Annuity

What is an annuity?

In its most general sense, an annuity is an agreement for one person or organization to pay another a stream or series of payments. Usually the term “annuity” relates to a contract between you and a life insurance company, but a charity or a trust can take the place of the insurance company. There are many categories of annuities. They can be classified by: Nature of the underlying investment – fixed or variable Primary purpose – accumulation or pay-out (deferred or immediate) Nature of pay-out commitment – fixed period, fixed amount, or lifetime Tax status – qualified or nonqualified Premium payment arrangement – single premium or flexible premium An annuity can be classified in several of these categories at once. For example, you might buy a nonqualified single premium deferred variable annuity. In general, annuities have the following attractive features: Tax deferral on investment earnings Many investments are taxed year by year, but the investment earnings—capital gains and investment income—in annuities aren’t taxable until you withdraw money. This tax deferral is also true of 401(k)s and IRAs; however, unlike these products, there are no limits on the amount you can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for 401(k)s and IRAs. Protection from creditors If you own an immediate annuity (that is, you are receiving money from an insurance company), generally the most that creditors can access is the payments as they’re made, since the money you gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities. And your money in tax-favored retirement plans, such as IRAs and 401(k)s, are generally protected, whether invested in an annuity or not. An array of investment options, including “floors” Many annuity companies offer a variety of investment options. You can invest in a fixed annuity which would credit a specified interest rate, similar to a bank Certificate of Deposit (CD). If you buy a variable annuity, your money can be invested in stock or bond (or other) mutual funds. In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point. For example, the annuity may offer a feature that guarantees your investment will never fall below its value on its most recent policy anniversary. Tax-free transfers among investment options In contrast to mutual funds and other investments made with “after-tax money,” with annuities there are no tax consequences if you change how your funds are invested. This can be particularly valuable if you are using a strategy called “rebalancing,” which is recommended by many financial advisors. Under rebalancing, you shift your investments periodically to return them to the proportions that you determine represent the risk/return combination most appropriate for your situation. Lifetime income A lifetime immediate annuity converts an investment into a stream of payments that last as long as you do. In concept, the payments come from three “pockets”: Your investment, investment earnings and money from a pool of people in your group who do not live as long as actuarial tables forecast. It’s the pooling that’s unique to annuities, and it’s what enables annuity companies to be able to guarantee you a lifetime income. Benefits to your heirs There is a common misconception about annuities that goes like this: if you start an immediate lifetime annuity and die soon after that, the insurance company keeps all of your investment in the annuity. That can happen, but it doesn’t have to. To prevent it, buy a “guaranteed period” with the immediate annuity. A guaranteed period commits the insurance company to continue payments after you die to one or more beneficiaries you designate; the payments continue to the end of the stated guaranteed period—usually 10 or 20 years (measured from when you started receiving the annuity payments). Moreover, annuity benefits that pass to beneficiaries don’t go through probate and aren’t governed by your will. Why should I consider purchasing an annuity? Annuities can serve many useful purposes. If you are in a saving-money stage of life, a deferred annuity can: Help you meet your retirement income goals. Employer-sponsored plans such as a 401(k), 403(b) or Keogh are an important part of planning for retirement. However, contributions to these plans and to IRAs are limited, and they might not add up to enough for the retirement income you need, especially if you started saving for retirement late or had contributions interrupted—perhaps due to job changes and/or family responsibilities. Moreover, your social security and defined-benefit pension (if you have one) may provide less than you need to retire. Remember that the purchasing power of defined-benefit pension income is eroded by inflation. Help you diversify your investment portfolio. Investment experts routinely advise that, to get the best return for a given level of risk, you should diversify your investments among a number of asset classes. Fixed annuities, in particular, offer a unique asset class—an investment that is guaranteed not to decrease and that will actually increase at a specified interest rate (and, often, potentially more). The guarantees are supported by the claims-paying ability of the insurer. Help you manage your investment portfolio. Investment experts routinely advise that, whenever your investments in various asset classes get too far from the percentage allocations you prefer, you “rebalance” to the original formulation, by shifting funds from the classes that have grown faster to the ones that have grown more slowly. If you do this with mutual funds, you pay capital gains taxes; if you do it in a variable annuity, you don’t pay capital gains taxes. When you eventually withdraw money from the annuity (which could be many years after the rebalancing), you pay tax then at the ordinary income rate. If you are in a need-income stage of life, an immediate annuity can: Help protect you against outliving your assets. Social security pays retirement income for as long as you live, as do defined-benefit pension plans. But the only other source of income available that continues indefinitely is an immediate annuity. Help protect your assets from creditors. Generally the most that creditors can access is the payments from an immediate annuity as they’re made, since the money you gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities. How are annuities different from life insurance? Both annuities and life insurance should be considered in your long-term financial plan. While both include death benefits, you buy life insurance in the event you die too soon and an annuity in case you live too long. In other words, life insurance provides economic protection to your loved ones if you die before your financial obligations to them are met, while annuities guard against outliving your assets. There are two main types of annuities—deferred and immediate—and two main types of life insurance—term and whole life. The chart below compares them. Life Insurance Annuities Term life Whole life Deferred annuities Immediate annuities Main reason for buying it Provide income for dependents Provide income for dependents or meet estate planning needs To accumulate money in a tax-deferred product To assure you don’t “outlive your income” Pays out when You die You die, borrow the cash value or surrender the policy You make withdrawals One period after you buy the annuity, stops paying when you die* Typical form of payment Single sum Single sum Single sum or income Lifetime income Buyer’s age when it is typically bought 25-50 30-60 40-65 55-80 Accumulates money tax-deferred? No Yes Yes Yes, but only in the early payout years Pays a death benefit? Yes Yes Yes *payments continue if the annuity has a guaranteed-period option that hasn’t expired at the annuitant’s death Are benefits taxable income when received? No No, unless a cash value withdrawal exceeds the sum of premiums Yes, but only the part derived from investment income Yes, but only the part derived from investment income How much should I invest in an annuity? Unlike a 401(k) or an IRA, there are no limits on the amount that you can invest in an annuity. Whether you’re considering a deferred or immediate annuity, the amount of money you should consider putting into an annuity depends on: Your immediate actual and potential financial needs Your long-term financial goals Your current savings/investment portfolio The range of alternatives available to you Of these, the most important is your immediate actual and potential financial needs. If you’re buying a deferred annuity and you have a sudden need for cash, you can usually withdraw a small amount without penalty. However, you’ll likely pay a penalty if you make a large withdrawal within a few years after you’ve bought the annuity. If you’re buying an immediate annuity, you usually can’t get any more than the regular payments, no matter how badly you need cash. However, if you have other sources of cash that are sufficient for any emergency or unforeseen needs, then the immediate needs criterion is satisfied and the other criteria become more important. What are the different types of annuities? Fixed vs. variable annuities In a fixed annuity, the insurance company guarantees the principal and a minimum rate of interest. In other words, as long as the insurance company is financially sound, the money you have in a fixed annuity will grow and will not drop in value. The growth of the annuity’s value and/or the benefits paid may be fixed at a dollar amount or by an interest rate, or they may grow by a specified formula. The growth of the annuity’s value and/or the benefits paid does not depend directly or entirely on the performance of the investments the insurance company makes to support the annuity. Some fixed annuities credit a higher interest rate than the minimum, via a policy dividend that may be declared by the company’s board of directors, if the company’s actual investment, expense and mortality experience is more favorable than was expected. Fixed annuities are regulated by state insurance departments. Money in a variable annuity is invested in a fund—like a mutual fund but one open only to investors in the insurance company’s variable life insurance and variable annuities. The fund has a particular investment objective, and the value of your money in a variable annuity—and the amount of money to be paid out to you—is determined by the investment performance (net of expenses) of that fund. Most variable annuities are structured to offer investors many different fund alternatives. Variable annuities are regulated by state insurance departments and the federal Securities and Exchange Commission. Types of fixed annuities An equity-indexed annuity is a type of fixed annuity, but looks like a hybrid. It credits a minimum rate of interest, just as a fixed annuity does, but its value is also based on the performance of a specified stock index—usually computed as a fraction of that index’s total return. A market-value-adjusted annuity is one that combines two desirable features—the ability to select and fix the time period and interest rate over which your annuity will grow, and the flexibility to withdraw money from the annuity before the end of the time period selected. This withdrawal flexibility is achieved by adjusting the annuity’s value, up or down, to reflect the change in the interest rate “market” (that is, the general level of interest rates) from the start of the selected time period to the time of withdrawal. Other types of annuities All of the following types of annuities are available in fixed or variable forms. Deferred vs. immediate annuities A deferred annuity receives premiums and investment changes for payout at a later time. The payout might be a very long time; deferred annuities for retirement can remain in the deferred stage for decades. An immediate annuity is designed to pay an income one time-period after the immediate annuity is bought. The time period depends on how often the income is to be paid. For example, if the income is monthly, the first payment comes one month after the immediate annuity is bought. Fixed period vs. lifetime annuities A fixed period annuity pays an income for a specified period of time, such as ten years. The amount that is paid doesn’t depend on the age (or continued life) of the person who buys the annuity; the payments depend instead on the amount paid into the annuity, the length of the payout period, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the pay-out period. A lifetime annuity provides income for the remaining life of a person (called the “annuitant”). A variation of lifetime annuities continues income until the second one of two annuitants dies. No other type of financial product can promise to do this. The amount that is paid depends on the age of the annuitant (or ages, if it’s a two-life annuity), the amount paid into the annuity, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the expected pay-out period. With a “pure” lifetime annuity, the payments stop when the annuitant dies, even if that’s a very short time after they began. Many annuity buyers are uncomfortable at this possibility, so they add a guaranteed period—essentially a fixed period annuity—to their lifetime annuity. With this combination, if you die before the fixed period ends, the income continues to your beneficiaries until the end of that period. Qualified vs. nonqualified annuities A qualified annuity is one used to invest and disburse money in a tax-favored retirement plan, such as an IRA or Keogh plan or plans governed by Internal Revenue Code sections, 401(k), 403(b), or 457. Under the terms of the plan, money paid into the annuity (called “premiums” or “contributions”) is not included in taxable income for the year in which it is paid in. All other tax provisions that apply to nonqualified annuities also apply to qualified annuities. A nonqualified annuity is one purchased separately from, or “outside of,” a tax-favored retirement plan. Investment earnings of all annuities, qualified and non-qualified, are tax-deferred until they are withdrawn; at that point they are treated as taxable income (regardless of whether they came from selling capital at a gain or from dividends). Single premium vs. flexible premium annuities A single premium annuity is an annuity funded by a single payment. The payment might be invested for growth for a long period of time—a single premium deferred annuity—or invested for a short time, after which payout begins—a single premium immediate annuity. Single premium annuities are often funded by rollovers or from the sale of an appreciated asset. A flexible premium annuity is an annuity that is intended to be funded by a series of payments. Flexible premium annuities are only deferred annuities; that is, they are designed to have a significant period of payments into the annuity plus investment growth before any money is withdrawn from them. What is the difference between a fixed and variable annuity? Fixed annuities pay a “fixed” rate of return. When you receive payments, the monthly payout is a set amount and is guaranteed. Fixed annuities may be a good choice for: Conservative investors who value safety and stability. Those nearing retirement who want to shelter their assets from the volatility of the stock or bond market. With variable annuities, you can invest in a variety of securities including stock and bond funds. Stock market performance determines the annuity's value and the return you will get from the money you invest. The amount of risk you are willing to assume should influence the kind of funds you select. You may want to consider a variable annuity if you are: Comfortable with fluctuations in the stock market and want your investments to keep pace with inflation over a long period of time. Young and want to prepare financially for retirement by reaping the gains in the stock or bond market over the long term. What are deferred and immediate annuities? Deferred Annuity This type of annuity is good for long-term retirement planning for the following reasons: Payments on income taxes are deferred until you withdraw the money. Unlike a 401(k) or an IRA, there are no limits on your annual annuity contributions. There is a death benefit. If you die before collecting on the annuity, your heirs get the amount you contributed, plus investment earnings, minus whatever cash withdrawals you made. Immediate Annuity This allows you to convert a lump sum of money into an annuity so that you can immediately receive income. Payments generally start about a month after you purchase the annuity. This type of annuity offers financial security in the form of income payments for the rest of your life. In other words, you cannot outlive it. Immediate annuities allow you to: Supplement your current income. If you are nearing retirement, you may consider transferring another savings or investment account into an immediate annuity. You can also move the proceeds from a deferred annuity into an immediate annuity. Pay taxes only on the portion of your immediate annuity payments that is considered earnings. You are not taxed on the portion that is principal. The principal is the initial deposit made with funds that have already been taxed. Like deferred annuities, immediate annuities can be fixed or variable. Fixed immediate annuity income payments are pegged to the amount you contribute, your age and the interest rate at the time of purchase. Those payments to you will not go up or down. Variable immediate annuity payments vary with the investments you chose. How are annuities sold? Annuities can be purchased through insurance agents, financial planners, banks and life insurance carriers. However, only life insurance companies issue policies. Here is a closer look: Agents Agents are insurance professionals who are licensed by your state insurance department. Some agents work exclusively for one insurance company, while others represent several. If you decide to use an insurance agent, find one who is knowledgeable about annuities and has a reputation for excellent customer service. The agent should be able to advise you and answer all your questions. If you are thinking about buying a variable annuity, the agent should also have a license to sell variable annuity products. Since variable annuities are considered securities, you should receive a prospectus describing the investment alternatives available to you. Banks and brokerage firms Products developed by life insurance companies are often marketed through banks and stock brokerage firms. Make sure the person who sells you the annuity is a licensed life insurance agent. In the case of a variable annuity, the agent should also be a licensed securities dealer. If you buy an annuity through a bank or brokerage firm, you should ask about the types of annuities the insurer issues and the financial strength of the insurance company.