Understanding Deferred Variable Annuities’ Two Phases

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.