Variable annuities allow money to be invested in insurance company "separate accounts" (which are sometimes referred to as "subaccounts" and in any case are functionally similar to mutual funds) in a tax-deferred manner.[6] Their primary use is to allow an investor to engage in tax-deferred investing for retirement in amounts greater than permitted by individual retirement or 401(k) plans. In addition, many variable annuity contracts offer a guaranteed minimum rate of return (either for a future withdrawal and/or in the case of the owner's death), even if the underlying separate account investments perform poorly.
This can be attractive to people uncomfortable investing in the equity markets without the guarantees. Of course, an investor will pay for each benefit provided by a variable annuity, since insurance companies must charge a premium to cover the insurance guarantees of such benefits. Variable annuities are regulated both by the individual states (as insurance products) and by the Securities and Exchange Commission (as securities under the federal securities laws).
The SEC requires that all of the charges under variable annuities be described in great detail in the prospectus that is offered to each variable annuity customer. Of course, potential customers should review these charges carefully, just as one would in purchasing mutual fund shares. People who sell variable annuities are usually regulated by FINRA, whose rules of conduct require a careful analysis of the suitability of variable annuities (and other securities products) to those to whom they recommend such products. These products are often criticized as being sold to the wrong persons, who could have done better investing in a more suitable alternative, since the commissions paid under this product are often high relative to other investment products.
There are several types of performance guarantees, and one may often choose them à la carte, with higher risk charges for guarantees that are riskier for the insurance companies. The first type is a guaranteed minimum death benefit (GMDB), which can be received only if the owner of the annuity contract, or the covered annuitant, dies.
GMDBs come in various flavors, in order of increasing risk to the insurance company:
Return of premium (a guarantee that you will not have a negative return)
Roll-up of premium at a particular rate (a guarantee that you will achieve a minimum rate of return, greater than 0)
Maximum anniversary value (looks back at account value on the anniversaries, and guarantees you will get at least as much as the highest values upon death)
Greater of maximum anniversary value or particular roll-up
Insurance companies provide even greater insurance coverage on guaranteed living benefits, which tend to be elective. Unlike death benefits, which the contractholder generally cannot time, living benefits pose significant risk for insurance companies as contractholders will likely exercise these benefits when they are worth the most. Annuities with guaranteed living benefits (GLBs) tend to have high fees commensurate with the additional risks underwritten by the issuing insurer.
Some GLB examples, in no particular order:
Guaranteed minimum income benefit (GMIB, a guarantee that one will get a minimum income stream upon annuitization at a particular point in the future)
Guaranteed minimum accumulation benefit (GMAB, a guarantee that the account value will be at a certain amount at a certain point in the future)
Guaranteed minimum withdrawal benefit (GMWB, a guarantee similar to the income benefit, but one that doesn't require annuitizing)
Guaranteed-for-life income benefit (a guarantee similar to a withdrawal benefit, where withdrawals begin and continue until cash value becomes zero, withdrawals stop when cash value is zero and then annuitization occurs on the guaranteed benefit amount for a payment amount that is not determined until annuitization date.)
Recently, insurance companies developed asset-transfer programs that operate at the contract level or the fund level. In the former, a percentage of client's account value will be transferred to a designated low-risk fund when the contract has poor investment performance.
On the fund level, certain investment options have a target volatility built within the fund (usually about 10%) and will re-balance to maintain that target. In both cases, they are stated to help buffer poor investment performance until markets perform better (where they will transition back to normal allocations to catch an upswing).
However, there are criticisms of these programs including, but not limited to, often mandating these programs on clients, restricting flexibility of investing, and not catching the upswing of markets fast enough due to the underlying design of such programs.
Be careful in regard to using GLB riders in non-qualified contracts as most of the products in the annuity marketplace today create a 100% taxable income benefit whereas income generated from an immediate annuity in a non-qualified contract would partially be a return of principal and therefore non-taxable.