Valuating Variable Annuity Contracts

Instructor: Bianca Ince

Bianca has FINRA Series 7, 63, SIE licenses and has licensing program at her firm for 5+ years.

Variable annuities are an attractive option for investors hoping to maximize their growth potential before retirement. During this lesson, we will review how the value of these contracts is determined.

Variable Annuity Phases

Carl is an investor thinking ahead. How can he make sure to maximize his growth potential before retirement?

Variable annuities are retirement vehicles in which the policyholder invests money for a period of time and then receives payments during retirement. The period in which Carl invests his premiums is called the accumulation phase. The annuitinization phase begins once he elects to start receiving payments.

During the accumulation phase, the premiums Carl makes are used to purchase accumulation units of the investments he chooses. The accumulation unit measures the value of a contribution to the investment selected. The number of accumulation units purchased, similar to shares of stock, will fluctuate with the market.

Therefore, during a downmarket, a contribution will purchase more shares of an investment than it would when market prices are up. The purpose of the accumulation phase is to boost the value of the separate account. Therefore, any dividends received are reinvested to purchase more accumulation units of that investment. Carl can elect to change investments according to his investment objectives and/or risk tolerance.

Calculating Accumulation Unit Value

So, how much ownership of an investment can Carl purchase with the premium amount? The accumulation unit value (AUV) can be calculated by dividing the total value of the investment by the number of accumulation units outstanding (owned).

Say the total value of Investment Pool XYZ is \$3 million, with 150k units outstanding:

• investment value / # units outstanding = AUV
• \$3,000,000 / 150,000 = \$20

Now the number of units a premium can purchase can be calculated by dividing the premium amount by AUV.

Carl should keep in mind that these figures will all fluctuate with the market. For example, say the market took a downturn, and the value of Investment XYZ decreased by half to \$1.5 million. The AUV would decrease by half as well to \$10, but the total units purchased with a \$500 premium would increase to 50 units. Since the AUV is 50% less, the same premium amount can purchase double the units.

Due to fluctuation within the market, the overall value of the separate account will consistently change. However, the value of the Carl's investments and the overall value of the separate account should also increase. This is the primary advantage variable annuities have over other types of annuity products.

Surrender Value

Variable annuities, like other retirement vehicles, are intended to be long-term investments. As a result, insurance companies deter annuitants from canceling their contracts with a surrender charge, typically a percentage of the cash value (the original amount paid for the contract).

During the surrender period, typically the first 10-15 years of the contract, Carl will receive only the cash surrender value if he cancels, which is the cash value after the surrender charge has been subtracted.

Say Carl decides to cancel his variable annuity contract during the surrender period. The cash value of the contract is \$20k, and the insurance company will access a 25% surrender charge upon cancellation. To calculate the surrender cash value he would receive:

First, determine the dollar amount of the surrender charge

\$20,000 * 25% = \$5,000. This is the dollar amount of surrender charge.

Next, subtract the amount of surrender charge from the cash value of the policy.

\$20,000 - \$5,000 = \$15,000. This is the surrender cash value annuitant will receive upon cancellation.

After the surrender period ends, the annuitant would not incur a surrender charge for canceling the policy. Therefore, the cash value amount and the surrender cash value would be the same.

Annuitization Phase

When Carl decides to begin receiving annuity payments, the annuitization phase begins. This could be when he retires or before (under certain circumstances). During the annuitization phase, the accumulation units in the separate account will be converted into annuity units. The annuity units will then be sold in the market depending on the annuity payout option selected.

If a fixed payout is selected, the amount of each payout is the same regardless of market performance. Variable payments, however, would change according to market fluctuation.

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