A variable annuity is an investment product with insurance features. It allows you to select from a menu of investment choices, typically mutual funds, within the variable annuity and, at a later date—such as retirement—allows you to receive a stream of payments over time. The value of your variable annuity will depend on how your investment choices perform.

Variable Annuities: Beyond the Hard Sell

The marketing efforts used by some variable annuity sellers deserve scrutiny—especially when seniors are the targeted investors. Sales pitches for these products might attempt to scare or confuse investors. One scare tactic used with seniors is to claim that a variable annuity will protect them from lawsuits or seizures of their assets. Many such claims are not based on facts, but nevertheless help land a sale.

While variable annuities can be appropriate as an investment under the right circumstances, as an investor, you should be aware of their restrictive features, understand that substantial taxes and charges may apply if you withdraw your money early, and guard against fear-inducing sales tactics.

FINRA is issuing this Investor Alert to help seniors and other prospective variable annuity buyers to make informed decisions about how to invest for their retirement. This alert focuses solely ondeferred variable annuities and the unique issues they raise for investors.

What Are Variable Annuities?

Although variable annuities offer investment features similar in many respects to mutual funds, a typical variable annuity offers three basic features not commonly found in mutual funds:

1. Tax-deferred treatment of earnings.
2. A death benefit.
3. Annuity payout options that can provide guaranteed income for life.

Generally, variable annuities have two phases:

1. The “accumulation” phase when investor contributions—premiums—are allocated among investment portfolios—subaccounts—and earnings accumulate.
2. The “distribution” phase when you withdraw money, typically as a lump sum or through various annuity payment options.

If the payments are delayed to the future, you have a deferred annuity. If the payments start immediately, you have an immediate annuity.

As its name implies, a variable annuity’s rate of return is not stable, but varies with the stock, bond and money market subaccounts that you choose as investment options. There is no guarantee that you will earn any return on your investment and there is a risk that you will lose money. Because of this risk, variable annuities are securities registered with the Securities and Exchange Commission (SEC). The SEC and FINRA also regulate sales of variable insurance products.

Evaluating Variable Annuities

The variety of features offered by variable annuity products can be confusing. For this reason, it can be difficult for investors to understand what’s being recommended for them to buy—especially when facing a hard-charging salesperson.

Before you consider purchasing a variable annuity, make sure you fully understand all of its terms. Carefully read the prospectus. Here are seven factors you should bear in mind before investing:

1. Liquidity and Early Withdrawals – Deferred variable annuities are long-term investments. Getting out early can mean taking a loss. Many variable annuities assess surrender charges for withdrawals within a specified period, which can be as long as six to eight years. Also, any withdrawals before an investor reaches the age of 59 ½ are generally subject to a 10 percent tax penalty in addition to any gain being taxed as ordinary income.
2. Sales and Surrender Charges – Most variable annuities have a sales charge. Like class B shares of mutual funds, many variable annuity shares typically do not charge a front-end sales charge, but they do impose asset-based sales charges or surrender charges. These charges normally decline and eventually are eliminated the longer you hold your shares. For example, a surrender charge could start at 7 percent in the first year and decline by 1 percent per year until it reaches zero.
3. Fees and Expenses – In addition to sales and surrender charges, variable annuities may impose a variety of fees and expenses when you invest in them, such as:
   • Mortality and expense risk charges, which the insurance company charges for the insurance to cover:
     • guaranteed death benefits;
     • annuity payout options that can provide guaranteed income for life; or
     • guaranteed caps on administrative charges.
   • Administrative fees, for record-keeping and other administrative expenses.
   • Underlying fund expenses, relating to the investment subaccounts.
   • Charges for special features, such as:
     • stepped-up death benefits;
     • guaranteed minimum income benefits;
     • long-term health insurance; or
     • principal protection.
   • These annual fees on variable annuities can reach 2 percent or more of the annuity’s value. Remember, you will pay for each variable annuity benefit. If you don’t need or want these features, you should consider whether this is an appropriate investment for you.
4. Taxes – While earnings in a variable annuity accrue on a tax-deferred basis—typically a big selling point—they do not provide all the tax advantages of 401(k)s and other before-tax retirement plans. 401(k)s and other before-tax retirement plans not only allow you to defer taxes on income and investment gains, but allow your contributions to reduce your current taxable income. That’s why most investors should consider annuity products only after they make their maximum contributions to their 401(k)s and other before-tax retirement plans. To learn more about 401(k)s, please read Smart 401(k) Investing. Once you start withdrawing money from your variable annuity, earnings (but not principal) will be taxed at the ordinary income rate, rather than at the lower capital gains rates applied to investments in stocks, bonds, mutual funds or other non-tax-deferred vehicles in which funds are held for more than one year. Furthermore, proceeds of most variable annuities do not receive a “step-up” in cost basis when the owner dies. Other types of investments, such as stocks, bonds, and mutual funds, do provide a step up in tax basis upon the owner’s death.
5. Bonus Credits – In an attempt to attract investors, many variable annuities now offer bonus credits that can add a specified percentage to the amount invested in the variable annuity, generally ranging from 1 percent to 5 percent for each premium payment you make. Bonus credits, however, are usually not free. In order to fund them, insurance companies typically impose high mortality and expense charges and lengthy surrender charge periods.
7. Exchanging or Replacing Your Current Annuity – 

