(Ref 1, “What Is a Variable Annuity?”) A variable annuity invests your premium payments in funds offered by the annuity provider, which is usually an insurance company. The funds offered by a provider closely mirror mutual funds sold to the public, but as an annuity owner, you do not own shares of the mutual funds; you own accumulation units in subaccounts.
Variable annuities have an accumulation period in which the annuity owner builds up the cash value of the contract. As an owner, you make regular premium payments to the annuity. Part of your premiums pay for expenses, fees and the contract’s death benefit. You invest the remainder in a “separate account,” which contains one or more subaccounts. Each subaccount owns shares of a particular mutual fund that the annuity provider makes available. Your accumulation units in each subaccount represent the value of your investment in the corresponding mutual fund.
An annuity provider pools the money from all annuity owners investing in a particular subaccount and uses it to buy shares in the linked mutual fund. Your accumulation units in that subaccount represent your share of the pooled value of the subaccount. Each accumulation unit has a value that reflects the net asset value of the underlying mutual fund and the account fees charged by the annuity provider. The price of an accumulation unit is arbitrarily set at the time the provider begins investing in a mutual fund. Over time, the accumulation unit value can differ significantly from the mutual fund’s net asset value.
Mutual funds must distribute all of their income each year. The distributions arising from dividend and interest income are commonly called mutual fund dividends. If you own a mutual fund directly, you receive the dividends in the form of cash. You can choose to reinvest the distributions in additional mutual fund shares. A subaccount doesn’t pay you the dividends from the mutual funds shares it owns. Rather, it uses the dividends to increase the annuity’s reserves. Therefore, the dividends paid by the mutual funds owned by the subaccounts don’t change the value or number of your accumulation units.
The reason for not paying out the mutual fund dividends to subaccount owners relates to taxes. Annuity growth is tax-deferred until you begin taking withdrawals. Annuity providers therefore don’t pay out the mutual fund dividends, since the money would be immediately taxable, even if you reinvested it in additional accumulation units. By adding the dividends to the annuity reserves -- made up of cash and negotiable securities -- the annuity provider offsets some of its costs, which in turn might help it lower the fees it charges you.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.