A variable annuity is a contract between you and an insurance company. It is a security that allows you to invest in a number of variable subaccounts, similar to mutual funds. Variable annuities offer the following benefits: the option to receive lifetime income guaranteed by the insurance company, investment diversification and flexibility, a residual death benefit, professional investment management and tax deferral.

In addition, many variable annuities offer optional features that can provide additional protection, including minimum income or accumulation guarantees for the owner or enhanced death benefits for the owner’s beneficiaries. Optional features are offered at an added cost. All guarantees are provided by the insurance company issuing the variable annuity. Before you invest, please speak with your Financial Advisor to discuss your investment goals.

Learning about variable annuities In order to be an informed investor in variable annuities, you should do several things. Every variable annuity provides an informational document known as a prospectus. You should read the prospectus carefully before investing. Since the guarantees in each variable annuity depend solely on the financial strength of the insurance carrier, you should evaluate the insurance company's financial condition. The prospectus includes a summary of the insurance company's financial information. You may also want to consult public rating agencies, such as Moody's, Standard & Poor's or A.M. Best, that evaluate insurance company financial strength. Finally, you should also discuss your investment goals with your Financial Advisor. Guarantees are subject to the claims-paying ability of the underlying insurance company.

For additional information on variable annuities and insurance in general, you can visit the Investor Alert section under Annuities and Insurance on the FINRA website (www.finra.org), the American Council of Life Insurers website (www.acli.com) or the Securities and Exchange Commission website (www.sec.gov). Morgan Stanley Smith Barney’s website (www.morganstanleyindividual.com) also provides information on our annuity offering.

Long-term nature of investment. Variable annuities are long-term investments designed for retirement purposes. Tax penalties and surrender charges may apply if you withdraw your money early. In addition, in order to benefit from the tax-deferral feature of variable annuities, in view of the costs and the tax treatment of withdrawals, a long-term holding period may be necessary. Variable annuities provide tax deferral of income and investment gains until you make withdrawals. However, withdrawals of gains are taxed as ordinary income and, if taken prior to age 59˝, may be subject to an additional 10 percent federal tax penalty.

Liquidity. Because of the possible tax penalties and surrender charges, variable annuities are not liquid investments. You should invest only funds that you expect to be able to leave invested in variable annuities long-term.

“Free Look" Period. Variable annuities typically have a free look period which begins on the date of receipt of your contract. During this period of time you can terminate the contract without paying any surrender charges and get back your purchase payments (which may be adjusted to reflect the charges and performance of your selected investments).

Market risk. The variable subaccounts have differing investment characteristics. The investment return and principal will fluctuate so that investors' shares may be worth more or less than their original cost. You should invest in funds that are consistent with your investment objectives and risk tolerance.

Costs. A variable annuity has two levels of fees: the cost of the annuity contract and the expenses of the variable insurance funds offered within the contract.

Annuity contract charges consist of ongoing asset-based "mortality and expense" and "administration" fees that are a percentage of your annuity assets and, in most cases, a flat annual contract maintenance fee. These charges are deducted from your annuity contract value.

While variable annuities typically do not charge an upfront sales load, they do charge a percentage of your annuity contributions should you decide to withdraw your money in the early years of a contract. This charge is called a contingent deferred sales charge ("CDSC").

Variable insurance funds have annual operating expenses that include management fees, 12b-1 (distribution) fees, the cost of shareholder mailings and other expenses. The expense ratio for each fund, which can be found in the variable annuity prospectus, helps you compare the annual expenses of the funds offered in a variable annuity. Fund operating expenses are deducted from the fund's total assets.

The variable annuities offered at Morgan Stanley provide several pricing alternatives:

"Traditional pricing." These annuities have a six- to eight-year CDSC on each contribution and asset-based contract charges generally in the 1.10 percent to 1.55 percent range. Contract fees generally range from $0 to $50. In addition to contract charges, the annuity cost includes the underlying fund expenses that generally range from 0.70 percent to 1.85 percent.

"Bonus” products.” These annuities have a eight- to nine-year CDSC on each contribution and asset-based contract charges generally in the 1.55 percent to 1.90 percent range. Contract fees generally range from $0 to $50. In addition to contract charges, the annuity cost includes the underlying fund expenses that generally range from 0.70 percent to 1.85 percent. Because this annuity contains an investment credit, it may have higher fees and expenses and a longer withdrawal charge period than other similar annuities without an investment credit. Over time, the higher expenses could be more than the value of the credits. Carefully consider the expenses along with the features and enhancements to be sure this annuity meets your financial needs.

"Shorter CDSC." These annuities offer a shorter CDSC period, three to four years on each contribution, but somewhat higher asset charges in the 1.60 percent to 1.75 percent range. Contract fees generally range from $0 to $50. In addition to contract charges, the annuity cost includes the underlying fund expenses that generally range from 0.70 percent to 1.85 percent. In addition to standard pricing, clients can add higher death benefits or living benefits in the form of contract riders. There is an additional mortality and expense charge for these riders, usually in the 0.25 percent to 1.50 percent range. The examples above do not reflect rider costs. Generally, traditionally priced annuities are the lowest-cost alternative between the alternatives listed above—provided you are willing to keep your investment until the end of the CDSC period. However, if you value the option to access your money earlier, you may prefer the shorter CDSC alternative. You should read the description of costs, including the applicable CDSC schedule for your product, in the respective variable annuity prospectus carefully before you decide to invest. You should weigh the higher costs of variable annuities versus the benefits before you invest. Also, since annuity terms differ and not all variable annuities offer the benefits described above, you should understand the features, benefits and costs of the variable annuity you are considering. You can find this information in the prospectus for the variable annuity. Please read it carefully before you invest.

