FIXED vs. VARIABLE ANNUITIES

A fixed annuity is a type of contract that allows for the accumulation of capital on a tax-deferred basis. It can be purchased with one lump sum investment or periodic investments. Later, the fixed annuity will pay the annuitant a guaranteed, fixed amount of income for life. These payments occur at regular intervals and do not begin until after a certain date. The annuitant is the owner of the annuity contract. Due to their predictability, stability, and guaranteed stream of income, fixed annuities are mainly chosen by retirees or by those who are still working but quickly approaching retirement. The insurance company assumes the risk. The annuity's securities might or might not perform well. To absorb the risk, the insurance company will place the annuitant's principal investment into a portfolio that is full of fixed-income investments. Later, when the annuitant begins to receive his payments, the amount of income he receives is based on that portfolio's value and on his mortality expectancy.

A variable annuity does not guarantee returns, and the investor assumes the performance risk of the securities in the portfolio. Even though he is assuming the risk, he is also increasing his potential for higher returns. With a variable annuity, a client's principal is invested in one or more sub-accounts that are comprised of stocks, bonds, and money market instruments. However, most variable annuities do offer a sub-account that does have a fixed rate of interest. Although variable annuities are more complex investments, many investors choose them in order to stay ahead of the rising cost of living (a fixed annuity loses its purchasing power over time).

TYPES OF VARIABLE ANNUITIES

There are two main types of variable annuities--immediate and deferred. The type is determined by how the premiums are paid and when the payouts (benefits) begin.

An investor purchases an immediate annuity with a lump sum. The insurance company will begin paying the annuity's benefits to the investor within 60 days. A "lump sum" payment is also referred to as "single-premium" payment.

As its name suggests, a deferred annuity pays its benefits to the investor at a later date.
The two types of deferred annuities are as follows:

• Single-premium deferred annuity-- An investor purchases the annuity with a lump sum payment, and the annuity's benefits are not payed to him until a later date.

• Periodic-payment deferred annuity-- An investor makes scheduled periodic payments (monthly, quarterly, or annually) to purchase the contract, and the annuity's benefits are not payed to him until a later date.

KEY FEATURES OF VARIABLE ANNUITIES

As previously discussed, an annuity allows an investor to receive periodic payments for the rest of his (or his beneficiary's) life. This protects him from the possibility that he might outlive his assets after he retires. Although variable annuities are usually invested in mutual funds, variable annuities offer three basic features not commonly offered by mutual funds.

1. An annuity's separate account is one of its key characteristics. Per its name, the separate account is an account kept separate from the general assets of the insurance company. This differs from a mutual fund because the investor directly owns the securities in this account instead of owning a share in a pool of securities. Therefore, the investor (not the insurance company) assumes all the risk of this separate account and could actually lose money. The general account is guaranteed by the insurance company, but the separate account is not. Most separate accounts require a minimum investment of $100,000. The separate account is comprised of sub-accounts, which are the investment fund options (often dozens of mutual funds). The separate account is considered a security because it is comprised of a pool of securities. It must be registered under the Investment Company Act of 1940 and follow the laws of the Securities Act of 1933. Details of the separate account and its sub-accounts must be found in the prospectus, depending on the variable annuity contract that the investor chooses.

2. Tax-deferred returns are one of the features of an annuity. All payments and returns in the annuity grow tax-deferred and at a fast pace. In other words, dividends, interest, and capital gains are automatically reinvested without incurring local, state, or federal taxes.

When earnings are withdrawn, they are taxed at ordinary income rates. Remember that the dividends, interest, and capital gains and losses of the separate account are kept apart from the finances of the insurance company (general account). An investor is also permitted to transfer money from one investment option to another without paying taxes at the time of the transfer. The benefits of tax deferral will outweigh the costs of a variable annuity if the investor holds it as a long-term, investment (retirement or other long-term goals).

3. Another common feature of a variable annuity is the death benefit. If an investor dies before the insurance company has started making payments to him, his beneficiary is guaranteed to receive either all the money in the annuity or a predetermined amount of money (usually equal to the amount of the investor's purchase payments). Basically, the beneficiary will receive whichever amount is the greater of those two options. The "benefit" here is that the beneficiary could potentially receive more money with this "guaranteed amount," if the investor dies at a time when his account value is worth less money. Some variable annuities allow an investor to choose a stepped-up death benefit. This guarantees that once the investor's account reaches a certain amount, he "locks in the amount" as a guaranteed minimum return. The account can still grow past this value, but it can never go lower than this locked-in amount, even if the account performs poorly. This protects the investor from any future possible declines in the account. If an investor chooses this stepped-up death benefit, there is charge for this that will reduce the value of the account.