An exchange of an existing annuity for a new annuity may be the only way a salesperson can generate additional business. However, the new variable annuity may have a lower contract value and a smaller death benefit. You should exchange your annuity only when it is better for you and not just better for the person trying to sell you a new annuity. To learn more about exchanges, please read our Investor Alert, 

Should You Exchange Your Variable Annuity?

1. Guarantees – Insurance companies issuing variable annuities provide a number of specific guarantees. For example, they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens. There are several credit rating agencies that rate a company’s financial strength. Information about these agencies can be found on the SEC’s website.
2. Variable Annuities within IRAs – Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson. Also, if the annuity is within a traditional (rather than a Roth) IRA, the government requires that you start withdrawing income no later than the April 1 that follows your 70½ birthday, regardless of any surrender charges the annuity might impose.

Individual Retirement Annuities – Some variable annuity providers sell what is termed an Individual Retirement Annuity (IRA). You should be aware that this “IRA” is not an Individual Retirement Account (IRA). The Internal Revenue Service sets specific restrictions regarding Individual Retirement Annuities, which are not met by all annuity products. To learn more, please read IRS Publication 590.

How to Protect Yourself – Brokers recommending variable annuities must explain to you important facts, including:

• liquidity issues, such as potential surrender charges and 10 percent tax penalties;
• fees, including mortality and expense charges, administrative charges, and investment advisory fees; and
• market risk.

Brokers also must collect important information from you about your age, marital status, occupation, financial and tax status, investment objectives, and risk tolerance to assess whether a variable annuity is suitable for you. Before purchasing a variable annuity, you should specifically—

Ask the person recommending that you purchase a variable annuity:

• How long will my money be tied up? Are there surrender charges or other penalties if I withdraw funds from the investment earlier than I anticipated?
• Will you be paid a commission or receive any type of compensation for selling the variable annuity? How much?
• What are the risks that my investment could decrease in value?
• What are all the fees and expenses?

Thoroughly Check Out Your Broker – Check FINRA BrokerCheck to learn whether your broker is licensed and has a history of complaints.

And remember to ask yourself:

• Am I already contributing the maximum amount to my 401(k) plan and other tax-deferred retirement plans?
• Do I have a long-term investment objective? Am I going to need the money before the surrender period ends (usually at least seven to 10 years)? Will I need the money before I’m 59½?
• Do I understand how the variable annuity works, the benefits it provides, and charges I have to pay?
• Have I read and understood the prospectus?
• Are there special features provided such as added long-term care insurance that I don’t need?
• If I’ve decided to purchase a variable annuity, have I shopped around and compared the features of various variable annuities, such as sales loads and other fees and expenses?
• Do I understand the effect annuity payments could have on my tax status?
• If I’m considering purchasing a variable annuity within an IRA, do I understand that IRAs already provide for tax-deferred savings?
• Am I being pressured into making a quick purchase?

Have You Already Purchased a Variable Annuity?

If you have purchased a variable annuity and now have second thoughts, the policy may have a “free look” period that allows you to cancel within a specific period. If you believe you were wrongly sold a variable annuity you can file a complaint online at FINRA’s Investor Complaint Center.

