The deferred variable annuity contract has two phases. In the accumulation phase of a variable deferred annuity, each premium payment purchases, after applicable contract charges are deducted, a number of accumulation units for each investment subaccountchosen by the contract holder.
Example: Mr. Jones has chosen five investment subaccounts from among those available in his variable deferred annuity. He has directed that each premium payment (after deduction for contract charges) be allocated to these accounts as follows:
The accumulation unit values of these accounts on the day his premium is received are set forth in the table below, along with the changes in the subaccounts that will occur when Mr. Jones makes a premium payment of $1,000 with $14 in applicable contract charges.
Accumulation unit values can, and often will, change each day according to the investment performance of the subaccounts, just as the net asset value of a mutual fund share does. However, there is a significant difference between the pricing of annuity accumulation unitsand that of mutual fund shares. When a mutual fund declares a dividend or capital gains distribution—through the realization of dividends or capital gains income by the fund—and the shareholder has elected to reinvest such distributions, additional shares are purchased for his account, and the price of all shares of the fund is reduced to reflect the distribution.
If the shareholder has elected not to reinvest such distributions, he receives cash, and the share price is reduced. By contrast, when a dividend or capital gain is realized by a variable annuity subaccount, the value of the accumulation unitis increased reflecting the dividend or gain received, but the number of units remains the same.
One of the main advantages of investing in a variable annuity is the access it provides to diversified investment types. The first variable annuities offered relatively few investment choices, and the choices were often limited to proprietary accounts; that is, accounts managed by the insurance company that issued the annuity, or a subsidiary. Newer contracts, by contrast, offer subaccounts representing a wide variety of asset classes, managed by a variety of money management firms.
Typically, the contract owner is permitted to choose several subaccounts, and to make exchanges among them, reallocating existing contract values, and to reallocate ongoing contributions without charge. Moreover, exchanges among subaccounts in a single contract are not taxable events for income tax purposes. These investment management features, together with features such as automatic portfolio rebalancing and “dollar cost averaging” from the annuity contract’s fixed account to the variable subaccounts, make the modern variable annuity a robust and powerful investment management tool.
The Distribution Phase
In the distribution phase, fixed annuities—either immediate contracts or deferred contracts that have been annuitized—provide a regular income by application of a chosen annuity payout factor to the amount that is converted to an income stream. For example, if Mr. Smith purchases a fixed immediate annuity for $100,000 or annuitizes a fixed deferred annuity having an annuity value of that same amount, and if he elects a Life & 10 Year Certain payout arrangement, and if the annual annuity payout factor for that option, for his age and sex, is 5.67, his annuity payments will be $5,670 per year from that point until the later of his death or the expiration of ten years.
Similarly, if he elects to annuitize a variable deferred annuity on a fixed annuity payout arrangement, and if the total value of the accumulation units in his contract, at the time of annuitization, is $100,000, he will receive that same income, assuming the same annuity payout factor.
If the annuity payout is to be on a variable basis, however, the amount annuitized (either a lump sum, in the case of an immediate variable annuity, or, in a deferred variable annuity, the current value of the accumulation unitsthe owner wishes to annuitize) is not converted to a fixed income stream by applying an annuity payout factor. Instead, the purchase payment or amount annuitized is used to buy a certain number of annuity units. The process works as follows:
- First, the payment, or annuitization amount, is reduced by any contract fee applicable and by any state premium tax due, and allocated to the investment subaccounts chosen by the contract owner.
- Next, the insurance company computes an initial income payment amountfor that portion of the purchase payment or annuitization amount allocated to each subaccount, using (a) the age and sex of the annuitant and (b) an Assumed Investment Rate (AIR). Many variable annuity contracts allow the purchaser to choose among several AIRs (e.g., 3 percent, 4 percent, 5 percent, and 6 percent). The higher the initial AIR chosen, the higher the initial variable income payment will be.
- Finally, the initial income paymentis divided by the value of the annuity unit for each subaccount chosen. The result is the number of annuity unitsof that subaccount which will be purchased by that payment. Subsequent annuity payments will increase or decrease in proportion to the extent to which the net investment performance, after application of the separate account charges, of the chosen variable subaccounts exceeds or lags the AIR.