How to Select Investment Options in Variable Annuities

by Rob Phillips, CPA

Choices, choices and more choices.

It is often said that a variable annuity brings together some of the best features of mutual funds and insurance. Features include the opportunity to receive a lifetime income stream upon annuitization and the assurance that your beneficiaries will receive a guaranteed death benefit if you die before taking income.

In addition, a variable annuity contract may offer enhanced benefits (some for additional fees), such as locked-in gains, automatic asset reallocation, or a larger number of free transfers among your portfolios. However, while the principal and interest rate of a fixed annuity are guaranteed based upon the claims paying ability of the insurer, the principal and return of a variable annuity are not guaranteed and will fluctuate with changes in market conditions.

A variable annuity contract offers a number of portfolios, each with specific investment objectives, similar to the many mutual funds that each have specific investment objectives.

A benefit of a fixed annuity or a variable annuity is the tax-deferred growth of earnings, something you achieve with a mutual fund only if you buy it within an IRA or qualified retirement plan. While you can put money directly into a mutual fund, however, you must buy the variable annuity contract before you can allocate money to the annuity’s portfolios. 

Variable annuity contracts carry different and/or additional fees than mutual funds. In addition to sales and surrender charges, an annuity may impose mortality and expense risk charges, administrative fees, charges for special features and other fees. Also, withdrawals from an annuity made prior to age 59½ may be subject to a 10% IRS penalty tax, whereas mutual fund redemptions, held outside a qualified retirement plan, are not.

All variable annuity contracts offer an array of portfolios ranging from as few as six to three dozen or more, some that invest in stocks, some in bonds, and some in cash or cash equivalents. However, the actual number of portfolio choices in a variable annuity contract is less important, than the variety.

Many variable annuity owners might find a larger number of choices intimidating. On the other hand, if you’re interested in diversifying your account across a range of investment options—a group of international stocks as well as small domestic company stocks, for example—then the more choices you have, the greater the opportunity to achieve the mix that can benefit your goals.

Types of Portfolios

While different variable annuity contracts offer different options, you’ll generally have a choice among these major categories: equity (domestic and international), bond, money market, and balanced portfolios. In addition, many variable annuity contracts also have a fixed account investment option.

All variable annuity contracts typically offer at least one portfolio in each category, and often more than one. When there is more than one, each portfolio will generally have a somewhat different investment objective from the others as well as different strategies for achieving the portfolio’s objectives. The specific investments it holds will also be different. This variety allows you to select the portfolios that are a precise fit your investment objectives.

Equity Portfolios

Equity portfolios invest in stocks and generally have growth as the overall objective. Some portfolios focus on growth and income, and purchase shares in stable, well-established companies that pay regular dividends but tend to grow at a relatively slower pace.

Other equity portfolios concentrate on aggressive growth, whereby they make investments in companies that have the potential of big returns in the future but present higher risk than more established companies.

A portfolio’s name will often give you an indication of its objective, for example “International Equity” or “Small Cap Growth”. However, an investor should carefully read and consider the portfolio’s objective and investment approach, as well as risks, fees and charges in the prospectus before investing.

Bond Portfolios

In most cases, annuity owners who put money into bond portfolios, are looking to increase their assets by adding income rather than looking for growth in value. While there are not as many bond as equity portfolios, most contracts offer choices here as well, including more stable portfolios that focus on government issues or high-grade corporate bonds in addition to those that buy more volatile high-yield corporate bonds.

Money Market Portfolios

The most stable and conservative portfolios are the money market portfolios. The funds in these portfolios invest only in short-term instruments, like Treasury bills and bank certificates of deposit. Even though the returns are often lower than the other portfolios, it is precisely this relative safety that makes them appropriate as a place to hold money while you decide on your next investment move.

A money market portfolio’s rate of return, called its yield, rises or falls along with prevailing short-term interest rates and will change in the portfolio over time. An investment in a money market fund (MMF) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a MMF seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.

Fixed Accounts

Fixed accounts pay a set rate of interest. Although they offer less growth potential than variable portfolio choices (except money markets), they are attractive because of the lack of volatility. Fixed portfolios are often most popular when annuity buyers want to take advantage of high interest rates, or want to provide balance to their more aggressive portfolios. Many investors prefer to own a single variable annuity that has the option of a fixed account in addition to the other portfolios, rather than to own both a fixed annuity and a variable annuity .

Who Manages the Funds?

The portfolios in a variable annuity contract may be proprietary, which means they are provided by the insurance company issuing the annuity and are managed by the investment managers of the company or its affiliates.

Or they may be portfolios managed by well-known mutual fund companies, investment advisory firms, brokerage firms or banks and run by money managers working for those institutions. Studies show that customers seem to be attracted to annuity contracts offering brand names they recognize. To meet those expectations and to expand their offerings at the same time, companies are increasingly offering both proprietary and third party portfolio choices.

Are They the Same or Different?

Often, the portfolios in a variable annuity contract may have a name that’s similar to a particular mutual fund. But even if the same fund manager runs both, they’re not the same funds. The money from the two funds is never mingled. If both the annuity portfolio and the mutual fund buy the same investments, they always buy separately. And they may even own different investments altogether.

An annuity portfolio and a similarly named mutual fund, both designed for long-term equity growth and run by the same manager, will likely show different returns. Since money may flow into a variable annuity on a more regular basis or be less apt to be withdrawn during fluctuating market conditions, the portfolio manager might make different investment decisions than he or she would for a mutual fund, which needs more cash reserves available for potential share redemption.

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