Variable annuities are also characterized by other features (some of which only apply to a certain type of annuity). The additional characteristics of variable annuities are as follows:

•Phases and payout options
•Charges & fees
•Taxation

PHASES

The accumulation phase is the period during which the investor is putting money into the annuity contract. An investor is considered to be in the accumulation phase while he is working, because he is putting aside funds or building up his account for a later time in life. This money is invested in the market and has the potential to grow over time. If an investor frequently contributes to his annuity during the accumulation period (and if this period is long), his investments can grow significantly. This is especially true with a deferred annuity--the more money that is contributed to the annuity during this period, the greater the income stream will be once this period is over. Remember that all contributes made to the annuity during the accumulation period grow tax-deferred. The accumulation period ends when the investor retires. If an investor transfers money from one investment option to another during this phase, he will not have to pay taxes on his current earnings ("tax-free 1035 exchange").

Accumulation units are the shares an investor owns in his separate account during the accumulation phase. The value of the annuity is calculated by multiplying the number of accumulations units by the dollar value of each unit. The value changes because it reflects the ongoing performance of the separate account during the accumulation period.

The annuitization phase is the period during which the annuitant starts receiving payments from the annuity. It occurs when the accumulation period ends and is also called the payout phase, the annuity phase, or the distribution phase. Payments are made to the annuitant on a monthly basis and last a lifetime. Although contributions made during the accumulation period grow tax-deferred, the payments made to the annuitant during the annuitization phase are considered to be taxable income.

When an investor begins receiving his payments during this stage, he trades in his accumulation units for annuity units. The exchange rate is calculated based on several factors, such as the annuitant's age, sex, payout option, and assumed interest rate (AIR). The number of annuity units determines the annuitant's proportionate ownership of the separate account. The value of annuity units might vary, but the number of annuity units remains constant (the number of accumulation units changes). These two factors (value and number) are multiplied together to determine the annuitant's lifelong monthly payment amount (if he chooses the monthly payout method).

At the beginning of the annuitization phase, the annuitant must choose how he wants to receive his payments (i.e. payments to himself or to a beneficiary; lump sum or periodic payments; payments received over a lifetime or over a certain amount of years, etc). Once he makes this decision, he is unable to change it.

The following are the annuity payout options that are available:

• Life annuity-- This is the "bare bones" option because it does not contain any additional clauses. It simply states that an annuitant will receive payments (usually monthly) over the course of his lifetime.

This option is considered to be ideal, since the insurer promises the annuitant a guaranteed income for life. Payments stop when the annuitant dies. Due to this fact, the annuitant might end up receiving more money than he originally invested if he lives a long time. However, if he dies early, the insurance company will benefit because they will no longer have to pay. This "life annuity" is also called a "straight life annuity." This option does not allow an annuitant to choose a beneficiary.

• Life annuity with period certain-- This option allows an annuitant to choose a beneficiary and also promises two things. The first is the promise to pay a lifetime of benefits. The second is the promise that these benefits will payed for a certain amount of time. For example, let's say annuitant chooses a "period certain" of 10 years. If he lives longer than 10 years, he will still receive payments until he dies (and his beneficiary receives nothing because he lived past the 10 years). If he dies before the 10 years are up, then his beneficiary will receive those payments until the end of that 10-year period.

• Joint life with last survivor-- This option covers two or more people (usually a husband and wife) and guarantees payments until the death of the last annuitant. In other words, even if the primary annuitant dies early, the same payments will continue until all the annuitants pass away.

• Life contingency-- This option includes a death benefit rider. It states that a full contribution will be made to the account if the annuity owner dies during the accumulation phase. The beneficiary will receive the full payout of the annuity.

CHARGES & FEES

Investors pay several fees when investing in a variable annuity. Unfortunately, these charges usually reduce the value of the account and the return on the original investment. Examples of the charges are as follows:

• Surrender charge-- An insurance company assesses this fee if an investor withdraws money (early) from his variable annuity during the surrender period. The surrender period is the short timeframe during which an investor will be charged a fee if he withdraws his money. This period is usually 6-8 years (sometimes 10 years). As this period declines towards 0 years, the fee amount also declines towards 0%. In other words, the longer an investor waits to withdraw his money, the less he will be charged. The fee is usually a percentage of the amount of money that the investor wants to withdraw. This fee covers the investment representative's commission. Once the surrender period is over, this fee will no longer be assessed. Sometimes, a variable contract will allow the annuitant to withdraw a portion of the account's value each year without paying a surrender charge.

• Mortality and expense risk charge-- This charge is equal to a certain percentage of the account's value (usually between 1% and 1.25% per year). This charge is used to compensate the insurance company for any risks it assumes. It might also be used to pay for any expenses incurred during the sale of the annuity (i.e. the commission paid to the investment representative) if the surrender charge does not cover this.