Variable Annuities in IRAs and Qualified Plans It's important to know that IRAs provide tax deferral of earnings. Purchasing an annuity within a retirement plan that already provides tax deferral under sections of the Internal Revenue Code results in no additional tax benefit. Therefore, an annuity contract should be used only to fund an IRA to benefit from an annuity's features other than tax deferral, such as the lifetime income options, guaranteed minimum death benefits and the ability to transfer among investment options without sales or withdrawal charges. However, if you are risk averse you may consider annuities as an IRA or qualified-plan investment alternative, particularly if you are concerned about market risk, the risk of outliving your income or the impact on your beneficiaries if you die during a down market. Variable annuities may provide financial guarantees during your IRA accumulation or distribution. They can also be converted into a guaranteed lifetime income stream. And at death, the value of your investment can be protected with a death benefit guarantee. The terms of variable annuities differ and not all variable annuities offer all the benefits described above.

Senior Suitability Considerations. In recent years regulators have expressed concern about annuity sales to the elderly. There are a number of key points of interest you should consider in advance of investing including your investment risk tolerance, liquidity and potential long-term care needs, life expectancy in contrast with the investment holding period, fees and charges of the product, tax consequences, as well as your ability to understand all the features, benefits and costs of the investment.

1035 Exchange. Section 1035 of the Internal Revenue Code provides for the direct exchange of a life insurance or annuity contract for another (restrictions apply) without incurring adverse tax consequences. It is important to review the transaction in advance with your Financial Advisor and your tax advisor in order to be certain the exchange is tax-free and to understand the charges to be realized.

Death Benefits and Taxes. There are pros and cons for transferring wealth via a variable annuity. Unlike taxable equity investments, variable annuities do not receive a step up in basis and are taxed on gains at ordinary income rates. On the other hand, variable annuities provide downside protection if the client dies in a down market, offer the ability to extend tax deferral after the owner’s death, allow spouses to continue deferral for their lifetime and heirs to take distributions over their life expectancy, as well as bypass the probate process. For these reasons, variable annuities may be appropriate for more risk-adverse equity investors that want to leave assets for their spouse or to provide a future income stream to other heirs.

Variable Annuities and Mutual Funds

Both variable annuities and mutual funds provide you access to professional money management. In general, mutual funds cost less than variable annuities with comparable investment managers. Because mutual funds may offer commission reductions at higher asset levels, the cost advantage of mutual funds increases at higher asset levels. On the other hand, variable annuities may offer financial guarantees such as guaranteed income benefits or death benefit guarantees that may reduce market risk. Variable annuities can also be converted into a guaranteed lifetime income stream. In addition, variable annuities purchased outside of an IRA or qualified plan provide tax-deferred growth potential. These benefits may outweigh the cost differential, depending upon your individual circumstances and willingness to assume risk. You should weigh the higher costs of variable annuities versus their benefits before you invest. Also, since annuity terms differ and not all variable annuities offer the guarantees described above, you should understand the features, benefits and costs of the variable annuity you are considering.

Compensation to Morgan Stanley channel on variable annuities is paid by the issuing insurance company and does not represent an additional charge to you. The insurance company pays compensation out of the asset charges, contingent deferred sales charges and any service fees or other revenues they receive from the mutual fund companies. Morgan Stanley Smith Barney and your Financial Advisor receive commissions that are a percentage of your annuity contributions plus an annual percentage of assets (“trail”). Commissions vary based on the cost alternative you choose: traditional, bonus, or shorter CDSC.
Commissions generally range from 0 percent to 5 percent of contributions and trails from 0.25 percent to 1.00 percent of variableannuity assets. A portion of the payment received by Morgan Stanley Smith Barney is then paid to your Financial Advisor. Within each pricing alternative, Morgan Stanley Smith Barney generally pays your Financial Advisor the same commission rate and trail. However, Morgan Stanley Smith Barney and your Financial Advisor receive different compensation for the different pricing alternatives described above. Clients are welcome to ask their Financial Advisor how he or she will be compensated for any variable annuity transaction.
In addition to commissions, the insurance companies may cover costs incurred by Morgan Stanley Smith Barney for client seminars and Financial Advisor Education.
To compensate Morgan Stanley Smith Barney for the costs of distribution, insurance licensing, insurance company due diligence and other home office services, the insurance carriers typically pay the Morgan Stanley channel an additional percentage of contributions of up to 0.80 percent and a percentage of variable annuity assets of 0.25 percent.
Morgan Stanley Smith Barney currently offers variable annuities issued by a variety of respected Insurance Carriers. Talk to your Financial Advisor for a current list of possible options.

The variable annuities offered through the Morgan Stanley channel include funds managed by Morgan Stanley & Co. Incorporated and its affiliates as well as funds managed by independent money managers. Morgan Stanley & Co. Incorporated, as a firm, earns management fees if you choose to invest in the Morgan Stanley & Co. Incorporated funds available within a variable annuity. However, our Financial Advisors receive the same commissions and trails regardless of the variable insurance funds you pick.

The information contained in Understanding Variable Annuities is as of June 2009.