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A variable annuity is a type of security offered by insurance companies. The purchaser pays a “premium” which is invested, tax deferred, in one or more securities sub-accounts (each sub-account corresponds to a different mutual fund option). [1] After a certain period of time has passed, the purchaser has the option of “annuitizing,” which means giving up any claim to the funds in the sub-accounts in exchange for a stream of income that lasts for either a prescribed number of years or for the life of the annuitant. The size of the income payments are primarily dictated by the aggregate value of the sub-accounts at the time of annuitization (for example, the contract may require payments of 5% of the sub-accounts’ aggregate value per year).

The purchaser is not required to annuitize, and always has the option to liquidate some or all of the sub-accounts and withdraw the liquidated funds. However, such withdrawals may be subject to surrender charges which can be as much as 20% of the investment. Surrender charges last for a specified number of years and generally decline in percentage points over that time period. For example, a “surrender schedule” could look like this: Year 1 – 8%; Year 2 – 7%, Year 3 – 5%; Year 4 – 3%; and Year 5 – 1%. Withdrawals are taxed as ordinary income, rather than at the more favorable capital gains rate, and if taken before age 59 and a half, withdrawals are subject to a 10% penalty tax.

Many variable annuities come with the option to purchase “lifetime benefit” riders which allow investors to immediately obtain a stream of income without annuitizing. Unlike with annuitization, the decision to take income under a lifetime benefit rider is not irrevocable, meaning that, down the road, the investor can still choose to liquidate the balance of her sub-accounts and withdraw the funds as a lump sum. Of course, such withdrawals are subject to applicable surrender charges and taxes.

Indexed annuities carry many of the same risks as variable annuities, including the liquidity risk that arises out of the annuity’s surrender features. However, indexed annuities differ from variable annuities in several significant ways. Unlike variable annuities, indexed annuities typically “guaranty” that the investor will receive a fixed minimum return of at least 1% to 2%, or that the investor’s initial contract value will be preserved. Also, while indexed annuities allow for returns in excess of their guaranteed minimums, unlike with variable annuities, the returns are calculated by reference to a securities index (e.g., the S&P 500) rather than through direct investments in securities themselves.

In light of the foregoing, indexed annuities are often touted as offering the best of both worlds — “guaranteed” returns and upside potential. This is misleading. To begin with, while the minimum returns are backed by the company that issued the annuity, they are not guaranteed. Insurance companies can, and do, fail. Furthermore, indexed annuities employ a variety of devices to inhibit growth. For example, “interest caps” and “spread fees” may be applied, both of which have the effect of imposing a ceiling on the investor’s returns. In addition, interest is usually calculated annually, thus depriving the investor of the benefit of compounding. It is also important to understand that the index that is being utilized is typically a price-return index, rather than a total-return index, and thus does not factor in dividends or dividend reinvestment. Based on the foregoing, most equity-indexed annuities are only suitable for ultra conservative investors who are so worried that they will “outlive” their assets that they are willing to accept drastically restricted upside potential in exchange for the comfort of knowing that they will receive lifetime income.

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[1] This article only describes deferred annuities which cannot be immediately annuitized.