In simplest terms, an annuity is a life insurance in reverse. In this contract, you hand a sum of money to an insurance company and receive payments for life. Annuities serve as a retirement savings vehicle and they also offer a good strategy for receiving a regular payout during retirement. Some people who may have already maxed out on their contributions to retirement accounts e.g. a 401(k) account and Regular/Roth IRA, may consider making additional contributions to a tax deferred annuity.
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In a tax deferred annuity, you contribute with after tax dollars, the earnings are not taxed until you take the distribution. This is also known as accumulation phase of an annuity. During accumulation, you are basically making premium payments whether it is in one go or at regular intervals. At the time of retirement, when you stop contributing to an annuity, and instead set it up for paying you back, that is called annuitization. At the time of annuitization, the insurance company determines the payment stream and payment terms. Annuity contracts are associated with the life of an annuity owner. That is why, they are offered by life insurance companies. Since annuities offer investment options in securities, their sale is governed by securities laws.
There are 2 basic types of annuities:
- Immediate Annuity - In this case you give a lump sum amount of money to the insurance company and the payments to you (from the insurance company) start immediately. In a down a down market if investors feel that stocks/bonds may not do well for a while, immediate annuity is a good investment vehicle for investors at or near retirement. Availability of cash is very important for such individuals and immediate annuity offers an insurance contract that guarantees a fixed payout for life or for a specific period of time.
- Deferred Annuity - In this annuity you need to wait for a future period (generally retirement) when the payments start coming your way.
During the accumulation phase of an annuity, based on the amount and frequency of the annuity premium and how those premiums are invested, an annuity can take one of the following forms. ...
Note that the payment and pay out method is based on how it is annuitized (explained later).
- Single Premium Deferred Annuity or SPDA - In this case an annuity owner makes one large lump sum contribution with the intention of taking the payout sometime in future. Until such time, this contribution earns interest which is tax deferred. This type of annuity is typically purchased if you have received a significant amount of money either through inheritance or other windfall income e.g. a lottery.
- Flexible Premium Deferred Annuity or FPDA - As the name suggests this annuity provides you the flexibility of contributing variable amounts. This feature is useful for those who don’t have a stable or those with cyclical income. In this case too, the payout would be later in future.
- Single Premium Immediate Annuity -In this case one lump sump payment is made by the annuity owner and the pay back begins immediately i.e. there is no more accumulation and the annuity is immediately annuitized. This is suitable for those who have either received a lump sum distribution from retirement account at the time of retirement, or received a significant amount of money from other sources and needs a regular payment for support.
- Fixed Annuity - In this case premium paid earns a fixed rate of return during the accumulation phase. So, the insurer bears the risk of changes in interest rates. Such annuities are suitable for investors with low risk tolerance.
- Variable Annuity -This annuity is associated with a sub account and premiums paid go to this sub account. In this case, the insurance company guarantees a minimum payment with rest of the payment coming from the performance of underlying investment portfolio in a sub account. As the owner of a variable annuity, you have the right to invest your contribution to the sub account in a variety of securities (generally mutual funds). Annuity owner bears the investment risk in this case. The income upon annuitization will vary depending on the returns of the underlying investment accounts.Total expenses for a variable annuity run about one percentage point higher than those of mutual funds. The reason is that some annuities promise a guaranteed minimum 'Death Benefit' for annuity holder's heirs. A recipient of life insurance proceeds could also consider buying an annuity from these proceeds.
During the distribution phase, an annuity can be annuitized in different flavors depending on the period and amount of each payment: ...
- Fixed Period Annuity - in this case annuity payments continue to a beneficiary for a fixed period even if the annuity owner dies before the fixed period. This feature benefits those who may have a sizeable balance in annuity and are concerned of losing it all to the insurance company if they die sooner. Of course, longer the length of fixed period smaller is the payment amount.
- Fixed Amount Annuity - in this case annuity owner decides the amount of payment and the insurance company determines the length of time for which payments will be made. This form is not used much but could be useful for those not in good health. .
- Simple Life or Straight Life Annuity - this annuitization provides a fixed payment for life. The payment amount is maximum in this case because insurance company gets to keep the entire annuity if you die immediately after annuitization contract. The other risk in this case is of inflation since the payment amount will remain fixed for life. .
- Life Annuity with Period Certain - to address the risk of losing it all if you die sooner, insurance companies offer this form in which your beneficiary is guaranteed to get the payment for a fixed period if you die sooner. This is different from fixed period annuity. Because in this case, if you live past the period certain, you continue to get payment for life whereas in case of fixed period annuity, the payment runs only for fixed period even if you live. .
- Joint and Survivor Annuity - This feature is very useful for a couple. It allows the payment to continue until the surviving spouse dies. This feature can be structured in a way that the payment is higher when both spouses are alive and is reduced to a lower amount when one spouse dies as the expenses also get reduced.
Here are some key benefits of annuities:
- An annuity is the only product that can provide a guaranteed income for life, thus addressing the risk of living too long and running out of your retirement savings.
- Any gain in annuity value is not taxed until you actually start withdrawing benefits. Therefore, it offers tax deferred gains similar to retirement accounts.
- Different types and features available in annuities offer you the flexibility to design an annuity that suits your needs....