What should I do before I invest in a variable annuity?

• Know how they work. Before you buy a variable annuity, know how it works, look up key terms you might not be familiar with, figure out how you’ll be charged, and be prepared to ask your financial professional questions about whether the product is right for you.
• Get the details—read the variable annuity prospectus. Different products have different features. Ask your financial professional for the variable annuity prospectus, which will describe the product you’re considering in detail. Read the prospectus carefully, and ask questions about what you don’t understand. The prospectus—which should be available free of charge—contains important information about much of what’s described in this Investor Bulletin, including charges, investment choices, death benefits, payout options, and other features.
• Understand that they are not appropriate for short-term investors. Variable annuities are long-term investments for retirement savings purposes and other long-range goals. They are not a good choice for short-term investing. If you take out your money too early from the variable annuity, substantial taxes and insurance company charges, among other things, may apply.
• Realize that you could lose money. Variable annuities involve investment risks, just like mutual funds do. If the investment choices you selected for the variable annuity perform poorly, you could lose money.

What’s different about a variable annuity?

Although variable annuities usually are invested in mutual funds, they are different from mutual funds in important ways:

• Variable annuities allow you to receive periodic payments. A variable annuity allows you to receive periodic payments for the rest of your life or for the life of your spouse.
• They offer a range of features, but be prepared to pay extra for them. For example, most variable annuities offer a death benefit, which means that if you die before the insurer has started making payments to you, a person you have named as a beneficiary will receive a specified amount. But you’ll pay for this feature during the time you own the product. Same with other features such as optional “riders,” including so-called “guarantees,” which are discussed in more detail below. Consider whether these features are right for you and are worth what you’re paying for them.
• Earnings are tax-deferred, but there are penalties for early withdrawal. You pay no taxes on any income and investment gains on the investments that you hold in the variable annuity until you withdraw your money. But when you take your money out, you will be taxed on the earnings at ordinary income tax rates rather than at lower capital gains tax rates associated with other investments, like mutual funds. In addition, you may face a 10% federal income tax penalty if you withdraw the money before you are 59½ years old. Finally, if you’re putting a variable annuity into a tax-advantaged account, like an IRA or other retirement account (e.g., a 401(k) plan), you’ll get no extra tax advantage.

How is my money in a variable annuity invested?

You allocate your payments (during what’s called the “accumulation phase”) to the investment choices available through the variable annuity. For example, you might direct 40% of your payments to a bond fund, 40% to a U.S. stock fund, and 20% to an international stock fund. The money you direct to each mutual fund investment choice will increase or decrease over time, depending on the mutual fund’s performance. In addition, variable annuities often allow you to direct part of your purchase payments to a fixed account run by the insurance company. A fixed account, unlike a mutual fund, pays a fixed or minimum rate of interest.

Ask your financial professional for the prospectuses of the investment choices available through the variable annuity before you decide how to invest your money. Consider these important questions for each investment choice you are thinking about: (1) investment objectives, (2) fees and expenses, (3) risks and volatility, and (4) how the fund fits into your overall investment strategy.

How do I get my money out of the variable annuity?

When you begin to take money out of the variable annuity, that’s called the “payout phase.” At the beginning of the payout phase, you can elect to receive the value of your variable annuity all at once. Or, you can choose to receive a stream of payments—for example, for a period that you select (say, 20 years) or for a specified person’s lifetime (such as your lifetime or the lifetime of you and your spouse).

What are living benefits?

Many variable annuities offer features designed to provide some protection from investment losses. These features are sometimes called “living benefits.” They may also have names such as “guaranteed minimum income,” “guaranteed minimum withdrawal,” “guaranteed lifetime withdrawal,” or “guaranteed minimum accumulation” benefits. Some such features provide that you will be able to receive a specified level of payments, regardless of the performance of your investment choices.

You pay extra for these features, so be sure what you choose is right for you, and worth what you’re paying for it. Our variable annuity publication—Variable Annuities: What You Should Know—has more information about these features generally, and the product prospectus will have more information on how the particular living benefit you are considering works.

What will I pay to invest in a variable annuity?

