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Annuity [Understanding the Different Types of Annuities]

Annuities

In the following Annuity Guide, we provide the essential information you need to equip and empower you to make an informed decision about annuities and if an annuity is the best option for you. If you have any questions, please don’t hesitate to reach out to us.

Annuities

Any retiree with a pension can attest to the value of a consistent, reliable source of financial support.  If you can accurately predict each month’s income, it’s much easier to develop a regular budget and plan for large, irregular expenditures.

Unfortunately, though, fewer and fewer employers offer pension plans.  In fact, if you work in the private sector, odds are you won’t receive a pension.

Social Security provides some steady income, but it’s almost never enough.  Modern retirees must be ready to rely on their own retirement savings to live comfortably through the golden years.

And, while a 401k or IRA is undeniably an integral part of any retirement plan, investment accounts are unpredictable and subject to market fluctuations.

If you’re looking for the kind of consistency and certainty that comes with a pension, annuities are a potential alternative worth serious consideration.

What is an Annuity?

Annuities are a financial product designed to provide a steady income stream similar to a pension plan.

In a nutshell, an annuity is a contract between you and an insurance company (or similar financial institution) under which, in exchange for one or more premium payments up front, the insurance company agrees to make regular payments to you for either the rest of your life or for a predetermined number of years.

It’s like reverse life insurance.  Instead of insuring against death, annuities protect against “longevity risk,” the risk that you will outlive your retirement savings.

Annuities can deliver guaranteed benefits for life because the insurance company pools demographically similar purchasers (“annuitants”) and calculates premium and pay-out rates based upon the group’s average life expectancy.

Statistically, annuitants who outlive the pool’s average are balanced out by annuitants who die early.  The insurance company calculates pay-out and premium rates using its estimates as to how long it will pay each annuitant and how much it will earn from investing the premiums.

A big advantage of annuities is that they are flexible and can be tailored to the purchaser’s specific needs.

While retirement planning is the most common market, annuities are also useful for turning large sums received from lawsuit settlements, lottery winnings, or inheritances into prolonged, guaranteed income, often with considerable tax advantages.

Annuities are well-suited for principal protection and as a hedge against market fluctuations but are not as liquid as some other investment and savings vehicles.

Depending upon the type of annuity and how it is set up, you can earn growth on premium comparable to a CD, or, with some annuities, index the pay-out rates to the stock market.

How do Annuities Work?

Every annuity falls within one of two categories:  immediate annuity vs deferred annuity.

Immediate annuities begin paying out on the first payment period after funding. Probably the most popular option is the SPIA Single Premium Immediate Annuity.

Deferred annuities start paying on a predetermined date in the future or when the annuitant reaches a certain age.

All things being equal, a deferred annuity will pay higher rates because the insurance company has more opportunity to invest the premiums prior to paying out income.

Annuity Premiums

Annuity premium payments are generally made each month but can also be scheduled quarterly or yearly.  The precise amount paid depends upon the annuitant’s age and life expectancy, the deferral period (if any), current interest rates, and the insurance company’s expectations for future rates – and, of course, the total premium paid to the insurance company.

Accumulation Phase

The “accumulation phase” is the time period while an annuity is being funded.  Funding can occur all at once – as with a retiree who converts a portion of his or her retirement account into an annuity – or through regular premium payments over an extended period, similar to a whole life policy.

Like retirement accounts, income tax on funds paid into an annuity is deferred until withdrawal, as is any tax due on the annuity’s earnings. Taxes on annuities are due on the income when the annuity begins to make distributions to the annuitant.

Unlike IRA’s and 401k’s, there’s no annual contribution limit for annuities, though individual insurance companies usually set limits.

Free Look Period

Depending upon applicable state law, annuities come with a “free look period” of between ten and thirty days after the contract is signed.

During the free look, you can cancel the contract for a full refund and no penalty if you reconsider the decision.

Following the free look period, the “surrender period” is the timespan during which the funds in the annuity cannot be withdrawn without penalty.

Penalties typically decrease gradually over the course of the surrender period, though the precise penalty varies from one annuity to another.

So, for example, a deferred annuity with a ten-year surrender period might charge a penalty starting at ten percent in year 1 and decreasing to one percent in year ten. Many annuities allow unpenalized access to accrued growth (but not principal) after the first year.

Annuitization

After all premiums are paid and any deferral has passed, an annuity enters the “annuitization phase,” also called the “payout phase.”  This is simply the time during which you receive payments from the insurance company.

With an immediate annuity, the annuitization phase begins with the first scheduled payment after purchase.  The annuitization period for most income annuities continues until death, though the period can also be a predetermined number of years.

Types of Annuities

The chief characteristics of an annuity are whether it is immediate or deferred, fixed or variable, and whether it pays for life or for a defined period.

