A variable annuity is a contract between an individual (the purchaser) and an insurance company (the insurer). In return for premium payments, the insurer agrees to make periodic payments to the purchaser (if the purchaser elects this option), beginning either immediately or at some future date. Deposits can be made by either a single purchase payment or a series of purchase payments.

Purchasers of variable annuities have some control over the manner in which their annuity premiums are invested (unlike fixed annuities). The investment options (or sub accounts) for a variable annuity will usually include stocks, bonds, money market instruments, or some combination of the three. As the purchaser, you can designate how your premium dollars will be allocated among the offered investment choices.

Variable Annuity Features
Like all annuities, variable annuities possess a unique combination of attributes:

• Tax deferral: Taxes on the income and investment gains from the annuity are deferred until money is withdrawn. Note that all distributed earnings are taxed at ordinary income tax rates and never at capital gains rates. Distributions taken before age 59½ are subject to a 10 percent early withdrawal penalty tax on earnings.
• Periodic payments: Proceeds can be distributed in periodic payments for the life of the annuitant, or for the lives of the annuitant and a spouse (or some other person). If this option is elected, the annuitant cannot outlive the payment stream.
• Death benefits: If an annuitant dies before reaching the annuity payout date, his or her beneficiary is generally guaranteed a death benefit. (Guarantees are subject to the claims-paying ability of the issuing insurance company.) The amount of the death benefit is usually the greater of an amount specified in the annuity contract, or the amounts contributed to the contract and the investment income credited to the contributions, reduced by any withdrawals made from the annuity. Annuity proceeds paid at the death of the annuitant will bypass probate if left to a named beneficiary.
• The funds in an annuity are generally unreachable by creditors (laws vary by state).

The Phases: Accumulation and Payout
Like other annuities, there are two phases to a variable annuity: the accumulation phase and the payout phase.

During the accumulation phase, you (as the purchaser of the annuity) make payments that are allocated to the various investment options. You can typically transfer funds from one investment option to another without paying tax on the investment income and gains.

After the accumulation phase, the funds are paid out (the payout phase). At the beginning of the payout phase, you generally elect how you want to take payouts--in a lump sum, as funds are needed, or annuitized over your life, the joint life of you and another individual, or over a specific period of time.

The amount of each periodic payment you receive depends in part, of course, on how you elect to take payouts.

The Death Benefit
Variable annuities commonly provide a death benefit. The amount of the death benefit may be specified in the annuity contract, or it may be calculated as the greater of some guaranteed minimum (e.g., all purchase payments minus withdrawals) or all the moneys in the account at the time of death. (Guarantees are subject to the claims-paying ability of the issuing insurance company.)

Many variable annuities allow you to choose a stepped-up death benefit for an additional charge. The stepped-up benefit is a higher guaranteed death benefit, for which the insurance company charges extra premiums. The advantage of these benefits is that you will know with some certainty how much your beneficiary will receive when you die.

A number of other optional benefits can be purchased as part of a variable annuity policy to guarantee higher streams of payments. Of course, these benefits add to the cost of purchasing the annuity.

Annuity Fees
Among the many major differences between mutual funds and variable annuities are the relatively high fees charged to annuity holders. But with variable annuities, the sales load is a substantial up-front amount the consumer must pay to buy into the contract, combined with an ongoing yearly maintenance fee, and finally a surrender charge, which is applied only on withdrawals during the initial years after purchase, usually about seven years.

All of these miscellaneous fees go directly into your stockbroker's pockets (Hey, muli-billion dollar international stock brokerage firms have to eat too! How else can they afford the Lear jets and a decent Ivy League education for Junior? Have a heart!)

Are Variable Annuities Right For You?
We very rarely advise our clients to invest in variable annuities. There are some cases--only if you've already maxed out your Roth IRA and 401k for the year in which you may look into a fixed annuity option. Otherwise, if you are under 40, your best bet to facilitate growth and minimize costs (go back and count the number of times we used the words "load" and "fee "above") is to stick with low-cost, no load index mutual funds. A diversified mix of quality index funds remains our favorite strategy, and we will continue to steer client away from the variable annuity trap.