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General Annuity Information

In the U.S., an annuity is a contract for a fixed sum of money usually paid by an insurance company to an investor in a stream of cash flows over a period of time, typically as a means of saving for retirement. In many cases, this sum is paid annually over the duration of the investor’s life. The investor, or annuity owner, is usually the policyholder and is often also the annuitant (the beneficiary (or beneficiaries) of the annuity whose life expectancy and age are used to determine the terms of the annuity). The owner controls incidents of ownership in the annuity, has the right to the cash surrender value, and can also assign the policy and make withdrawals. Insurance companies that offer annuities pay a specific amount over a predetermined period of time either as an immediate annuity (beginning immediately) or as a deferred annuity (after an accumulation phase). Earnings in annuities grow and compound, tax-deferred, which means that the payment of taxes is reserved for a future time.

Most people use annuities as supplemental investments in combination with other investments such as IRAs, 401(k)s, or other pension plans. Many people find that as they get older, investment options with tax shields approach or reach their contribution limits. As a result, conservative investment options can be sparse, and buying an annuity can be a viable alternative. Annuities can also be helpful for those seeking to diversify their retirement portfolios. The majority of annuity investments are made by investors looking to ensure that they are provided for later in life. In general, annuities make sense for some, but not all. It is important for each individual to evaluate their specific situations or consult professionals.

There are many different types of annuities, including tax-advantaged annuities, fixed or variable rate annuities, annuities that pay out a death benefit to families or last a lifetime, and more. Different annuities serve different purposes, and have pros and cons depending on an individual’s situation.

Quick Pros and Cons of Annuities

Fixed vs. Variable Annuities

Most annuities can be differentiated as fixed or variable annuities. However, there is a third category that is becoming increasingly common, called “indexed annuities,” which combines aspects of both.

Fixed Annuities

Fixed annuities pay out a guaranteed amount after a certain date, and a return rate is largely dependent on market interest rates at the time the annuity contract is signed. In theory, high interest rate environments allow for higher rate fixed annuities (annuity investors make more money). However, the value of existing, already issued fixed-rate annuities is not impacted by changes in interest rates. Most do not have cost-of-living adjustments (COLA), and as a result, their real purchasing power may decline with time.

Variable Annuities

Unlike fixed annuities, variable annuities pay out a fluctuating amount based on the investment performance of assets (usually mutual funds) in an annuity. This type of annuity allows the most flexibility in terms of where investments can go, such as large-cap stocks, foreign stocks, bonds, and money market instruments. As a result, this type of annuity requires that an investor spend some time managing these investments. It is important to note that variable annuities do not guarantee the return of principal.

Indexed Annuities

An indexed annuity, sometimes called an equity-indexed annuity, combines aspects of both fixed and variable annuities, though they are defined as a fixed annuity by legal statute. They pay out a guaranteed minimum such as a fixed annuity does, but a portion of it is also tied to the performance of the investments within, which is similar to a variable annuity.

Immediate vs. Deferred Annuities

Choosing between an immediate or deferred annuity is just as important as choosing between a fixed or variable annuity.

Immediate Annuities

An immediate annuity involves an upfront premium that is paid out from the principal fairly early, anywhere from as early as the next month to no later than a year after the initial premium is received. This means that, for the most part, immediate annuities will not have accumulation phases. An immediate annuity primarily serves as a great way to guarantee a fixed stream of predictable income for retirement.

Deferred Annuities

A deferred annuity is one that is built over time with tax shields. Usually, deposits are made over many years (though deposits can be made as a lump sum) until a specific date at which the total is taken over by the annuity issuer, probably an insurance company, and an income stream is provided. The advantage of a deferred annuity, as compared to an immediate annuity, is that taxes on built capital are deferred.

Surrendering an Annuity

Canceling an annuity contract is called surrendering an annuity. Most insurance companies charge a surrender fee if canceled within the first 5 to 9 years of ownership. In general, the shorter an annuity is owned, the higher the surrender fee. As an example, if an annuity contract has an eight-year surrender period, it’s quite possible to have to pay eight percent of the value of the investment if it is surrendered within the first year. The second year would be seven percent, and so on.

Annuity Fees

Like most financial products, annuities have certain associated fees. These fees are sometimes called basis points. The number of basis points reflects a percentage of the investment. For instance, 100 basis points would be 1% of an investment, while 115 basis points would be 1.15%. Different annuities have different fees, but most of the fees below pertain specifically to variable annuities, which generally have more fees due to their more complex nature.

Surrender Charges

This only applies when canceling or “surrendering” an annuity. In most cases, it only applies to the beginning 5 to 9 years of the life of an annuity, but some plans may be subject to a surrender charge for as long as 15 to 20 years. For some policies, the surrender charge may decline over the years. It is possible to find annuities that don’t have surrender charges, but these likely require higher annual expenses. Surrender charges can also be called contingent deferred sales charges or back-end sales load.

Administrative Charges

These are used to cover the cost of mailings and ongoing service. It can range anywhere from 0.10% to 0.30% of the policy value per year.

Commissions

Annuities are generally sold by insurance brokers who charge a fee of anywhere from 1% for the most basic annuity to as much as 10% for complex annuities indexed to the stock market. In general, the simpler the annuity structure or the shorter the surrender charge period, the lower the commission.

Rolling 401(k)s or IRAs Into Annuities

It is possible to roll over qualified retirement plans like 401(k)s and IRAs into annuities tax-free. After all, these retirement savings accounts do have the primary purpose of providing income in retirement. Annuities can help dictate how retirees live in accordance with their funds or at least make their future income streams more predictable through fixed annuities. As a result, annuities can act as a sort of insurance for guaranteed income in retirement. The resulting annuities are classified as “qualified annuities,” which means they are funded with pretax money.

Several things to keep in mind:

• While transfers aren’t taxable, they must still be reported on tax returns for that year.
• Only one IRA rollover to another account can be completed within any one-year period.
• When rolling into an annuity, remember to complete the transaction within 60 days.