What Are Variable Contracts?
Variable contracts are a type of investment vehicles that combine features of traditional insurance products with elements of securities. Primarily issued by insurance companies, these contracts allow for the growth of capital on a tax-deferred basis, with the ultimate payout or death benefit fluctuating based on the performance of underlying investment options, known as sub-accounts. As such, variable contracts fall under the broader financial category of insurance and investment products. Unlike fixed insurance products, the contract holder bears the market risk associated with the investment choices.
History and Origin
The evolution of variable contracts is closely tied to the need for financial products that could offer protection against inflation, a concern not adequately addressed by traditional fixed-income insurance products. While the precise origin can be traced to earlier insurance innovations, a pivotal moment in the regulation and widespread adoption of variable contracts in the United States occurred with the landmark Supreme Court case SEC v. Variable Annuity Life Insurance Company (VALIC) in 1959. This decision established that variable annuity products, despite their insurance characteristics, were indeed securities and thus subject to federal oversight by the U Securities and Exchange Commission (SEC) and the Investment Company Act of 1940, in addition to state insurance regulation.4 This ruling paved the way for a dual regulatory framework that continues to shape the variable contract landscape.
Key Takeaways
- Variable contracts are hybrid financial products combining insurance features (like a death benefit) with investment components.
- The value of a variable contract fluctuates based on the performance of its underlying investment options, placing investment risk on the contract holder.
- These products are subject to dual regulation by both state insurance departments and federal securities regulators, including the SEC and FINRA.
- Variable contracts offer tax-deferred growth, but withdrawals before a certain age may incur tax penalties in addition to ordinary income tax.
- They typically come with various fee structures, including mortality and expense charges, administrative fees, and underlying fund expenses.
Interpreting the Variable Contract
Interpreting a variable contract primarily involves understanding its dual nature as both an insurance policy and an investment. The value of the contract's accumulation units depends directly on the performance of the chosen sub-accounts, which are essentially investment portfolios similar to mutual funds. Contract holders should regularly review the statements to track the growth or decline of their account value and assess how well the chosen investments align with their investment objectives and risk tolerance. Unlike a fixed annuity where payouts are guaranteed, the future income stream or payout from a variable contract is not fixed and will vary based on investment results, which is a critical distinction for financial planning.
Hypothetical Example
Consider Sarah, a 45-year-old professional looking to save for retirement planning. She decides to invest in a variable contract with an initial premium of $100,000. Sarah allocates her premium across three sub-accounts: 50% in a large-cap equity fund, 30% in a balanced fund, and 20% in an international equity fund.
- Year 1: The large-cap fund gains 15%, the balanced fund gains 7%, and the international fund loses 5%.
- Large-cap: $50,000 * 1.15 = $57,500
- Balanced: $30,000 * 1.07 = $32,100
- International: $20,000 * 0.95 = $19,000
- Total value before fees: $57,500 + $32,100 + $19,000 = $108,600.
After deducting annual fees (e.g., mortality & expense, administrative, and fund operating expenses), assume total fees are 2% of the account value. - Net value: $108,600 - ($108,600 * 0.02) = $106,428.
- Year 2: Sarah decides to rebalance her portfolio, increasing her allocation to the international fund. She also notes that her account value will continue to fluctuate based on the performance of these underlying investments.
This example illustrates how the contract's value is directly tied to the investment choices and their market performance, after accounting for various charges.
Practical Applications
Variable contracts serve various financial planning needs, primarily for long-term savings and retirement. They are commonly used by individuals seeking tax-deferred growth potential and access to professionally managed investment portfolios within an insurance framework. These contracts can offer guaranteed income options for life through annuitization, although the amount of income will depend on the contract's value and chosen payout options. They also frequently include a death benefit feature, which ensures that beneficiaries receive at least the amount invested (or the current account value, whichever is greater) upon the contract holder's death, bypassing probate in many cases. Due to their complexity and the investment risk involved, the sale of variable contracts is heavily regulated by both state insurance authorities and federal bodies like the Financial Industry Regulatory Authority (FINRA), which sets standards for suitability and disclosure to protect investors.3
Limitations and Criticisms
While offering potential benefits, variable contracts also come with notable limitations and criticisms. A primary concern is the layered fee structure, which can include mortality and expense charges, administrative fees, charges for optional riders (such as guaranteed minimum withdrawal benefits), and the operating expenses of the underlying investment options. These cumulative fees can significantly erode investment returns over time. The complexity of these products can also make them difficult for average investors to fully understand, leading to potential suitability issues if not properly explained or if the product does not align with an individual's investment objectives or risk tolerance. Critics also point to the lack of transparency in some older variable contract disclosures, though regulatory efforts, such as the SEC's summary prospectus proposals, aim to enhance clarity for investors.2 Furthermore, unlike direct investment in mutual funds, funds held in variable contracts are generally not accessible without potential surrender charges for a period after purchase, or tax penalties if withdrawn before age 59½.
Variable Contracts vs. Variable Annuities
The terms "variable contracts" and "variable annuities" are often used interchangeably, but "variable contracts" is a broader term encompassing both variable annuities and variable life insurance policies.
| Feature | Variable Contracts (General Term) | Variable Annuities | Variable Life Insurance |
|---|---|---|---|
| Primary Goal | Investment growth with insurance features. | Income for retirement (accumulation and payout phases). | Life insurance coverage with investment component. |
| Payout | Can be income stream or death benefit, depending on the specific contract. | Typically focuses on providing an income stream during retirement, often for life. | Focuses on a death benefit paid to beneficiaries upon the insured's death. |
| Taxation | Tax-deferred growth; withdrawals taxed as ordinary income (and potentially penalties). | Tax-deferred growth; income payments taxed upon receipt. | Tax-deferred growth of cash value; death benefit is generally tax-free to beneficiaries. |
| Common Use | Long-term savings, wealth accumulation, estate planning, or retirement income. | Retirement planning and supplemental retirement income. | Estate planning, wealth transfer, and permanent life insurance needs. |
Both involve sub-accounts for asset allocation and expose the contract holder to investment risk. The confusion often arises because variable annuities are the most common type of variable contract. However, variable life insurance is also a significant product under the variable contract umbrella, offering a death benefit alongside cash value growth tied to market performance.
FAQs
What is a sub-account in a variable contract?
A sub-account within a variable contract is an investment option, similar to a mutual fund, into which the contract holder can allocate their premium payments. The value of the contract's cash value fluctuates based on the investment performance of these chosen sub-accounts.
Are variable contracts suitable for everyone?
No. Variable contracts typically carry higher fees than direct investments in mutual funds, and the investment risk is borne by the contract holder. They are generally considered suitable for individuals with a long-term investment horizon, who have maximized other tax-advantaged savings options, and who understand and accept the associated risks and costs. An assessment of one's risk tolerance and investment objectives is crucial before considering a variable contract.
How are variable contracts regulated?
Variable contracts are subject to dual regulation. They are regulated by state insurance departments as insurance products and by the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) as securities. This dual oversight aims to protect consumers by ensuring proper disclosure and sales practices.
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Can I lose money in a variable contract?
Yes, you can lose money in a variable contract. The cash value and potential income stream from a variable contract are tied to the performance of the underlying investment options (sub-accounts). If these investments perform poorly, the value of your contract will decline, and you could receive less than your initial investment, especially after accounting for fees and charges.