- Some insurance companies guarantee a minimum level of return even in a down market, thereby offering a floor for your investment. While variable annuities have received some bad press in the past due to aggressive sales tactics of some, they offer a good investment choice, if the idea of holding stocks makes you lose sleep at night. The downward protection against a market downturn is achieved because variable annuities are wrapped by an insurance contract. At the same time it offers a reasonable participation in the upside for a fee. Note that all annuity guarantees are based on the good standing of insurance company. While there is always a risk of an insurance company failing, in general they are heavily regulated, thereby reducing their chance of failure. With many companies closing the doors on their pension plans and offering lump sum distribution, it is important to consider the pros and cons of moving this lump sum payment to either a retirement plan (401k), or moving it to an annuity, or a combination of the two. Having some money in a low cost fixed annuity provides an income floor. Note that guarantees on annuities are subject to the claims-paying ability of the issuing insurance company. As a result their credit rating (AAA being the highest) and claims paying record is very important.
- Some insurance companies are also coming up with annuities with several features combined. One such annuity is ‘Growth and Guaranteed Income Variable Deferred Annuity’. This annuity provides a guaranteed minimum withdrawal for life benefit and blends the benefits of guaranteed lifetime income, with growth potential, and access to assets with surrender charges should the need arise. Some of these annuities may have a guaranteed minimum death benefits.
- Annuities with a guaranteed income have a guaranteed annual income locked in that will not go down even when market performance is poor and the annuity contract value falls.
Different types of charges applied to annuities make it hard to figure out which policy is better than the others. However, it is useful to understand different types of charges and how they are applied so that you can make an informed decision.
- Front End Load: The front-end load is the commission you pay out of your investment contribution. It goes to cover salesperson’s commission and it could be significant. For instance, in case of a variable annuity with a 4% front-end load, $4 of every $100 you put into the policy goes to the agent leaving $96 worth of investment.
- Back End Load or Surrender Charges: This charge is applied when you surrender the policy within first few years. Typically surrender charge is 6 to 8% in the first year and then going down by about 1% each year. In some cases, the surrender charge may never never zero and some companies make it tricky by restarting the surrender charge period each time you contribute to your annuity (for that part of contribution). Annuities with guaranteed benefits generally have a surrender charge for withdrawals in excess of the guaranteed benefit. Sub account investment options have charges too.
- Rolling Surrender Charges: Some variable annuities also carry rolling surrender charges, meaning that even investment gains are subject to the surrender charge. So, you will always have to pay a surrender charge no matter what. The only way to get out of this vicious cycle is to annuitize the policy. Only a very few companies offer annuities without surrender charges. ...
- No Load Annuities: There are some no-load annuities i.e. you don’t pay sales charge from your contribution. However, you do pay a slightly higher annual expense fees on mutual funds allowed in the separate account.
- Mortality and Expense Risk Charges: Mortality and expense risk charges are usually a percentage of the account balance. Typically they range from 1 to 1.5%. This charge compensates the insurance company for the risks it assumes on your behalf and administrative expenses associated with the annuity contract. Some insurance companies charge a flat monthly fee regardless of your account balance.
- Annual Contract Fee: A majority of variable annuities assess an annual contract fee of $20 to $40. This fee is independent of the performance of investments in the sub account of your variable annuity.
- Fees for Optional Features: Annuities also offer several optional features to make them more attractive. However, these features come at a price. The industry average fee for such features ranges from 0.4% to 0.5% annually. Some of these features include:
- Guaranteed minimum income benefits (GMIB) – this feature allows an annuity holder to receive a certain minimum payment irrespective of how the annuity has performed and however bad the market conditions may be. It provides a floor to the annual payout and as a result peace of mind.
- Guaranteed minimum accumulation benefits (GMAB) – this feature or rider on a variable annuity contract guarantees the minimum amount received by the annuity holder once the annuity accumulation period is over. This guarantees a minimum gain to your annuity investment irrespective of market conditions.
- Guaranteed minimum withdrawal benefits (GMWB) – Unlike GMIB, this feature gives you the right to withdraw a certain maximum percentage of investment each year during retirement until the initial investment amount has been recouped. This allows you to get back at least what you invested while also giving you the benefit of any upside to the gain of your investment. For instance, let’s say you bought an annuity for $100,000 with a 10% GMWB, but due to market downturns it is now only worth $75,000. Because of GMWB feature you will be able to withdraw 10% of $75,000 (current value) until the entire $100,000 is recovered.
Here are some of the things you need to watch for:
- Buy an annuity from a company that has a high credit rating (AAA). Don’t underestimate this attribute given that some insurance companies face a survival test in challenging financial markets. In case of variable annuities, although the funds are placed in separate accounts from an insurer's general account and are not subject to claims by policyholders, a company with financial troubles can still impede policyholders from recovering their investments. Insurance company ratings can be checked at www.ambest.com under ratings and analysis.
- It may be a good idea to buy multiple policies from different insurers so that your insurance does not exceed the limit of the state regulator provided protection (typically $100,000 ) in case the insurance company goes belly up. ...
- If you want to change your insurance company for annuities, do not simply cancel it. Instead, use what’s known as IRS Section 1035 exchange to avoid tax penalties.
- Pay close attention to annual annuity charges such as front-end loads, back-end loads (also known as surrender charges), mortality and expense risk charges, annual contract fees and optional feature fees. Consider this, if you purchase an annuity for $100 with 4% sales charge and 7% surrender charges, and you surrender it within a few months (past lookup period), you will get only $89 back. So, it is important to look at these costs and shop around while comparing them with industry averages.
- If you are concerned about your insurance company’s health yet you don’t want to dump your cash-value policy, one way to safeguard the cash is by borrowing against it.
