The Investment Series: Annuity Basics
Annuity Basics (Go to the Investment Series for other Basics)
This is the seventh article in a series on investment basics. If you are new to investing, it is recommended that the articles be read in order. Prior articles introduce terminology that is used in later articles.
|Income for Life||The Worry List|
|The Types of Annuities||Part of a Plan|
|The Tax Advantage||References|
|Fixed versus Variable||Recommended Reading|
An annuity is a series of payments made at regular
intervals over a period of time. Annuities are issued by insurance
companies. Typically, you pay in an amount of money and receive regular
payments in return.
State lotteries are typically paid as annuities. A
10 million dollar winner does not receive 10 million dollars upon
winning. The winner receives a payout of $500,000 per year for 20 years.
The state has purchased an annuity at a cost considerably less than 10
million dollars to do so.
The original driving force behind annuities was an
income for life. Insurance companies could statistically predict the
life expectancy of a large group of people with a fair degree of
accuracy. Their annuity product could then be priced accordingly. With
life insurance, you collect if you die. With a life annuity, you collect
if you live. It’s the life insurance “bet” in reverse.
Annuities are a complex product. Nonetheless, the product can be classified into several major types.
The terminology used may vary somewhat among
publications, but these are the basics.
A fixed annuity provides a series of regular
payments of a specified dollar amount for the specified term.
A variable annuity will provide regular
periodic payments but the dollar value of those payments may vary
depending on the performance of the underlying investments.
An immediate annuity begins the payments
immediately after payment for the annuity.
A deferred annuity will delay starting
annuity payments for some period of time. this allows an accumulation
period during which time the investment can grow.
Even the premium may be a single lump sum payment
or a periodic payment- and that periodic payment may be fixed or
Along with a variety of ways to pay for and
structure the basic contract, there are variety of payout options.
Life annuity provides regular payments for
the life of the annuitant (the person receiving the payments). Live
long and beat the insurance company. Don’t live long and the insurance
company keeps the money.
Life with cash payment provides regular
payments for the life of the annuitant. However, if the annuitant dies
before the total payments equal the amount paid in, the balance will go
to the beneficiary. The beneficiary may receive the leftover as a lump
sum or by continuing the payments as an installment refund.
Life with term certain provides for regular
payments for the life of the annuitant. If the annuitant dies before the
specified minimum number of time periods, then the beneficiary
will continue to receive payments for the rest of the specified time.
Joint and survivor provisions provide income
for the life of the annuitant and the specified survivor-usually a
spouse. The benefit amount typically decreases after the passing of one
of the annuitant.
Fixed period provides payments for a
specified number of periods.
Lump sum provides for a single lump sum
payout of the annuity.
The contributions made to annuities are not tax
deductible, but the taxes on earnings are deferred until the money is
withdrawn. There is a 10% penalty for withdrawing the money before age
59 ½ and withdrawals have to start by age 70 ½. When the money is
taken out, it is taxed as ordinary income, not as capital gains. And
there is no limit on how much money can be put into an annuity.
By not paying taxes on earnings, more of your money
is earning money every year than would be the case if taxes were coming
out every year. This substantially improves the rate of growth over
The experts we spoke with recommended that
individuals not pursue an annuity for tax deferral benefit until their
401K plans and IRA options were fully funded. Both the 401K plan and
traditional IRA are funded with pre-tax dollars, whereas the annuity is
funded with post tax dollars.
Our experts also recommended in general against purchasing an
annuity within another tax deferred vehicle such as an IRA or a 401k
plan. Both the IRA and 401k are limited in the amount of funds that can
be deposited each year. Placing an annuity within one of these vehicles
does not gain any additional tax deferral on the earnings of the
annuity since annuity earnings are already tax deferred.
With a fixed annuity, the insurance company invests
the premiums in fixed-rate investments such as bonds. You earn a
guaranteed fixed rate of return for a specified initial period. When the
initial period ends, your assets are rolled into a new time period at a
new rate. The new rate may be better or worse depending on the state of
the economy. In many fixed annuities, there will be a guaranteed minimum
rate which is often related to the rate of treasury bills. With a fixed
annuity, your insurance company is taking on the investment risk.
Variable annuities are quite different. With a
variable annuity, your premiums are invested in the likes of stocks,
bonds, mutual funds, money markets, and even real estate. Many mutual
funds are part of a family of funds and the investor can transfer funds
among members of the fund family without incurring additional fees.
Similarly, the owner of the annuity may have the option to transfer the
assets within the annuity between various investments. Thus with a
deferred variable annuity, the amount of dollars developed during the
accumulation period can vary substantially depending on the performance
of the investments.
The payout of the variable annuity is based on the
number of units held by the annuitant. Think of a “unit” as
analogous to a “share” in a mutual fund. You own a certain number of
shares in a mutual fund but the value of the share fluctuates.
Similarly, the annuitant is credited with a number of units, but the
value of those units will fluctuate resulting in a variable payout.
Thus, with the variable annuity, the risk is taken
by the holder of the annuity rather than the insurance company.
Annuity contracts offer a host of things to consider. Here are some.
Contracts carry a surrender charge that should taper of to zero after a number of years, but can be initially as high as 10 percent.
Contracts may include provisions for partial withdrawals with no penalty imposed by the insurance company. However, tax considerations would still apply.
Contracts may offer provisions for loans.
Contracts may guarantee a return of premium or principal upon liquidation or as a death benefit.
Contracts may include special provisions if the annuitant is admitted to a nursing home or diagnosed with a terminal illness.
Contracts can include varying fees which the
buyer should consider when evaluating the cost of the policy.
If buying an annuity, here is a short list of some things that should be of particular concern:
The solvency of the insurance company offering the annuity. There have been failures.
The expenses, commissions, and surrender charges.
For deferred fixed annuities, the history of the renewal rate. Less ethical companies may offer a high initial rate guarantee, and then more than make it up through very low renewal rates- to the detriment of the contract holder.
For variable annuities, who is the fund manager and what is the performance history of the fund or funds being offered. Read the prospectus for any investment.
If one chooses to buy an annuity, it should be done as
part of an overall financial plan. Financial planning is complex because
it involves many options and considerations. An annuity is also complex
and involves many options and considerations. We continue to recommend
using professional help in developing a financial plan.
National Insurance Consumer Hotline Info
SEC on variable annuities
SEC quickline on annuities
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Guaranteed Income for Life: How Variable Annuities Can Cut Your Taxes, Pay You Every Year of Your Life, and Bring You Financial Peace of Mind
This book includes information on annuities and on investing in support of those pursuing variable annuities.
The Complete Idiot's Guide to Buying Insurance and Annuities
This books covers annuities and other insurance products.
|This certified financial planner offers annuity expertise to Eastern PA and NJ|
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