There are many different types of annuities, so it’s understandable why some investors get confused by all the available features and options. Deferred annuities are just one variation available to retirement investors seeking income later in life. On the surface, annuities may sound safe and appealing, but they’re often complex and can have significant tradeoffs. Before considering a deferred annuity, you should know the facts.
What Are Deferred Annuities?
Annuities generally have two phases—accumulation and annuitization. During the accumulation phase, you deposit funds into the annuity. For deferred annuities, this phase can last years or even decades. During the annuitization phase, you stop depositing funds and convert your deposited premiums into periodic payments. Deferred annuity payouts start later, hence the name “deferred” annuity.
The opposite of a deferred annuity is an immediate annuity in which payouts start right away. Immediate annuities have very short accumulation phases or no accumulation phase at all. Investors may only make one large deposit into an immediate annuity before receiving payments.
When you defer annuity payouts, the amount you deposited is intended to grow during the accumulation phase until you annuitize the contract and begin receiving payouts. When your accumulation period ends, you may elect to take your full cash surrender value or begin taking periodic payments from the contract through annuitization
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 generally before age 59.5, you may face a withdrawal penalty plus ordinary income tax.
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Types of Deferred Annuities
Two of the most common types of deferred annuities are fixed and variable:
Fixed annuities guarantee your deposited premiums grow at a “fixed" rate during the accumulation phase, after which the rate typically changes. They are similar to certificates of deposit (CDs) because you receive periodic payments. The insurance company sets the accumulation rate with a guaranteed minimum. After the first few years of the initial rate period, the insurance company could increase or reduce the accumulation rate. For example, this could be a 5% rate of return during the first two years and a guaranteed 1% for the life of the contract.
Variable annuities allow your deposited premiums to be invested in sub-account funds comparable to mutual funds—meaning that your deposited premiums grow at a “variable” rate during the accumulation phase. Unlike fixed annuities, and depending on the contract, variable annuities don’t generally guarantee a minimum return. If the value of the investments declines, so will the contract’s value.
Risks Associated with Deferred Annuities
As with any investment, there are risks you should evaluate before purchasing a deferred annuity:
Depending on the type of annuity you choose, inflation can eat away at your purchasing power over time. Fixed annuities often have lower guaranteed rates of return that aren’t much better than the low interest rates banks offer on CDs. Payments from fixed annuities aren’t typically adjusted for inflation, unless a separate rider is purchased. While it may be comforting to know your annuity contract won’t lose value during a bear market, this certainty comes at a price—potentially missing out on increased returns during a bull market.
When you invest in annuity, you typically aren’t able to withdrawal your funds until the end of the contract without incurring additional costs. If you need access to your funds, you may have to pay a surrender penalty to withdraw them. This could be a problem in times of emergency or if something unexpected comes up and you need quick access to cash.
Annuities may have complex fee schedules 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 that can add to the already expensive base annuity costs. These added costs can eat away at your income and growth potential over time.
Taxes are deferred until you start taking withdrawals from your annuity. While deferring your gains may appear attractive, investment gains in an annuity are taxed at your ordinary income rate as opposed to usually long-term capital gains realized in taxable accounts. This could be a disadvantage if your income tax rate is higher than the long-term capital gains rate in retirement. Even when the money from an annuity passes on to heirs, they may end up having to pay the taxes on any gains at their ordinary income tax rates. This should be discussed with a tax advisor to best evaluate the underlying circumstances.
If growth is one of your primary investment objectives, there are likely better options than annuities. Having your money tied up in an annuity can prevent you from benefiting from stock market growth, especially if your annuity has a performance cap.
How Fisher Investments Can Help
If you own annuities, have a portfolio of $500,000 or more and would like more in-depth evaluation, contact us. We have licensed Annuity Counselors that can educate you on all the pros and cons that apply to your specific annuity contract, or any on that you me be considering.
The contents of this document should not be construed as tax advice. Please contact your tax professional.