Variable Annuity Expenses: Your existing variable annuity policy contract with Company X and the prospectus you have forwarded with it show expenses and charges that could be significantly reduced or avoided with a similar annuity from a “no-load” company (i.e., one with no-commission products). You could clearly do better with this alternative if, as we will discuss, there is not a prohibitively high “surrender cost” imposed on your existing account value if you make a policy exchange. An exchange can be made on a tax-free basis if it is made directly from one company to another.

All investments have some costs associated with them, but most variable annuities have inordinately high expenses, and your current annuity is a prime example. Based on our review of the information provided, the expenses in your annuity break down as follows.

Mortality & Expense Risk Charge — 1.25%

Administrative Charge — .25%

Added Charge for “Highest Value” Death Benefit — .20%

Total Costs before Fund Expense Costs — 1.65%

Comparable expenses from a “no-load” variable annuity could eliminate about three-fourths of those expenses, with charges of about .45% for a similar annuity. A variable annuity from one well-known no-load company, for example, would have comparative costs of .42% - .20% for the mortality and expense risk charge, .10% for an administrative charge, and .12% to guarantee the highest annual account value in the case of the annuitant’s death before the annuity’s distribution phase.

For each $100,000 you have invested in this annuity, for example, you are paying extra and unnecessary expenses of over $1,200 annually in comparison with the charges of a no-load annuity. Based on the amount you currently have invested of about $420,000, your added expenses are actually about $5,000 annually.

Investment Management Expenses: In addition to the internal annuity expenses of 1.65% of the account value, you have annual investment management expenses ranging between .30% and 1.2%, depending on your investment choices within the annuity. You are currently paying .60% for an investment in what appears to be a generic “income and growth” fund, which could cost no more than .30% with a no-load company. With most no-load annuities, the investment management expenses for comparable investment funds are lower and may range from .10% to 1.0%. So you should save an average of .20% annually in investment management expenses in any case, or $200 every year for each $100,000 invested, by investing in a no-load annuity – in addition to the savings on internal annuity charges outlined above.

Surrender Charges: Your current annuity contract shows surrender charges as high as 7 percent in the first year and declining by 1 percent each year. Your annuity was purchased in 1997 with an initial $200,000 investment, and it has declining surrender charges over eight years on the initial premium and on each subsequent investment. At some point, you made an additional $100,000 premium payment. The following surrender charge penalties would apply to this additional $100,000 to the extent all or any of that amount was invested within the last 8 years if you make this exchange now: a maximum of 6%, down to 5% after 3 years, 4% after 5 years, 3% after 6 years, 2% after 7 years, and no penalty after 8 years. As noted, this annuity is costing you about $5,000 more in internal charges annually than the no-load alternative (exclusive of differences in investment management expenses). You should make the exchange today no matter what the surrender charge is. The surrender charge will be less than the additional extra annuity charges you will incur, at a current rate of $5,000 annually, as you wait for the surrender charge period to expire. So you are better off making the exchange now to a no-load annuity.

No-load annuities do not have surrender charges. So you could exchange a no-load annuity for another, if for some reason it made sense to do so, or you could simply withdraw all of the account value, without incurring a surrender charge.

The Tax Treatment of Your Annuity Distributions: The income tax treatment of annuities depends on the manner and timing of their distribution. Distributions made over the life of the annuitant(s) or on a regular basis during the distribution phase receive more favorable treatment than irregular distributions or those that are taken during the annuity’s accumulation phase.

Taxation of regular distributions during the withdrawal phase: When you take regular distributions over your life (which can also be guaranteed for a period of years) or systematically over a period of years during the withdrawal (as opposed to accumulation) phase of the annuity contract, each payment is deemed to return to you a portion of your premium investment. Since you have already paid taxes on those premium payments made with after-tax dollars, you will not be taxed again on your investment - only on your earnings that have accrued within the annuity prior to distribution.

For regular or variable distributions, the insurer calculates the taxable portion of each payment using a formula known as the “exclusion ratio.” This formula establishes the ratio that the premiums invested in the annuity bear to the total expected amount of annuity payments for the term of the distribution. The insurer then applies that ratio to each payment to determine the non-taxable portion of the distribution attributable to your premium investment. The remaining portion of each payment is taxable at ordinary income tax rates.

Once your premium investment in the annuity has been paid out, as determined by the exclusion ratio, the remaining annuity payments represent earnings only and therefore are fully taxable.

Taxation of irregular or partial withdrawals: If you make partial or irregular withdrawals, as opposed to regular withdrawals over your life or a scheduled period during the distribution phase of the annuity, you will be taxed at ordinary income rates on earnings you withdraw at that time. For purposes of this rule, withdrawals are deemed to be taken first from earnings on the annuity and, only after the earnings are fully taxed, then from the premium you invested. This “investment in the contract” can generally be described as the cost of the annuity, and it generally includes all premium payments minus any amounts you have already withdrawn that represented the return of invested money, as opposed to earnings within the annuity.

If you were to withdraw all of your annuity balances today, for example, you would owe taxes, at ordinary income rates, on your combined investment gains within the annuity annuities of about $120,000.

A tax disadvantage of variable annuities: A tax disadvantage of variable annuities is that, while taxes are deferred until money is withdrawn, earnings within them are eventually taxed at ordinary income rates even when they consist of dividends and long-term capital earnings. Normally, under today’s Federal income tax laws, dividends and long-term capital gains are taxed at just 15 percent. For those who are, or anticipate being, in a relatively high Federal income tax when the earnings are withdrawn from a variable annuity, the tax deferral afforded by the annuity comes with a price of a much higher tax rate – at least much higher than that which normally applies today for dividends and long-term capital gains . No one can predict with certainty how capital gains and dividends might be taxed in the future, or whether there might even be, at some point, a lower than ordinary income tax rate applied to the earnings within a variable annuity.

It is possible that if you were to surrender your annuity today and pay taxes on all of the investment gains and reinvest the balance in such a way that all of your future income from this investment consists of dividend and capital gains, you could come out ahead in the long run. But that would require a willingness on your part to pay significant extra taxes currently for the possibility of saving taxes later and an assumption you would have to make that the current tax disadvantage of investing in equities within an annuity instead of directly will continue indefinitely in the future. We doubt you will want to make this choice. However, the ordinary income tax treatment of the income from equity investments within variable annuities in comparison with the lower rates from such income from individual stocks or mutual funds may well be a reason that you will not want to make any additional variable annuity investments.

If you like, please call to discuss our findings and suggestions and the additional ways we can help you determine the best course of action for your annuity.