You pay charges when you invest in a variable annuity. Be sure you understand all the charges before you invest. These charges will reduce the value of your account and the return on your investment. Often, they will include:

• Surrender charges—Withdrawals made within a certain period after your purchase payment (usually within six to eight years, but sometimes 10 years or longer) will usually have a “surrender” charge deducted from the amount you withdraw.
• Mortality and expense risk charge—This charge is based on the value of your account—usually around 1.25% of the value of your account per year. It pays for the death benefit, and is sometimes used to pay the insurance company’s costs to sell the contract—like commissions.
• Investment option expenses—Expenses for the investment choices you select.
• Charges for other features—Special features, such as a living benefit, an enhancement to the basic death benefit, or long-term care insurance, often cost extra.

Read the variable annuity prospectus and ask your financial professional to explain the charges that may apply. We’ve highlighted some of the key ones here.

What are tax-free exchanges?

Under U.S. tax law, you can exchange a variable annuity contract for a new annuity contract without paying any tax on any income and investment gains in your current variable annuity. These exchanges might be useful to you if you own a variable annuity but another annuity has features that you prefer, such as a larger death benefit, different annuity payout options, or different living benefits.

Exchanging your original variable annuity for a new one may have drawbacks. For example, when you surrender the old variable annuity, you may have to pay surrender charges. (Remember—exchanging your original variable annuity contract for a new annuity contract generally is considered a withdrawal.) Also, a new surrender charge period generally begins when you exchange into the new variable annuity. This means that, for a significant number of years, you typically will have to pay a surrender charge if you withdraw funds from the new variable annuity. In addition, features under the original contract, such as the death benefit and living benefits, might be better than you might have under the new contract. And the new variable annuity may have higher fees and charges than the old variable annuity, which will reduce your returns.

What are bonus credits?

Some insurance companies give you a credit that is added to your variable annuity contract value based on a percentage (typically from 1% to 5%) of your purchase payments. Sometimes the bonus is limited to money you put in initially or during the first year of owning the contract.

Ask questions before you invest—in anything

Don’t be afraid to ask the financial professionals who are trying to sell you a variable annuity whether the product is right for you. Keep asking them questions until you are satisfied with their answers. And write down their answers, so there won’t be any confusion later as to who said what.

Remember: Before purchasing a variable annuity, learn as much as possible about how it works, the benefits it provides, and the charges you will pay.

Should You Exchange Your Variable Annuity?

If you have a life insurance or annuity contract, you may have been approached to exchange it for a new model, one with better or the latest features. You need to know that even though tax law makes the exchange income tax free and the new contract may sound better for you, you may be losing—not gaining—if you make the exchange.

We are issuing this Alert because we have found investor confusion about variable annuity exchanges, and we have brought cases where investors were investing in variable annuities that were not suitable for them. This Alert will give you information on how to determine if an exchange is right for you, and how you can find out what you need to know to make a smarter decision.

Some Background

You may know that an annuity is a contract between you and an insurance company where the company promises to make periodic payments to you, starting immediately or at some future time. You buy the annuity either with a single payment or a series of payments.

You should also know that annuity contracts come in three flavors: fixed, variable and equity-indexed. Fixed means that the earnings and payout are guaranteed by the insurance company. Variable means that the amount that will accumulate and be paid will vary with the stock, bond, and money market funds that you chose as investment options. Unlike fixed contracts, variable annuities are securities registered with the Securities and Exchange Commission (SEC). Sales of variable insurance products are regulated by the SEC and FINRA. Equity-indexed annuities(EIAs) have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity. 

Variable annuities may impose a variety of fees when you invest in them, such as: surrender charges, which you owe if you withdraw money from the annuity before a specified period;mortality and expense risk charges, which the insurance company charges for the insurance risk it takes under the contract; administrative fees, for recordkeeping and other administrative expenses; underlying fund expenses, relating to the investment options; and charges for special features, such as a stepped-up death benefit or a guaranteed minimum income benefit.

The Internal Revenue Service allows you to exchange an insurance contract that you own for a new life insurance or annuity contract without paying tax on the income and the investment gains earned on the original contract. This can be a substantial benefit. Because this is governed by Section 1035 of the Internal Revenue Code, these are called “1035 Exchanges.”¹

But this benefit comes with some important strings.