Annuities that pay for life are often referred to as “income annuities.”  Precise terminology varies among insurance companies and products, but most annuities fall within certain basic classes.

Income Annuities

Popular in retirement planning, deferred income annuities begin paying after a certain number of years following purchase and then pay a guaranteed, unchanging amount for the rest of the annuitant’s life.

So, for example, a sixty-year-old male who purchases an annuity for $100,000 that begins paying at age seventy might receive a monthly pay-out of around $1,000 guaranteed for life.

This type of annuity is ideal for protecting against longevity risk and for eliminating risk of investment lost.

Subscription deferred income annuities have similar terms but allow for premium payments over time during the annuitization phase.

An initial investment of $5,000 to $10,000 is usually required up front, and the remaining premium payments are then made over several years, sometimes with minimum and maximum yearly contributions.

Income tax due on funds paid into a subscription annuity is deferred until paid out.

A Qualified Longevity Annuity Contract (QLAC) is a deferred income annuity purchased using retirement account assets and which begins paying out after age seventy years and six months.

Often referred to as a “personal pension within IRA,” a QLAC can be funded with up to $130,000 of retirement account assets and is exempt from minimum distribution requirements until age 85.

An immediate income annuity works like a deferred income annuity, except that pay-outs begin with the first payment period after the annuity is funded.  Because the insurance company does not have the extended period to invest the funds before annuitization begins, an immediate annuity will have lower pay-outs than a similar deferred annuity.

Generally, the right to receive payments on an income annuity terminates upon the annuitant’s death, though riders can be added that require payment of any remaining principal to the annuitant’s estate.

If a “life with period certain” rider is selected, payments are guaranteed for the longer of the annuitant’s life or a defined period of years.

If the annuitant dies before the end of the period, the insurance company makes the remaining payments to the estate or to the annuitant’s designated heirs.

A rider that provides for payment after the annuitant’s death, or to the annuitant’s surviving spouse, will have either lower pay-out amounts or higher funding requirements.

Multi-Year Guaranteed Annuity

A Multi-Year Guaranteed Annuity (MYGA) is similar to a CD in that it comes with a guaranteed rate of return over a specified duration, with higher rates paid for longer terms.

After you purchase the MYGA, the insurance company holds the funds for three to ten years, paying a fixed interest rate.

Income tax due on earnings is deferred until paid out, and early withdrawals are subject to a contractual penalty.

Similar to 401k withdrawal rules, if a withdrawal is made before age 59 and a half, there is also an IRS penalty like with an IRA.

At the end of an MYGA’s term, you can cash out, convert the funds to another MYGA or other investment option, or accept annuitized payments over an extended period.  In the latter case, the funds will continue to earn interest, though not necessarily at the same rate.

MYGA’s can be conceived of as CD’s sold by an insurance company and designed specifically for retirement planning.  However, unlike CD’s, annuities are not FDIC insured, so it’s important to choose a well-rated company.

Variable Annuities

Variable annuities tie pay-out amounts to investment performance and therefore are not guaranteed.

Variable annuities are described as an “investment product with insurance features.”(1)

You get some say as to how the funds are invested, but options are usually limited to a menu of mutual funds or bonds designated by the insurance company.

As with a retirement account, annuity earnings are tax deferred, and early withdrawals are subject to an IRS penalty.

Though variable annuities have greater potential upside, they do not offer the hedge against market volatility, principal protection, and budgeting certainty advantages provided by fixed annuities.

However, many variable annuities offer a rider for an extra charge which guarantees a minimum pay-out even if investments perform poorly.

Fixed Indexed Annuities

Fixed indexed annuities are a variation on variable annuities that index returns to the stock market.  Their big selling point is that the insurance company guaranties the annuity will not lose money even if the market goes down.

In exchange for the no-loss guaranty, earnings are either capped at around 4.00% or the insurance company keeps a designated percentage of earnings as a fee.  Some fixed indexed annuities only guarantee principal up to a certain percent (often 87.5%), usually in exchange for either a higher earnings cap or lower fee percentage.

Structured Annuities

Structured annuities are also indexed to the market, but, instead of absolutely guarantying principal, the insurance company cushions losses and bears some or all of the risk of a major downturn.

The risk-sharing is either allocated as a buffer, where the insurance company covers the first ten percent or so of losses, or as a floor, where the insurance company covers any losses over five percent or so.  Because you share some of the loss-risk, the cap on growth is higher than with fixed indexed annuities, usually around 12%.

By way of example, if a structured annuity is set up with a 10% buffer on losses and a 12% cap on gains, and the market goes down 9%, the insurance company would bear all of the loss.

Or, if the market goes up 15%, the annuitant receives the 12% cap and pays the other 3% as a fee to the insurance company.

On the other hand, if the annuity has a 5% floor and the market drops 3%, the annuitant bears the entire loss.

