What are annuities?

What is an annuity?
An annuity is a contract between you and an insurance company. Generally speaking annuities are either immediate or deferred. An immediate annuity generates income right away. A deferred annuity may pay income in the future and deferred annuities are also tax deferred. Sometimes people buy a deferred annuity and never start the income. They just allow the account to grow in a tax deferred status.  Tax deferred means you don’t pay taxes on the interest you earn until you withdraw money from the contract.


What are the different types of annuities?
Immediate annuities are often called single premium immediate annuities and in the industry they are referred to as a SPIA. A SPIA is designed to generate income on a guaranteed basis. Essentially you give the insurance company a lump sum of money and they guarantee you an income stream. The income can be guaranteed for a lifetime or for a certain number of years (known as period certain) like 5 years because you are laddering your income stream in retirement.

Deferred annuities generally do not produce any immediate income, although they could. Deferred annuities are designed to grow until income is needed.These deferred annuities generally come in three flavors:

1) You can purchase a deferred fixed annuity that just pays a fixed rate of interest, this type of contract is similar to a certificate of deposit offered by a bank, but of course annuities are not FDIC insured.

2) You can purchase a variable annuity that generally works like a mutual fund and will fluctuate with the the stock and bond markets.

3) Or you can purchase a newer hybrid annuity, which are called fixed indexed annuities, and guarantee a fixed interest rate but allow you to participate in the upward movement of an equity index such as the S&P 500 or the Dow Jones Industrial Average.  These hybrid annuities are designed to protect your principal from a stock market decline, but allow you to earn interest based on the upward movement of the stock market index. We refer to these as hybrid annuity contracts because they combine the elements of safety found in a fixed deferred annuity and allow for greater return potential as found in a variable annuity.

Are annuities safe?
The answer is both yes and no.  There are a lot of different types of annuities so it really depends on the contract your are purchasing. An annuity is a contract with an insurance company so the degree of safety, is in large part, determined by the financial strength of the company offering the contract.

Fixed annuities and single premium immediate annuities, which are not issued by fraternal organizations, may also be covered by a state guarantee association. So if an insurance company should fail there may be a secondary safety net to protect the owner of the contract. Each state has its own guarantee association, and you can learn more at nolhga.com.Fluctuations in the value of variable annuities where a consumer has agreed to bear market risk are generally not covered by any guarantee association. However certain guarantees offered by variable annuities might be covered. These annuities are designed to fluctuate based on market conditions.

If you are looking for safety of your principal, then a fixed annuity would be considered safer than a variable annuity.

Who should buy an annuity?  
From my experience people who purchase annuities tend to be more conservative and do not want to gamble or risk all of their income needs in retirement to the whims of the stock market. If you think about it, when you buy an annuity contract you are basically buying insurance on your income. We tend to insure the things that are important to us. We insure our homes so if your home burns down we would not need to deplete our life savings to rebuild our house. We insure our lives so that if we die our loved ones will have the resources they need to be able to manage the transition. We insure our health so that if we get very sick our life savings is protected from a catastrophic loss, and we pool resources with other insureds to make sure we have the care we need and do not lose every penny we have saved due to a health crisis.

When you buy an annuity you are insuring your income needs. Generally the risks to your income are either inflation, longevity and stock market volatility.  An insurance company can pool life expectancy risks to help make sure you never have to worry about running out of income in retirement. Visit http://www.gao.gov/new.items/d11400.pdf to view a report that was released in 2011 by the Government Accountability Office (GAO) that explores retirement income and the use of annuities.

How can you find the best annuity?
One of the reasons annuities are hard to shop for is because a lot of contracts, features, options and riders are available plus annuity contracts can be complicated and hard to understand. To make matters even more confusing, they are regulated by the state you live in and not the federal government. So different annuities will be available to you depending on where you live.

The most important thing you can do is find an independent licensed insurance agent who has the ability to shop around multiple companies to help you find the best annuity for your situation. Try to get quotes from more than one person. Make sure you find an agent who explains both the advantages and disadvantages of the contract you are considering.

Many times agents have a reputation for telling you all about the benefits of annuities and leave out the specifics about the downsides of the contracts. A perfect investment or insurance contract does not exist. Every financial vehicle has advantages and disadvantages, and it’s important to weigh all of the benefits as well as the risks and fees to make sure the contract is not only appropriate, but also the very best option available for you.

An annuity is a contract between you and an insurance company. Generally speaking annuities are either immediate or deferred. An immediate annuity generates income right away. A deferred annuity may pay income in the future and deferred annuities are also tax deferred. Sometimes people buy a deferred annuity and never start the income. They just allow the account to grow in a tax deferred status.  Tax deferred means you don’t pay taxes on the interest you earn until you withdraw money from the contract.
What is the purpose of the money?
Before you buy an annuity, you should be able to answer this question, “What is the purpose of your money?”

Oftentimes when I am meeting with folks and ask them what is the purpose of the money they have saved for retirement, they will tell me first and foremost the purpose is to provide for their retirement.This is usually in the form of income. If you are looking for income, safety, and guarantees then an annuity might be a good fit.

Why should you purchase an annuity?
I’ve found the best use for annuities is to help solve for the retirement income gap. The retirement income gap is basically the difference between your budget and guaranteed income sources such as social security or a pension. For example if you have social security of $2,000 per month, and a budget that requires $5,000 per month of retirement income, then the gap is $3,000 per month.