• Administrative fees-- Per its name, these fees cover administrative expenses such as recordkeeping. The insurance collect these fees two different ways. They might charge an annual account maintenance fee (i.e. $30 per year), or they might charge an annual percentage of the account's value (i.e. 0.15%).

• Underlying fund expenses-- These fees are associated with (and differ according to) the "separate" account of each investor.

Additional charges will be assessed for any of the following:

• Guaranteed minimum income benefit-- This is an optional feature guarantees a minimum amount of annuity payments to the annuitant even if he does not have enough money in his account to support the payments. Many variable annuities offer this optional feature, but an investor might not select it since it comes with additional fees.

• Long-term care insurance-- Per its name, this will pay for nursing home or in-home health care if the annuitant becomes seriously ill. This is also an optional feature that will require additional fees if selected.

• Tax-free 1035 exchanges-- Recall that Section 1035 of the U.S. tax code allows an annuity contract owner to exchange an existing variable annuity for another without paying taxes on the income and investment gains that are in the current account. These 1035 exchanges are useful for an investor who wants the features of a different annuity instead of his current annuity. Some of these features might include a larger death benefit, different annuity payout options, or a wider selection of investment choices. Surrender charges still apply on the old annuity if the investor is still in the surrender period. A new surrender charge period also begins when the client switches to the new annuity. Therefore, an investor will be in some kind of "surrender period" for several additional years, and he might be paying as high as 9% of the purchase payments if he decides to withdraw funds from the new annuity! He must also consider that the new annuity might have higher annual fees than the old one, reducing the annuity's returns even more.

TAXATION

The following information pertains to the taxation on withdrawals from an annuity:

• They are subject to ordinary income taxes on earnings.

• They are deducted (as a percentage) from sub-accounts.

• A minimum account value is required to qualify for certain withdrawal options.

• A minimum withdrawal amount might be required and will only allow a certain number of withdrawals per year.

• Lump sum withdrawals are taxed on a LIFO (last-in, first-out) basis. In other words, earnings are taken out first and are taxed as ordinary income. Anything that exceeds the earnings amount is taken out of the principal and is not taxed. Each payout consists of two parts--principal and rate of interest. The latter is taxable but the former is not. Remember that each payment is adjusted by the exclusion ratio (the invested amount versus the total expected return).

• Withdrawals before the annuitant reaches age 59 1/2 are subject to a 10% federal tax penalty unless he qualifies for an exemption. Exemptions include any withdrawals due to disability, death, or SEPP plan. A SEPP (substantially equal periodic payment) plan allows an individual to withdraw funds prior to age 59 1/2 without early withdrawal and income tax penalities if he has invested in an IRA or some other qualified retirement plan.

VARIABLE LIFE INSURANCE

The cash value and death benefits fluctuate according to the performance of underlying investments (stocks, bonds, money market funds, etc). and the rate of return is not guaranteed (the cash value is equal to the market value of the investments in the separate account). A variable life insurance policy is similar to a variable annuity contract. Both require their investors to deposit premiums into a separate account. Recall that the separate account is comprised of sub-accounts, which contain investment vehicles that are specific to the needs and goals of each investor. Most contain mutual funds. The separate account is considered to be a security since it contains multiple securities. Therefore, a prospectus must be used when selling variable life insurance products. Variable like insurance combines the protective and savings features of traditional life insurance with the growth potential feature of mutual fund investments. Variable life insurance policies are characterized by the following:

• They are a permanent form of insurance.
• They are considered to be securities contracts (although they are primarily insurance vehicles).
• They are suitable for investors who are looking to offset inflation, are seeking flexible insurance protection, and are not concerned with investment losses.
• The policyowner assumes all of the investment risk.
• They are interest-sensitive.
• They offer a build-up of cash value.
• They offer policy loans.
• They have a fixed premium.
• They have flexible death benefits.

• They have the ability to earn a variable rate of return.
• They provide the opportunity for tax-deferred investment growth

Additional details regarding variable life insurance policies are as follows:

A portion of each paid premium goes into the investment portfolio. The policy's face amount and cash value will vary according to the portfolio's performance (value). However, the death benefit amount cannot fall below the policy's initial face amount. When the portfolio's value significantly increases, the policyholder can use the extra cash in the sub-accounts to purchase additional insurance coverage. The policyholders can also borrow against the accumulated cash value in the policy ("take out a policy loan"). Sometimes, loans between 75% and 90% of the cash value are permitted. After three years, at least 75% of the cash value must be made available to each policyholder. Since a loan reduces the cash value, it also reduces the death benefit. Taking out a loan is not considered to be a withdrawal and is therefore not taxable. Loans can be paid back using interest.

Earnings are not taxed until withdrawn and are only taxed if they exceed the amount of premiums that were paid into the policy. When death benefits are paid upon the death of the policyholder, the cash value will be included in the owner's gross estate and will not be taxed as ordinary income.