But, if the market drops 15%, the annuitant bears the first 5%, and the insurance company absorbs the rest.

Structured annuities are a relatively new product, first introduced in 2010.  Because they offer greater upside than variable or fixed indexed annuities with meaningful though not absolute loss mitigation features, structured annuities have quickly increased in popularity.

Annuity Riders

Annuities come with a host of optional riders for an additional charge that allow you to modify the contract to your specific needs.  Importantly, rider fees are normally paid throughout the life of the annuity as a reduction to principal or earnings rather than as a single upfront charge.

Death Benefit Rider

Death benefit riders add a life insurance-like payout to your estate or named beneficiary.  They can be set up so that any remaining principal is paid to your estate if you do not reach a certain age or regardless of when death occurs.

Life With Period Certain Rider

Similarly, a life-with-period-certain rider guaranties payment for life, but, if you die within a certain number of years, the insurance company will continue making regular payments to your heirs or estate until the designated period has ended.

Terminal Illness Rider

A terminal illness rider accelerates payments in the event you are diagnosed with a terminal illness.

Income Rider

An income rider gives you the right to choose when a deferred annuity begins paying out.

Riders allowing cost of living adjustments (COLA) and protecting against inflation (Inflation Riders) can also be added for a moderate premium increase.  Numerous other riders are available, depending upon the specific insurance company and product.

Who Offers Annuities?

Annuities are available from top rated insurance companies and sold by banks, brokers and independent agents.

Annuity providers must be licensed to sell life insurance and, if they offer variable annuities, must have a securities license as well.

Annuities are a particularly helpful product for life insurance carriers because income annuities act as a hedge against the financial risks involved in issuing life insurance policies.

Both annuities and life insurance are grouped within risk pools of similarly situated individuals.  If a certain pool, on average, exceeds its estimated life expectancy, the insurance company will likely pay out more on annuities than it had anticipated.

But the payments will be balanced against fewer life insurance payments to clients within that demographic.  And, of course, it works the other way around, too – a higher number of life insurance payouts equates to a lesser amount paid out on annuities.

Because annuities are only guaranteed by the financial institution itself, and not the FDIC, you should verify that the institution is highly rated before purchasing an annuity.

Top Annuity Companies to Consider

\We  recommend only buying income annuities from institutions with an A.M. Best rating of A or better. New York Life, Penn Mutual, Lincoln Financial, Mutual of Omaha, Guardian Life, and Mass Mutual are all top-rated providers offering a variety of annuity options.

In a worst-case scenario, state guaranty associations provide some protection in the event of provider insolvency, but coverage is limited to current value and subject to caps.

If purchasing an annuity in an amount anywhere near your state’s cap, it’s a good idea to spread funds between two or more institutions.

Likewise, retirement planning experts suggest putting only a portion of retirement savings into annuities and holding the rest in other savings or investments.

Tax Considerations with Annuities

As mentioned above, annuities provide some noteworthy tax advantages, including tax deferral on earnings similar to retirement accounts.

Unlike IRA’s and 401k’s, deferred annuities for retirement have no annual contribution limit.

So, even if you have reached the annual limit on your retirement account, you can still contribute funds to an annuity with no present income tax.

Of course, the money is taxed as income upon withdrawal, and the IRS charges a 10% penalty for funds withdrawn before age 59 and one-half.

A QLAC allows you to “roll-over” up to $130,000 or 25 percent of the account balance (whichever is lower) from an IRA or 401k into an annuity.  The resulting “personal pension within IRA” is exempt from required minimum distributions until age 85.  It’s a good idea to keep at least some of your retirement savings in your IRA to allow for continued growth and to provide a hedge against inflation.

Along the same lines, you can convert the cash value of a life insurance policy into an annuity through a “1035 exchange” without paying any income tax on the policy’s growth.

Ok…

Now that we’re done, let us be the first to admit that, that was a ton of information!  Some of which was probably pretty easy to understand, while other parts may have been a bit challenging.  And that’s the problem when you start working with some of these more “complex” financial instruments.

The good news is…

That here at I&E, we understand that not everyone is going to have a “knack” for understanding how Annuities work.

“And that’s OK!”

We don’t expect anyone who calls us to be an expert on any of the products that we offer at I&E.  All we want is for you to feel comfortable enough to tell us what your “goals” are in purchasing your annuity and for you to feel comfortable enough to ask a ton of questions if you have them.

You see…

At the end of the day, because we here at I&E work with dozens of different companies who offer a wide variety of products, we’re not forced to have to try and make any “one product” work for everyone.

So…

If it doesn’t look like an annuity is going to be “right” for you, no problem, perhaps one of the many other products we offer will be a good fit!

We just won’t know until we learn a little bit more about you and what you’re hoping to achieve.  So, what are you waiting for?  Give us a call today and see what we can do for you!

 

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