They can be purchased with either a single premium payment, or a series of premium payments, and, depending on how soon you want to receive income, are available in two types: deferred and immediate.
Deferred annuities: This type of annuity has two phases, accumulation and income. During the accumulation phase, you contribute funds to the annuity, and they accumulate on a tax-deferred basis. During the income phase, you have the option to “annuitize” those funds—meaning you exchange the lump-sum value of the annuity for a stream of guaranteed payments, such as lifetime income—or to make withdrawals, without annuitizing. Through withdrawals, you retain access to the lump sum value. Immediate annuities: Immediate annuities begin to pay an income shortly after the premium is paid in exchange for a lump sum payment, which is no longer accessible.
If annuitized, the income paid out is calculated based on the age and sex of the annuitant, selected by the owner, and the duration of payments. The annuitant and the owner can be the same person, but they don’t have to be. In addition to being either deferred or immediate, annuities are non-qualified or qualified. Qualified annuities are part of a pension plan or IRA. They’re subject to any limits those plans impose and are purchased with before tax dollars. Non qualified annuities are paid for with after tax dollars and are not subject to contribution limits.
Surrender Period
Most deferred annuities have a surrender period, typically the first five to ten years, and cashing in or cancelling your annuity during that time can lead to a hefty surrender charge. This charge declines over time and disappears once the surrender period ends. Annuities can only be sold by licensed life insurance agents. Ensure your agent or advisor is registered with your state’s insurance department before you invest. You should also be aware that sellers of most annuity products earn commission for selling them.
Types of Annuities
Annuities are available in three investment styles.
Fixed
Fixed annuities pay a rate of interest that is guaranteed for a period of time, from one year to the life of the annuity policy. The account value of the annuity is guaranteed by the insurance company. The premiums are invested in the insurance company’s general account portfolio of bonds and other investments. Fixed immediate annuities pay a predetermined income to the owner. Fees and expenses for fixed annuities are generally limited to surrender penalties and optional rider charges. Sometimes you may also be charged an annual contract fee, typically around $30.
Variable
Variable annuities have a menu of investments to select from that are like mutual funds called sub-accounts. The policy values reflect the performance of the funds and are not guaranteed. Variable immediate annuities pay income to the owner that rises and falls with the value of the funds. Fees and expenses for variable annuities generally include mortality and expense charges, fund management fees, administration fees, surrender penalties, and optional rider charges. Variable annuity fees and expenses can be 2% or more.
Indexed
Indexed annuities have a menu of financial indexes to select from, like the S&P 500, or the Russell 1000. The account value of the annuity is measured by the performance of the index. If the index is positive, a portion of the gain is credited to the account. If the index is negative, the account value remains the same, there are no losses. But while the performance of the account is measured by the index selected, the premiums are invested in the insurance company’s general account, not indexed mutual funds. Indexed annuities may offer investors more upside than fixed annuities while still offering guarantees. Calculating how the gain is credited, however, can be complicated. For example, caps, participation rates, threshold rates, and spread rates are common devices used to limit gains, and they’re frequently used together. Fees and expenses for indexed annuities are generally limited to surrender and optional rider charges. Currently, there are no indexed immediate annuities available.
Annuities & Riders
Riders are optional benefits the insurance company offers at an additional cost. Some common riders are:
Guaranteed Minimum Income Benefit (GMIB)
The GMIB rider provides a minimum guaranteed lifetime income at retirement based on a GMIB amount, and not the general account value. The minimum income is based on the original investment accumulated at an interest rate specified in the policy. Like annuitization, once the option is selected the owner has no access to policy values. The GMIB can be based on one or two people.
Guaranteed Lifetime Withdrawal Benefit (GLWB)
The GLWB rider also provides a minimum amount of lifetime income when you retire regardless of investment performance. Unlike the GMIB, the owner does have access to the account values. Withdrawing money in excess of the withdrawal limit (such as 5%) will, however, reduce or eliminate the guaranteed income. The GLWB benefit can be based on one or two people.
Guaranteed Minimum Accumulation Benefit (GMAB)
The GMAB rider also guarantees a minimum account value regardless of investment performance. The rider guarantees that you can access a percentage of your premium payments, such as 90% or 100% , after a holding period, such as 5-10 years.
Enhanced Death Benefits
The standard annuity death benefit is the account value. There is no charge for the standard death benefit, but some life insurance companies offer death benefits that step up or increase based on a formula. For example, the rider could periodically “lock in” investment performance or guarantee a death benefit equal to your account value plus a minimum rate of return.
What Does It Mean to Annuitize?
When you annuitize, the insurance company agrees to pay you an income in exchange for a premium (which may be your contract value in the case of a deferred annuity). Once you pay the premium, you have no access to the money. Common annuitization options include:
Life Only
The insurance company agrees to pay income for life. The payments stop whenever the annuitant dies, there is no payment to beneficiaries.
Period Certain and Life
The insurance company agrees to pay income for life or a minimum number of years, whichever is longer. A life annuity with a 10-year period certain means the insurance company will pay the income for at least 10 years. If you live longer than 10 years, it’ll pay your regular income for life, but if you die during the 10 year period, your beneficiary will receive payments for the remainder of the 10-year term.
Joint And Survivor
The insurance company agrees to pay income for the lifetime of two annuitants – the account holder and the beneficiary. The income stops when the last annuitant alive dies. Since the payments to the survivor are an added benefit, the typical payment amount is lower than that from a life only annuity. While the annuitization rates vary by insurance company and change regularly. Here’s an example of how much lifetime income per month $200,000 can buy for a couple aged 65 years.
Do I Need an Annuity?
The average American will spend 20 years in retirement. In fact running out of money is a top concern for retirees. A deferred or immediate annuity is a way to guarantee a lifetime income whatever interest rates, or market conditions may be. Generally, deferred annuities are best for people in the 40-65 years age group, with enough liquid investments to cover any immediate needs, unusual expenses, or emergencies. Here are some of the ways you can use them.
Supplement Retirement Savings
If you are contributing the maximum amount to your company sponsored retirement plan, or IRA, a deferred annuity may be a good option because of the favorable tax treatment (the account values of annuities grow tax deferred). There are low cost annuities available on the market that are designed only for accumulation.
Downside Protection
For some investors, the downside protection features of indexed annuities or variable annuities may be attractive. Variable and indexed annuities offer a variety of living benefit riders to protect retirement income and principal from down markets. Death benefit riders can protect the value of the annuity for beneficiaries as well.
Lifetime Retirement Income
There are only three sources of a guaranteed lifetime income: pensions, social security, and annuities. If you are concerned about potentially running out of money later in retirement, annuities can provide a foundation for income. You can use your IRA or in some cases 401k to fund the annuity, as well as non-qualified money.
Estate Planning
Proceeds from an annuity death benefit pass directly to the named beneficiary, avoiding probate. Some annuities offer enhanced death benefit riders which provide additional protection for the beneficiary. Enhanced death benefits can be an attractive option for investors unable to obtain life insurance.
Alternatives to Annuities
Annuities can be very effective financial tools, but they are long term investments, and may have significant fees and surrender penalties. If you need the money before the surrender penalties expire, or if you don’t need the insurance features, an annuity may not be right for you. In addition to annuities, qualified retirement plans like Individual Retirement Accounts (IRAs) and 401(k) and 403(b) plans, plus personal brokerage accounts let you invest money in mutual funds, stocks, bonds, CDs, and others. Each has different tax treatment, benefits, and limitations.
