Variable life insurance and annuity products have been offered for decades. A detailed explanation of these complex products comes in a specific product’s prospectus. Basically, variable products offer investment options, or subaccounts, that invest in underlying funds. The contract owner may select from among the subaccounts, or “investment portfolios,” offered in the product. Additional information is available about the underlying funds in their prospectuses. This differs from a fixed product where the issuing company declares and pays a set interest rate.
It is important to determine when or if a variable product is suitable for a client. The fact-finding process must include careful and in-depth exploration and documentation of the client’s unique investment profile.
When may a variable product make sense?
The basic idea behind variable life insurance and variable annuity designs is to allow the individual owner to choose, monitor, rebalance and revise their own selections from among the investment portfolios available with the product. Some purchasers believe making their own selections within their variable contract makes financial sense for them. If this idea resonates with a prospective purchaser, they may want to consider a variable product.
Who may elect to purchase a variable product?
A suitable purchaser of a variable life insurance or annuity product must be someone who understands its risks, fees, limitations and guarantees as described in the product and underlying fund prospectuses. This person must have a need for the particular benefits offered by the product, and a tolerance and level of comfort about the investment risks that are an integral part of variable products. Costs, limitations and risk exposure must be weighed against features and their potential benefits. It is essential investors consider the contract and the underlying portfolios’ investment objectives, risks, charges and expenses carefully before investing.
Any insurance company guarantees offered with the product should be ones a prospective buyer needs, wants and understands. A portion of the fees and charges described in a prospectus covers the guarantees. A suitable owner most often will be a person who has a medium or higher tolerance for investment risk, needs the insurance guarantees offered by the product and understands and is willing to pay for these guarantees, along with other policy fees and charges.
What guarantees may be provided by the issuing company?
Only a life insurance company can issue a life insurance policy or a personally owned retirement annuity available for sale to the general public. Issuers are subject to stringent oversight by the insurance commissioner of their home state. Every product offered must be approved by the insurance department of the state in which it will be sold, or by the Interstate Insurance Product Regulation Commission.
A variable annuity offers guaranteed payment factors, which will apply to the contract value when the owner elects an annuity option guaranteed in the contract. Many variable annuities also offer optional income benefits in addition to the annuity option for an additional charge. These generally are known as a guaranteed lifetime income benefit and a guaranteed minimum withdrawal benefit.
A separate fee is charged for a lifetime income benefit guarantee option. The potential amount of any guaranteed lifetime income from an optional income rider is determined by a complex calculation process described in the product prospectus. An owner may also be required to select particular, specified asset allocation percentages from among the investment options in order for the lifetime income payment guarantee to be available. Also, in order to maintain the level of lifetime income, only the guaranteed withdrawals are typically allowed. Provided the rules described in the prospectus are followed, the issuer’s guarantee of lifetime income typically is not dependent on the actual nonguaranteed performance of the investment portfolios.
Variable life insurance policies often provide a guarantee that a specified minimum death benefit will be paid to the named beneficiary at the death of the insured, provided:
- the policy is in force at the time of the insured’s death, and
- the policy’s cash value account has been maintained at a level sufficient to pay ongoing cost of insurance charges and other fees and charges.
Again, provided the rules described in the product’s prospectus are followed, the issuing insurance company’s guarantee of payment of a specified policy benefit at the insured’s death typically is not dependent on the nonguaranteed performance of the product’s portfolios selected by the owner over the time period the policy has been in force.
Do variable products offer their owners potential income tax advantages?
A nonqualified deferred annuity offers tax-deferred growth potential. This is a trade-off for ordinary income tax treatment of any gains earned inside of the annuity contract when such distributions are made. Distributions taken “not as an annuity” – which means ones not annuitized – are distributed gain first. Of course, 100 percent of all distributions from a traditional IRA annuity contract are taxed as income to the owner, or to a beneficiary receiving distributions after the death of an IRA owner.
Conversely, a nonqualified annuity contract that has been annuitized produces distributions “taken as an annuity.” This means only a portion of each periodic distribution is characterized and taxed as ordinary income, with the balance treated as a return of the after-tax premium contribution. Such a distribution is based on an “exclusion ratio,” because the portion of each distribution attributed to the premium contribution is excluded from taxation. Once distribution of the entire premium paid has been made, any further distributions are fully taxable as income.
A life insurance contract not classified as a modified endowment contract allows its owner to take distributions of the policy cash value with non-taxable premiums considered distributed first, followed by the taxable distribution of any gain within the contract, which is received as ordinary income by the owner. Before the taxable distribution of any policy gain, an owner may elect to take nontaxable loan distributions from the policy. Care must be taken to keep a life insurance policy in force until the death of the insured. Otherwise, if total policy loan distributions and interest due on the loan exceed total premium contributions and the policy lapses before the insured’s death, loan distribution amounts in excess of total premium contributions are taxed as ordinary income to the policy owner.
What about the income tax ordering of retirement distributions? Can a variable product help?
A variable annuity or variable life insurance contract may assist its owner with the process of selecting the ordering of retirement income distributions that are non-taxable, partially taxable or fully taxable. Although no additional tax advantage is gained, a Roth IRA may use a variable annuity as its funding vehicle and earnings can qualify to be distributed tax free. As for taxation of life insurance policy distributions, these can be taken income tax free up to the amount of the total of premiums paid into the life insurance contract. Also, income tax free distributions of policy loan amounts may be available from a variable life insurance contract.
Partially taxable distributions can be taken from the annuitization option available from most nonqualified annuity contracts. Nonqualified single premium income annuities and annuitized distributions taken from nonqualified deferred variable annuities are also received as partially taxable income.
Fully taxable distributions come from IRAs, 401(k) plans, and qualified retirement plans such as 403(b), 457, pension plans. The use of a variable annuity as a traditional IRA annuity funding vehicle can offer fully taxable income distributions. Again, no additional tax advantage is gained from the annuity.
How might variable life and annuities fit an owner’s financial objectives?
Variable annuities and life insurance contracts are versatile products — ones that offer benefits and guarantees that only insurance companies can provide. The combination of benefits and guarantees may be unavailable from other types of financial products. As with all variable products there are risks, policy fees and charges to consider. A careful matching of client objectives and risk tolerance, along with an understanding of how the product works, may result in a variable annuity or variable life insurance contract that is a suitable and sound choice for your clients.