the amount invested) plus a credit determined by a competitive interest rate. Note that if the contract value grows, monthly income payment may be higher, but never lower than the guaranteed minimum amount.
Guaranteed minimum accumulation benefit (GMAB)—Guarantees that the variable annuity contract value will be at least equal to a certain minimum amount—typically the premium amount after a specified number of years, regardless of actual performance. Many GMABs guarantee the return of premium after a 10-year period.
A surrender charge is a charge levied against an investor for the early withdrawal of funds from an insurance or annuity contract, or for the cancellation of the agreement. Surrender charges act as economic incentives for investors to maintain their contract, and they allow insurance companies to have reasonable expectations for the frequency of early withdrawals.
A 401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an after tax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.
A defined contribution plan is a retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee. There are restrictions as to when and how you can withdraw these funds without penalties.
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59�, unless an exception applies.
Tax-deferred—In a tax-deferred investment, such as an annuity or a traditional IRA, no current tax is payable on gains within the investment, and no taxes are due until you make withdrawals. Taxes on earnings are postponed until any earnings are withdrawn from the annuity.
Asset allocation does not guarantee a profit or protect against loss in declining markets.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is being provided for general and educational purposes only. It is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information.
This document serves as reference material for information purposes only. This document does not constitute an offer to acquire, solicitation of an offer to acquire, an offer to sell, or solitication of an offer to sellany variable annuities or any securities, or investment advice on any securities, and cannot be used for any of the foregoing. Lord Abbett does not offer variable annuities.