variable annuity is an annuity contract whose cash values and benefit payments vary directly with the experience of assets designated to back the contract. Assets backing variable annuities, as with those backing variable life policies, are maintained in a separate account, and the variable annuity values directly reflect the accounts investment results. In contrast, the life insurer’s general account assets back the earlier discussed products. Variable annuities were first offered in the United States by the College Retirement Equities Fund, a nonprofit insurer specializing in the educational market. However, it was not until the mid-1960s that life insurers truly can be considered as having entered the market, only after some regulatory issues were resolved. The rationale for variable annuities is that they should offer, over the long run, protection against the debilitating affects of inflation on fixed incomes the kind of income provided by fixed annuities. The hope is that long-run returns on common stocks and other investments will keep pace with inflation a reasonable expectation if past results are a reflection of future results. As might be expected, sales of variable annuities tend to rise in rising stock markets and vice verse. Sales of fixed annuities tend to move in the opposite direction of sales of variable annuities.
Cash Surrender Values The cash surrender value of a variable annuity is its cash value less surrender charges. Most variable annuities have minimal front-end loads but have back- end loads that grade to zero over the first 5 to 10 contract years. The surrender charges are comparable to those for fixed-value FPDAs. Variable annuity premiums paid to the insurance company are placed in a special variable annuity account. Each year the premiums, after deduction for expenses, are applied to purchase accumulation units in the account, the number of units depending upon the current unit value. Thus, if each unit, based on current investment results, is valued at $10, a premium of $100 after expenses will purchase 10 units the following year. If the unit value is changed, the $100 premium would purchase more or less than 10 units. This procedure continues until annuity payouts begin. (For constant premium payments, this procedure is the same as dollar cost averaging as an investment strategy.)
Under a traditional FPDA, SPDA, or other fixed-value annuity, the insurance company guarantees a minimum interest rate to be credited to the cash value during the accumulation period. In addition, a minimum annuity payout is guaranteed. Most variable annuities do not contain these interest guarantees. The contract owner typically bears the investment risk and receives the return actually earned on invested assets, less charges assessed by the insurance company, No minimum cash value is guaranteed.
The general accounts of insurance companies are restricted as to the kind and quality of investments they may hold. Because these investments support liabilities for products with interest guarantees, they should offer safety of principal and a predictable income stream. In contrast, comparatively few restrictions apply to separate account investments. Income, gains, and losses on separate account assets are credited to or charged against the separate account. Income, gains, and losses on the company’s general account business and other separate account business have no effect on the separate account.
Funds of variable annuity contract owners are held in the separate account, and the contract owners participate fully in the investment results. Thus, in theory, the account could fall to zero. As with the variable life policy, the variable annuity permits simultaneous investment in multiple funds. Transfers among funds are permitted, usually at no charge for up to four transfers per year. Most insurers permit transfers during both the accumulation and liquidation periods. Some insurers even permit a transfer from a variable to a fixed basis.