Annuity Breakdown

Annuities are commonly pitched as simple products—“safe” and “guaranteed” are two big annuity buzzwords. But when sold, they often come with thick contracts or multi-hundred page prospectuses, which usually aren't written in a very easy-to-digest manner—an odd dichotomy! So it’s understandable that many investors have questions or some confusion regarding annuities.

Below is a list of common questions about annuities. They range from the most basic to the more complicated and involved.

1. What is an annuity?

There are two broad categories of annuities: Immediate and deferred. Immediate annuities begin payments immediately upon purchase of the contract, so immediate annuities tend to be used by retiring or retired folks. Deferred annuities delay payment to some future point determined by the contract. These are often used by folks saving for future retirement and are the much more commonly sold product.

A deferred annuity has two important phases: The accumulation phase and the annuitization phase. In the accumulation phase, the contract owner typically isn’t taking regular withdrawals. He or she is, usually, making a lump sum contribution (single premium) or regular premium payments. The premiums paid plus some rate of return (more on that momentarily) aim to increase the value of the annuity. During accumulation, the owner has ownership rights over the money and can cancel the contract (called surrendering), move it to another company or otherwise alter it. (There may be penalties and/or taxes involved.)

At annuitization this changes. Let’s say, for example, you retire and need to start drawing an income from savings held in a deferred annuity. You could annuitize the annuity, which means giving up control and ownership of the money to the insurer for a stream of payments. The amount of your payments is determined by the annuity value, the contract terms and the insurance company’s actuaries upon annuitization.

At this point, you typically cannot cancel or change the contract. This is generally an irrevocable life decision. You’ve given up the right to reconsider in exchange for payments (that you either cannot outlive or will continue for some specified period).

3. What are the different types of deferred annuities?

There are many different permutations of deferred annuities. But all deferred annuities fit within one of three broad types: Fixed, variable or equity indexed (sometimes called fixed indexed). The primary difference between the three is how the returns are determined during the accumulation phase.

Fixed annuities generally guarantee a fixed or minimum rate of return over a specified time period. They effectively operate like a CD—no volatility of principal but a relatively low return.

Variable annuities allow the buyer to select underlying subaccounts similar to mutual funds. They might contain stocks, bonds or some combination of the two. Some variable annuities offer a minimum rate of return, but returns typically aren’t guaranteed—they fluctuate with the value of the underlying securities. (Thus, the name “variable.”) Fees are a major consideration with variable annuities, as they can be substantial.

Equity- or Fixed-Indexed annuities are effectively fixed annuities with a fluctuating interest rate that’s tied to the performance of a stock market index, like the S&P 500. Your principal doesn’t experience volatility, but in exchange, you often get a (much) reduced return that’s generally a fraction of the index return due to participation rates or caps.

4. What are the tax implications of annuity ownership?

The contents of this document should not be construed as tax advice. Please contact your tax professional about tax consequences of annuities. There is some general information we can share with respect to annuities.

In the accumulation phase, money invested in an annuity contract isn’t subject to income or capital gains taxes—taxes on the gains are deferred until you withdraw the funds or annuitize the contract. This can mean a greater compounding effect, since you don’t have to pay taxes along the way and would do so only after retirement.

However, there are drawbacks. For one, while the taxes are deferred, upon withdrawal you pay at your income tax bracket on any gain. You typically cannot offset gain with loss. Further, if you’re younger than 59 ½ years old, you may be subject to an additional tax penalty on withdrawn funds (10% on top of your tax bracket).

5. What are some major annuity advantages?

Annuities generally have a few advantages. For very averse investors who want no volatility of principal and are comfortable with a relatively low return, a fixed or equity-indexed annuity may provide some attraction. In addition, the tax deferred status of annuities’ growth is a benefit, at least in the near term. And finally, annuitizing may provide some investors peace of mind.

6. What are some major annuity disadvantages?

Annuities have many disadvantages.

  1. Variable Annuities Have High Fees: The annual cost of owning an annuity is often in excess of 3%.[1] That’s a huge detraction from performance and is something that must be weighed by any annuity owner.
  2. Fixed Annuities: Will you earn enough in a fixed annuity to meet your long-term goals? After all, these products pay a rate of return based on prevailing interest rates. And the insurance companies aren’t nonprofits—they take a slice of the return before paying you.
  3. Equity indexed annuities: The performance calculation generally works against the annuity owner.
  4. Illiquidity: In the accumulation phase, annuities can be very illiquid and restrictive, often carrying long periods in which investors are harshly penalized should they choose to liquidate the annuity. After annuitization, most annuities offer no liquidity options, and the payments typically aren’t inflation indexed and generally are locked in at a specified amount.

7. Some helpful tips for annuity owners

  1. If you buy because of a guarantee, make sure you know what’s guaranteed. In variable annuities, it’s generally not the account value. Understanding that is critical. Ask the salesperson what’s being guaranteed and how you get the guarantee.
  2. If you are considering annuitizing, ask whether the payments are indexed for inflation, and ask what happens to the money when you pass away.
  3. A guarantee is only as good as the company behind the words. Make sure you understand the financial standing of the insurance company.
  4. Buying an annuity in an IRA or with 401k money is generally a no-no. Doing so duplicates tax deferral. Make sure you have a great reason why you’re rendering redundant one key benefit of an annuity in this way.

Ultimately, this is just the tip of the iceberg. There is a lot more to learn if you own or are thinking of buying an annuity. A suggestion: It’s critical to get educated—and then get a second opinion on your annuity. It may be that, like many investors, your annuity just doesn't really fit your overall financial picture. If that's indeed the case, looking at alternatives makes sense—and doing so early can be critical.

[1]Source: Insured Retirement Institute, 2011 IRI Factbook, Pages 36-38, 56. Figure includes average 1.18% Mortality and Expense Risk, 0.19% Administrative fees, 0.94% average subaccount expense ratio, 0.61% Optional Death Benefit Rider and 1.03% Optional Guaranteed Lifetime Withdrawal Benefit Rider.

After all, paying too much in fees or locking in long-term suboptimal returns isn't exactly a proven path to prosperity.

This constitutes the views, opinions and commentary of the author as of June 2013 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. No assurances are made regarding the accuracy of any forecast made. Past performance is no guarantee of future results. Investing in stock markets involves the risk of loss.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns.
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