With a variable annuity the annuity owner has the opportunity to allocate his premiums among a number of subaccounts. In return for the opportunity to benefit from any appreciation in underlying investments, the owner assumes the risk that his investments may decrease in value, thereby resulting in lower accumulation values or a lower monthly income. The variable annuity is considered a "security" under federal law and anyone selling a variable annuity must have the required securities licenses and the purchaser must be given a prospectus (see footnote 3, page 301). The purchase can be made with either a single premium or a series of premiums (see Annuity Matrix, page 318).
In addition to a fixed or general account, the typical variable annuity might offer the following investment options: (1) growth or common stock fund; (2) balanced fund; (3) index fund; (4) global fund; (5) bond fund; (6) government securities fund; and (7) money market fund. Asset management or investment fees will vary depending upon the type of fund. In addition to an annual administration fee, an annual mortality charge is made for a guaranteed "death benefit" (e.g., provided the owner dies prior to age 80 his beneficiary is guaranteed to receive the greater of his original investment or the policy's value at the time of death, less withdrawals). Some contracts offer "stepped up" death benefits that lock in investment gains at a given point in time.
During the accumulation phase premium payments are applied toward the purchase of accumulation units. The value of an accumulation unit is determined by dividing the market value of the underlying investments by the total number of units outstanding. Dividends and capital appreciation or depreciation are reflected in the value of the accumulation units. The owner also has the option to transfer funds between investment subaccounts, subject to certain dollar amounts and timing limitations. Unlike mutual funds, all accumulations are tax deferred and transfers of assets between accounts are free of current income taxes. A decreasing surrender charge is generally applied if the annuity is surrendered within a given period (see chart, page 299).
During the distribution phase the annuity owner can cash in the contract, take periodic withdrawals, or annuitize the contract. All gains are taxed as ordinary income when distributed. Annuity payments can be received on a fixed or variable basis, or a combination of both, and can be paid as a single life annuity or joint and survivor annuity. If variable benefits are to be received the accumulation units are first exchanged for annuity units. Unlike accumulation units, the number of annuity units then remains constant. Variable benefit payments will differ from month to month, or from year to year, depending upon the value of the annuity units. A new living benefit feature currently being developed offers a guaranteed minimum account value, or minimum payout amount, regardless of the actual performance of the subaccounts. See also, the discussion of the Guaranteed Lifetime Withdrawal Benefit on page 439.