• The tax code says that the old insurance contract must be exchanged for a new contract—you cannot receive a check and apply the proceeds to the purchase of a new insurance or annuity contract.
• The tax code also says you can make a tax-free exchange from: 1) a life insurance contract to another life insurance contract or an annuity contract or 2) from one annuity contract to another annuity contract. You cannot, however, exchange an annuity contract for a life insurance contract.

Why Make a Section 1035 Exchange?

There are various reasons why a variable annuity contract holder may want to exchange an existing variable annuity contract.

• Many annuity contracts now offer premium—sometimes called bonus—credits toward the value of your contract, of a specified percentage ranging from 1-5% for each purchase payment you make.
• Also, in recent years, there have been new developments in annuity features, especially in variable annuities, that are valid reasons to consider an exchange. The number of investment options has increased. Less expensive variable annuity contracts have been created. Death and living benefits have been enhanced. Also, with the growth in the stock market in the 1990s, many insurance contract holders have wanted to take part in that growth. These are all valid reasons for considering exchanging one insurance contract for another.

Why Not Make a Section 1035 Exchange?

Generally, the exchange or replacement of insurance or annuity contracts is not a good idea, for a variety of reasons.

• “Bonus” or “premium” payments made to you are usually offset by the insurance company’s adding other charges it makes to you.
• Other contract provisions, like surrender charges, eventually expire with an existing contract. However, new charges may be imposed with a new contract or may increase the period of time for which the surrender charge applies.
• You may also have to pay higher charges, such as annual fees for the new contract.
• You may not need the costly new features of the new contract.
• In many instances your broker is getting paid a higher commission for a variable annuity than he or she would for the sale of another securities product, such as a stock, bond, or mutual fund.

What You Should Watch For

You should exchange your annuity only when you determine, after knowing all the facts, that it is better for you and not just better for the person who is trying to sell the new contract to you.

Much of the sales growth of variable annuities in recent years has been from Section 1035 Exchanges. Even though some variable annuity enhancements have made variable annuities more attractive, you need to be sure that the exchange meets your objectives and benefits you. Variable annuities are long-term, retirement-oriented investment vehicles, and exchanging them may not benefit you. 

Caution! Variable annuity sales have dropped along with the decline in the equity marketplace. A recommendation for the exchange of an existing annuity contract for a new annuity contract may be the only way a salesperson can generate additional business. However, the new variable annuity contract may have a lower contract value and a smaller death benefit. As in any circumstances, you should exchange your annuity only when it is better for you and not just better for the person trying to sell you a new annuity.

Brokers or insurance agents recommending the exchange of an annuity contract must tell you important facts about the pros and cons of the exchange. Your broker or insurance agent is permitted to recommend such an exchange to you only if it is in your best interest and only after evaluating your personal and financial situation and needs, tolerance for risk, and the financial ability to pay for the proposed contract. This “suitability” obligation is based on FINRA rules.

Many states and brokerage firms require forms to reflect customer acknowledgment of a replacement transaction. These forms are to be signed by the annuity contract owner and the salesperson. These forms may provide a comparison of the features and costs of an existing contract to a proposed contract, and point out what you need to focus on when considering the exchange. You should review these forms closely.

Regardless of whether such forms are provided to you, you should specifically ask the person recommending that you exchange your variable annuity:

• What is the total cost to me of this exchange?
• What does the change in the surrender period or other terms mean for me?
• What are the new features being offered? Why do I need or want those features?
• Are those features worth the increased cost?
• Will you be paid a commission for the exchange, and if so, how much is it?

You should not sign any exchange form or agree to exchange or purchase an annuity until you study all of the options carefully, have all of your questions answered, and are satisfied that the exchange is better than keeping your current contract.

What Regulators Do to Protect You

We and the SEC have conducted a series of special sales practice examinations that have focused on the sales of variable contracts—variable annuities and variable life insurance. These examinations have resulted in a number of cases that have found that some brokers and insurance agents recommended unsuitable variable products for their customers, and that the firms employing those brokers and insurance agents did not supervise them properly to prevent those unsuitable recommendations.

In addition, FINRA’s examinations of its members selling variable contracts routinely investigate for inappropriate sales of variable contracts, including unsuitable variable contract exchanges or replacements. Remember, however, that no matter how much regulators try to protect you, you are your own best protection by knowing what to avoid in the first place.