Are You Considering Deferred Annuities?


As you approach retirement, you may worry about running out of money. As people are living longer, retirement savings must last longer. To avoid the risk of depleting their retirement income later in life, investors often turn to deferred annuities.

What Are Deferred Annuities?

These annuities are contracts in which investors deposit funds with an insurance company and elect to have their income payouts deferred for a certain period of time. Investors deposit payments either as a lump sum or in installments. In return, they receive a guaranteed income stream for a certain term or for life. Unlike immediate annuities in which payouts start right away, deferred annuity payments start later—maybe in 10 or 20 years. Typically, the longer you defer receiving payments, the higher your income is likely to be. When you defer annuity payouts, the amount you deposited can continue to grow until the distribution period. These arrangements come with the risk that you may not reach the age at which you have chosen to start receiving distributions.

Annuities generally have two phases—accumulation and annuitization. You deposit funds into the account during the accumulation phase. The type of annuity you choose determines how those funds will grow. For example, in an immediate annuity, your contract can be annuitized immediately. In a deferred annuity, you annuitize the contract at a later date. During the annuitization phase, you convert your deposited premiums into periodic payments. When your accumulation period ends, you may elect to take your full cash surrender value or begin to take periodic payments from the contract through annuitization.

Types of Deferred Annuities

Deferred annuities offer several features, including guaranteed payouts, tax-deferred growth and death benefits (paid out to your beneficiary after your death). Two of the most common types of deferred annuities are fixed and variable.

Fixed Annuities. These annuities guarantee a fixed interest rate over the accumulation phase after which the rate typically changes. Fixed annuities are similar to certificates of deposit (CDs) in that you receive guaranteed interest payments. The insurance company sets the accumulation rate with a guaranteed minimum. This could be a 5% rate of return during the first two years and a guaranteed 1% for the life of the contract. After the first two years, the insurance company could increase or reduce the accumulation rate. One notable difference between a CD and a fixed annuity is the tax treatment of earned interest. Any interest earned from a CD is generally subject to taxes the year it was received, whereas interest earned from an annuity can be deferred until you take a withdrawal.*

Variable Annuities. These annuities allow for premiums to be invested in sub-account funds comparable to mutual funds. Types of sub-accounts can vary between contracts, but like mutual funds, they can contain a mix of stocks and bonds. The returns depend on how these underlying sub-accounts perform. Variable annuities don’t guarantee a minimum return. If the value of the investments declines, so will the contract’s value. Most variable annuities are sold with a rider, an additional benefit that, for a fee, guarantees lifetime income when the buyer activates the income stream. Some variable annuities are indexed or benchmarked to a stock market index such as the S&P 500 so that the annuity has a rate floor and cap, typically 3% and 9%.

Deferred Annuity Features

Generally speaking, deferred annuities include an investment period before contract holders start receiving income from the account. But what if you have an emergency and need access to those funds during the required investment period? This is one problem you could encounter with a deferred annuity. If you decide to withdraw during this period, you may be subject to surrender fees.

Deferred annuities are similar to tax-advantaged retirement accounts in that they allow the deposited funds to grow tax-deferred. Also similar to other retirement accounts, if you withdraw any gains before age 59.5, you may face a withdrawal penalty plus ordinary income tax.

Risks Associated with Deferred Annuities

  • Inflation: Inflation is insidious. Depending on the type of annuity you choose, inflation can eat away at your purchasing power. Fixed annuities often have lower guaranteed rates of return that aren’t much better than bank CD interest rates. Fixed indexed annuities or equity-indexed annuities are linked to an index’s performance but often have performance caps. They also guarantee your return won’t fall below zero. While it may be comforting to know your annuity contract won’t lose value during a bear market, this certainty comes at a price–missing out on most of the returns of bull markets.
  • Liquidity: The surrender period in an annuity contract brings a great deal of liquidity risk. Investors in retirement often encounter unexpected costs, and not being able to access your money when you want can be difficult.
  • High Fees: Annuities have complex fee schedules that vary depending on the type of annuity you choose. Variable annuities typically offer features such as a death benefit and future benefit guarantees. These features, referred to as riders, come at a high cost. These costs can eat away at your income and prevent you from reaching your longer-term goals. And don’t forget, surrender charges and penalties for withdrawing your money too early. In our experience, these costs can run as high as 10% for withdrawing in the first year of the surrender period.
  • Tax consequences: Taxes are deferred until you start taking withdrawals. While deferring your gains may appear attractive, investment gains in an annuity are taxed at your ordinary income rate as opposed to long-term capital gains. This could be a disadvantage if your income tax rate is higher than the long-term capital gains rate in retirement.
  • Opportunity cost: If growth is one of your primary investment objectives, there are likely better options. Having your money tied up in an annuity can prevent you from benefiting from the stock market’s historically high returns.

We Can Assist With Your Retirement Needs

With all these pitfalls in mind, you are probably better off building an investment portfolio with the help of a trusted financial adviser. Our financial professionals can work with you to design a retirement strategy that makes sense for your situation. If you have $500,000 in investible assets, you can use our personalized and comprehensive Annuity Evaluation Service to better understand any annuities you own or are considering purchasing.

*The contents of this document should not be construed as tax advice. Please contact your tax professional.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations.