What is an Annuity?
An annuity is a long-term retirement savings product that can help protect you from outliving your money. It has the potential to grow tax-deferred, have death benefits to protect your beneficiary and optional living benefits to protect your retirement income. You can choose how to fund your annuity, how interest is credited to it and how you take payments from it.
Why Should You Consider Using an Annuity in Your Retirement Plan?
Let’s compare an annuity to buying life insurance. If you think about it, these two products are direct opposites. Life insurance protects against the risk of death, or dying too soon. If the insured dies, the insurance company pays out a sum of money to one or more designated beneficiaries. Annuities, on the other hand, protect you from living too long. Depending on the type of annuity you purchase, you can ensure that your regular income stream is protected and extended by a number of years which you designate, say 10 or 20 years, or you can ensure that you have income for the rest of your life, whether you live to 80 or 120. Many people retire and worry that they will outlive their retirement income. Money from savings, pensions, Social Security and other sources such as home equity may or may not comfortably get you there. Betting on stable income for a lifetime is a calculated risk and one that you may not wish to be calculating and worrying about every day. Adding an annuity product, based on age, life expectancy, gender and marital status, can provide needed diversification to your retirement income and ensures that you and your loved one will be protected until the day you die and, in some cases, your loved ones will continue to receive that same comfort and benefit beyond your death.
How Does an Annuity Work?
When you purchase an annuity, you are agreeing to provide and set aside initial funding to an insurance company who will service the product in exchange for an immediate or deferred income stream for either a period certain of your life or for the remainder of your life. The insurance company uses your original investment into the annuity by investing in interest-earning financial instruments (such as bonds) to meet the contractual demands of your annuity and to guarantee your dollars will grow and support your retirement income needs later in life. There are various products and types of annuities available in the financial marketplace that can serve your specific requirements and needs, depending of the rate of growth you seek and the level of risk you are willing to accept.
What Are the Phases in the Life of an Annuity?
When you enter into a contract to purchase an annuity, you will generally go through two key phases during the life of your annuity… accumulation and annuitization.
- Accumulation – This period represents how long you will make payments into the annuity to a pre-determined amount before you begin to receive regular payments from the contract. Investors either pay and purchase the entire amount of the annuity upfront or choose a fixed premium option that enables lesser payments until the annuity is fully funded and ready for annuitization. During the accumulation period, insurers are investing your money into low-risk financial instruments such as bonds to seek steady growth for your annuity over time.
- Annuitization – This is a designated time and date when the insurer is required to begin making payments back to you. How much and how long you will receive payments are determined in your initial contract. You can receive payout for a certain period of time or for the rest of your life. The amount of payout is determined by how much is initially invested and the period of time designated. There are different forms of payout which are determined by you based on your specific needs and wishes. Once you enter into the annuitization phase, your annuity will continue to grow, depending on the type of annuity you have purchased. You will continue to earn interest or make potential gains through the market which will add to your original investment in the annuity, once again depending on the specific product purchased.
What Kind of Annuity Products Are There?
There are two general classes of annuity products – immediate and deferred.
- Immediate Annuities – This annuity class begins payment to you immediately once your annuity contract is in force. The lump sum premium you have made, in essence, is annuitized and begins its designated stream of income payments to you. You are basically seeking income immediately to add to your retirement income portfolio.
- Deferred Annuities – Accumulation is the ultimate goal with deferred annuities. Through your contract with the insurer, you designate a set period of time, say 5 or 15 years, in which you make regular payments to fund the annuity and grow with interest until it is ready to be annuitized and transitioned into a regular stream of income for you. You are basically seeking growth on your investment until the time you believe retirement income dollars are needed. Both immediate and deferred annuities offer income product types that are described as either fixed, indexed or variable, which offers various opportunities for growth depending on your level of risk tolerance.
What Types of Deferred Annuities Are Available?
- Fixed Annuity – This product type ensures a guaranteed minimum interest rate of return by the insurer. A fixed annuity generally offers low volatility, low risk and low reward.
- Indexed Annuity – An indexed annuity offers a guaranteed minimum interest rate of return plus potential growth that is pinned to a specific index measuring the performance of the stock market such as the Standard and Poor’s (S&P) 500. In other words, your annuity grows beyond the minimum guaranteed interest rate of return, depending on the fluctuations of the market. There are formulas built into indexed annuity products to determine what interest rate you will earn, depending on an interest rate cap, participation rate, and spreads. A great benefit of an indexed annuity is that investors do not lose principal of their original annuity investment or accrued to-date earnings even if the stock market underperforms and loses money during a particular year. An indexed annuity generally provides moderate risk and moderate reward.
- Variable Annuity – The variable annuity would be best classified as a product which has the highest risk but also the highest opportunity for reward when the stock market is performing at its best. There is no minimum guaranteed interest rate of return but the upside potential of a variable annuity comes from the direct choices you make in the stock, bond, mutual funds and related options offered by the insurer. Your annuity will be credited directly with any gains or losses of your investment choices. The principal of your original investment is not always guaranteed. Based on the risk and the investment opportunities afforded by these annuity product types, you should be aware that fixed and indexed annuities are considered insurance products and variable annuities are considered securities products. As such, they are regulated by different state and federal entities, such as state insurance commissions, the Securities and Exchange Commission (SEC) or the Financial Regulatory Industry Association (FINRA) which all collectively oversee the product development and sales processes for annuity, insurance and securities products in the United States.
What Type of Annuity Should I Consider?
If you determine that an annuity is the best solution to your needs, consider the following questions to help you select the type of annuity you will need.
What level of risk am I willing to assume with the annuity?
- If you are most concerned about high minimum guaranteed interest, regardless of the lower level of interest crediting and or interest gains, consider a fixed annuity.
- If you are comfortable with accepting a lower minimum guarantee than a fixed annuity, but looking for potentially greater interest crediting and/or interest gains, consider an indexed annuity.
- If you are willing to accept no minimum guaranteed interest, and the possibility of unlimited loss in exchange for the possibility of unlimited interest crediting or gains, consider a variable annuity.
How soon will I need the regular stream of income payments from the annuity?
- If income will be taken within the first year, consider an immediate annuity (offered in fixed, indexed, and variable types).
- If income will be taken at some time further in the future, consider a deferred annuity (offered in fixed, indexed, and variable types).
How Do I Buy an Annuity?
Once you have reviewed the array of annuity possibilities available and determined the right type for you, you will enter into a contract with your selected firm and/or professional. You will indicate your preference for either an immediate or deferred annuity and, associated with your current level of risk tolerance, whether it will be fixed, indexed or variable. You will determine how much you will originally invest in the annuity and for how long. Depending on these decisions, a premium for payment will be determined. Generally, annuities are funded by premiums that can be paid in a variety of ways.
Single Premium – A one-time payment which fully funds the annuity outright, whether it is for an immediate or deferred annuity. You may hear the descriptions single premium immediate annuity (SPIA) or single premium deferred annuity (SPDA).
Fixed Premium – This approach offers a systematic way to fund the annuity regularly over a designated period of time until the annuity is completely funded.
Flexible Premium – You are able to make payments when and how much you choose to pay, as long as the minimum regular premium is met.
When and How Do I Receive Payments from an Annuity?
If you purchased an immediate annuity product, you forgo accumulation and your income stream begins within 12 months of starting your contract. You are seeking immediate income for your financial and retirement needs. If you purchased a deferred annuity product, this means you are making payments now for a designated period of time to accumulate funds until annuitization and payout of your annuity begins. You are also seeking additional growth of your annuity through interest or market gains until you need it. Payouts from annuities can be done in a variety of ways and a very important consideration to make as it concerns your spouse and/or beneficiaries.
Most common payout options are:
Straight Life – You would receive a regular and consistent stream of income for life, regardless if the annuity’s original principal has been exceeded. Straight life offers a high risk/high reward scenario. If you live beyond the annuity’s original value, there is high reward through continued payments. If you die before the annuity’s value is depleted, there is no death benefit paid to your designated beneficiaries. The remaining proceeds are returned to the insurer.
Period Certain – Fixed payments are designated for a certain period of time until the proceeds of an annuity are exhausted. If death occurs before the annuity proceeds run out, the designated beneficiary receives the remainder.
Fixed Amount – Similar to period certain, you would receive a fixed payment until the proceeds of the annuity are exhausted. If death occurs before the annuity proceeds run out, the designated beneficiary receives the remainder.
Life Income with Period Certain – You are seeking income payments for life. In case of death, a period certain is also designated for which payments will be made to the beneficiary until the period is completed.
Joint Life – You, your spouse or another designee will receive income streams for life. If one dies, the income stream ends and the annuity’s remaining value stays with the insurer.
Joint Survivor Life – Regular payouts continue until the deaths of you and your joint designee, regardless of whether the original value of the annuity has been exhausted.
Joint Survivor Life With Period Certain – You and your designated partner receive income for life, regardless of the annuity’s original value. A period certain is also designated for beneficiary purpose in the case that both of you die within the period certain. The beneficiary will receive the remaining value of the annuity existing within the designated period certain.
What Are the Typical Fees and Expenses Associated with an Annuity?
As you consider the purchase of an annuity product, it is not only very important to understand its potential as a strong retirement income savings vehicle, but you should be very clear about the fees and expenses associated with them.
Surrender Charges – Most annuities impose a surrender charge, which are basically a penalty for early withdrawal. Depending on the company and the specific annuity product, insurers seek full use of the money invested for an extended period of time to gain optimum performance. Surrender charges can be significant, depending on how much and when early withdrawals take place. Most companies provide set limits and guidelines for early withdrawal without penalty. Always ask your advisor about potential surrender charges.
Rider Charges – Annuity riders are optional features that provide added benefits to a basic annuity contract. For example, some riders focus on offering greater access to the annuity’s principal, or providing long-term income. Annuity riders usually come with an annual cost, generally ranging from .1% to 1.0% of the annuity’s value. Review the annuity sales materials and prospectus for a description of applicable fees and charges. The availability of a specific annuity rider usually depends on the annuity issuer and the type of annuity you are considering.
Commissions – The insurance agent or financial advisor who sells an annuity to you generally receives compensation from a commission built into the contract. The payout structure for commissions varies by company and product. Be sure to ask your agent or advisor for full disclosure on how he or she will receive compensation and how much. Today, there are a growing number of companies who are creating and offering fee-based annuity products, which eliminate or greatly limit commissions.
Investment management fees. These are generally charged as part of a sale of a variable annuity product, since you are directly investing in the financial marketplace through stocks, bonds, mutual funds and other related products. The insurer receives management fees in overseeing the performance of these products.
Insurance charges. Also known as mortality and expense (M&E) fees (variable annuities only) and administrative fees, these charges pay for insurance guarantees that are automatically included in the annuity. Sales expenses such as commissions would be part of these charges.
Where Do I Find Annuity Products to Consider?
Annuity products can only be sold by insurance companies, which may subsequently distribute them through a variety of financial institutions and/or professionals such as banks, credit unions, mutual fund companies, and financial advisory firms. These organizations have individuals who are licensed and regulated by state and federal authorities to sell insurance and securities products.
When purchasing an annuity product, be sure the firm and/or professional provides documentation that they are indeed licensed by proper authorities including your state’s insurance commission, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Each of the entities’s web sites can verify whether the firm and/or professional are currently licensed. It’s also a good idea to request additional background information of your firm and/or professional, through what is called a Form ADV required by the SEC for disclosure of the firm’s history, its leadership and its compensation methods. Representation in professional organizations such as the National Associatiion of Insurance and Financial Professionals (NAIFA) and the Financial Planning Association (FPA) is also a good indicator of commitment to professional and ongoing continuing education on financial products and issues of the day.
By law, your firm and/or professional is required to provide you with baseline information about the annuity being purchased, including a prospectus, when applicable, and a disclosure form on the annuity’s particular fees and charges and how the firm and/or professional will be paid in exchange for the sale, a buyer’s guide to assist you with questions and issues to consider before purchasing an annuity, and, finally, a document which describes the suitability of the annuity product to your particular financial situation and needs. Of course, the sale of the annuity will be documented by an application form and contract to make explicit the responsibilities of the insurer, purchaser and sales professional involved.
How Do I Find a Reputable Financial Advisor?
SAFE recommends that you seek a professional who has obtained certification in the fields of insurance and/or financial planning. Certification denotes that an individual has met educational competency requirements to enable him or her to practice in their chosen fields. Designations such as CFP (Certified Financial Planner), ChFC (Chartered Financial Consultant), CPA/PFS (Personal Financial Specialist who is a CPA), and CLU (Chartered Life Underwriter) are good starting indicators when searching for a qualified financial advisor. Go to certifying organizations and professional associations such as the Certified Financial Planner Board of Standards (CFP Board), the Society for Financial Services Professionals , the Financial Planning Association , the American Society of Certified Public Accountants , or the National Association of Insurance and Financial Advisors to learn more about financial advisors in your area.
Is It True That the Insurer Keeps My Annuity Money if I Die the Next Day?
Likely no, but it will depend on what kind of annuity you purchase. Immediate annuities typically offer several different payout options to the purchaser. One payout option, the ‘Life Only Option,’ provides a paycheck for the rest of your life until you die. Comparatively speaking, this payout option often provides a paycheck that is a greater amount than other payout options, simply because of the unknown risk of when one may die. The insurer also retains the remaining balance at death. However, there are always numerous other payout option choices, from which the immediate annuity purchaser can choose.
Is My Principal Always Protected?
Your principal payment is not protected when you purchase a variable annuity, as you are making a commitment to invest in the market for potentially stronger performance. The flip side of this is that you could also experience losses as a result of market performance. Your principal payment is protected when you purchase a fixed or indexed deferred annuity. Be aware, however, that some annuities offer additional benefits, or riders, which you may choose to purchase to ensure additional protection and growth. In some cases, these rider purchases could chip away or deplete the principal payment of the annuity, in the event that the non-guaranteed credited interest is insufficient to cover the costs. Be sure to ask your financial advisor or insurance professional to explain.
When Do Most People Buy An Annuity? At What Age? For What Reason?
Most people who purchase immediate annuities make their purchase close to retirement time or upon retirement. Research shows that people who purchase deferred annuities make their purchase prior to retirement- typically around age 63. Because deferred annuities allow you to defer taking income from the annuity and provide the ability to earn additional interest for retirement, a deferred annuity can be purchased at nearly any age.
Why Do I Have to Pay Surrender Charges on My Deferred Annuity?
Deferred annuities are long-term savings vehicles intended to safely compound earnings over a period of years while preserving your initial principal payment. Surrender charges are in place to reimburse the insurance company for some of their acquisition costs, or the costs incurred to manufacture, distribute, issue and manage your deferred annuity policy in the event you, as a potential owner/annuitant may decide to request a large portion of their money be immediately returned. Some of these large expenses include paying a commission to the distributor and/or your financial advisor, and to reimburse for the costs of reserving and investing your money to meet the guaranteed elements of your policy. These significant upfront overhead expenses (employees, computer systems, real estate, regulatory requirements) are mitigated when the owner/annuitant allows the insurance company ample time to invest their funds for the long term, which is why surrender charges historically decrease with time.
Why Are Some Surrender Charge Schedules Longer than Others?
Some deferred annuity surrender charges are longer than others because of the additional expense incurred to issue certain policies. These products may have larger distributor expense, greater choice of product features and greater inherent guarantees. Because of this, some insurance companies require a larger percentage surrender charge, a longer surrender charge schedule, or both.
Why Do I Have to Pay a 10% Tax Penalty if I Withdraw Funds from My Qualified Deferred Annuity Before Age 59 ½?
This is a federal retirement savings requirement enforced by Internal Revenue Code Section 72(q). It is there to ensure Americans do not tap into needed retirement resources too early. A similar penalty is enforced for premature withdrawal from other similar retirement plan products such as a 401(k). However, Section 72(q)(2)(A) states that any distribution made on, or after the date on which the taxpayer attains age 59 1/2, is NOT subject to the 10 percent penalty.
What Does Tax Deferred Mean?
Tax deferred means not taxed until sometime in the future. In regards to a qualified deferred annuity, earnings are free of current federal, state, and local income taxes until you start receiving annual payments. This enables all earnings to compound without being reduced by income taxes. Withdrawals of earnings are subject to ordinary income tax, and a 10% federal income tax penalty may apply if you take the distribution before you reach age 59½.
Why is My Deferred Annuity Renewal Rate Lower than Before?
Renewal rates are sensitive to changes in prevailing interest rates. For example, if an insurance company needs to adjust crediting rates on a deferred annuity because the underlying investment portfolio supporting that product has drifted 0.1% points up or down, the carrier will simply adjust the renewal crediting rates by exactly 0.1%. Approaches to renewal rate setting will differ between insurance companies however. A top-notch financial advisor will weigh this risk in determining which insurance company they recommend to offer the client the best renewal rate scenario.
Are Lifetime Income Annuities a Good Deal?
Otherwise known as immediate annuities, most people don’t realize how these products are able to offer higher lifetime cash flows and payout rates as compared to other retirement income investments. The difference is primarily due to mortality credits offered by insurance companies. Income annuities generate their income from interest earned, return of principal, and mortality credits whereas a traditional investment offers income from interest earned and/or return of principal. Mortality credits occur when premiums paid by those who die earlier than expected contribute to gains of the overall fund pool. This, in turn, provides a higher yield or credit to survivors than could be achieved through individual investments outside of the pool. The mortality credit you receive increases significantly with age and hedges longevity risk, or the risk of outliving your income, often creating a return that would be impossible to match with other investments. A consumer must weigh the opportunity costs of purchasing an income annuity to maximize their lifetime income versus dying prematurely and forgoing any future mortality credits earned.
Are Insurance Company Financial Ratings Important to Me as an Annuity Purchaser?
Insurance company ratings are important in determining the financial strength of the underlying company. The company makes promises as to the future performance of the annuity, and a low-rated insurer may find it difficult to meet their future obligations and product promises. Because of the long-term nature of annuity products, insurer financial strength should never be overlooked as an important criterion in determining which company to entrust your funds. Rating companies such as Standard & Poor’s (S&P) or AM Best are well known for their ongoing efforts to review insurance company performance and capability from a long- and short-term historical perspective.