An annuity or sometimes laddering annuities can be a very smart, safe and low cost way of making sure you will have the income you need on an inflation adjusted basis without having to worry about interest rates rising or the stock market crashing.

What happens to an annuity when you die?
I know you won’t like this answer, but it depends. Remember annuities are contract driven so you need to ask the agent you are working about death benefits. The reason people ask this question is because in the old days when you purchased a guaranteed income stream from an insurance company if you died your heirs would not receive any benefit.

So if you bought a lifetime single premium immediate annuity today and died in one week there may not be a benefit for your heirs. Insurance company annuity contracts have changed and evolved a lot since the old days of annuities. Today many annuity contracts allow for income and also have death benefit provisions. It’s important that you know how your annuity works. It is still possible to buy the old type of annuity that would not provide any benefit to your heirs, but in my experience I’ve found that most people do not want those contracts.

What about annuity fees?
This is a great question and one that most agents do not like to talk about. All annuities have some kind of fee structure. In my experience variable annuities seem to have a reputation for the highest fee structure. When reviewing variable annuity contracts, I’ve found some that have had ongoing annual fees as high as 3.5% per year.

Single premium immediate annuities generally don’t have an ongoing fee but they have a liquidity cost. Once you start the income, you lose access to the principal for a lump sum distribution. This may not be a direct fee but it is certainly could be considered an opportunity cost because you lose out on the opportunity to have access to the contract for a lump sum distribution.

Many fixed deferred annuities actually have a very low fee structure. The best contracts I’ve seen do not charge any ongoing annual fee. These fixed annuities usually carry a surrender charge though. The nice thing about a surrender charge is that you only pay that fee if you take more than a certain percentage per year.

An example of a good deferred fixed deferred annuity looks like this. In 2009 a person purchased a fixed deferred annuity, and the insurance company agreed to pay the person 4% per year for 5 years. There is no annual cost for the contract, but there is a five year surrender charge penalty. In this particular contract, the client can withdrawal 10% per year from the contract with no penalty. However, if they draw more than 10% in any one year they would pay a penalty. The penalty in the first year is 9%, 8% in the second year 7%, 6% 5% for subsequent years and at the end of the fifth year the client can walk away with all of the interest earned and pay no surrender charge. So if you were to treat this as a five year contract and not take any money out you would earn 4% per year for five years, and then walk away with you principal and interest earned at the end of the term.

How do taxes work with annuities?
Annuities are generally tax deferred. You do not get a tax benefit for contributing to an annuity like you would a traditional IRA, but the money in a deferred annuity will grow tax deferred just like it would in an IRA.

Depending on how you take money out of an annuity will determine the tax at the time of withdrawal. If you just take a withdrawal from an annuity it is taxed using LIFO tax treatment — last in first out. So your interest comes out first, and your interest is taxed at ordinary income tax rates. Your ultimate tax would be determined by the effective tax rate for that year.

If you annuitize a contract and have the annuity pay out over a lifetime or a period certain, then the IRS allows you to use the exclusion ratio. The exclusion ratio is basically a formula the IRS will use to determine which portion of the income you receive is considered interest earned vs a return of principal. This is the most tax efficient way to get money back out of an annuity over a number of years, and can also be a good way to generate cash flow on a tax favorable basis.

Should you purchase an annuity inside of an IRA?
From a tax planning standpoint there is no additional tax benefit by holding an annuity inside an IRA. An IRA is tax deferred, and so is an annuity. There is no such thing as double tax deferral.

However many people will use an annuity to fund an IRA because they are interested in the safety and guarantees being offered by the insurance company. Some people would argue that it makes sense to hold your at-risk investments in non-qualified accounts rather than an IRA or 401k because in years where you lose money, you can deduct the losses from non-qualified accounts on your tax return. Whereas if your IRA were invested in an at-risk position and you lose money, then you generally cannot deduct the losses on your tax return. There are many instances where it may make sense to hold an annuity in an IRA, but doing so for tax reasons is not one of them.

How can I find the best annuity rates?
Because annuities are regulated by each state it is difficult to have a single website that can provide all of the rates available. Our best advice is to contact more than one independent agent and ask them to shop rates for you. The annuity market place is very competitive and insurance companies want to try and win your business so it will usually payoff to put in some extra research.

Annuity Calculators:
Here are some links to popular annuity calculators
Bank Rate Annuity Calculator
Immediate Annuity Calculator
Fixed Annuity Calculator


Top 5 individual annuities by sales for the first quarter of 2013:
LIMRA does a lot of research and reporting on the sales of individual annuities. Below are 5 of the top individual annuities by sales based on LIMRA research for the first quarter of 2013.  Click here for the full list.

Top 5 Variable Annuities:

  1. Jackson National Life
  2. Prudential Annuities
  3. MetLife
  4. Linclon Financial Group
  5. TIAA_CREFF

Top 5 Fixed Annuities:

  1. Allianz Life of North America
  2. New York Life
  3. Security Benefit Life
  4. American Equity Investment Life
  5. AIG Companies
 
This article was also featured in the September 2013 Kitsap Peninsula Business Journal.

 

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