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What is an Annuity? Get a fixed annuity quote Deferred Annuities - The most popular type of annuity is the deferred annuity. With a deferred annuity a premium is deposited with the insurance company. In exchange, they agree to credit to you a certain rate of interest for a certain period of time. The most important feature of a deferred annuity is that the interest accumulates on a tax deferred basis. Except for this important tax advantage, deferral of taxes on interest, an annuity performs much like a bank Certificate of Deposit (CD) in its accumulation phase. For most people who are in higher income tax brackets and plan to invest for a longer period of time, deferred annuities should significantly outperform bank CDs.
Immediate Annuities - With an immediate annuity, the annuitant pays an insurance company a certain amount of money as a premium. In return for this premium, the insurance company promises to pay a specified amount to the annuitant (or his or her beneficiary) for a specified period. With an immediate annuity, a 60 year old annuitant may pay a $100,000 premium to an insurance company. After considering the annuitant's age and gender the company will then guarantee to pay the purchaser some fixed fee per year for as long as he or she lives (or a certain period of time). A portion of this payment is considered a return of premium and therefore not taxable to the annuitant. The remainder is considered interest and will be taxable as such. One of the advantages of an immediate annuity is that an annuitant cannot outlive his or her guaranteed payments.
Who Should Invest in an Annuity?
Annuities should be purchased mainly by investors who plan to invest for the long haul (7+ years). Because of loads and fees associated with this product, investing for a shorter period usually does not make sense. Another important consideration is an annuitant's age. Because annuities receive preferential tax treatment, distributions before age 59 1/2 will be subject to a 10% IRS penalty, and potentially to any surrender charges imposed by the insurance carrier. Annuities can make sense for younger investors, but they should be prepared to keep the investment until age 59 1/2.
Most annuities are relatively conservative investments. They will generally credit an interest rate about 1.5% to 2.0% below the yield of the insurance company's portfolio. Most insurance companies invest in high grade government and corporate bonds. Knowing this, you can see that you aren't going to get rich quick by investing in an annuity. However, the slow and steady performance, combined with a tax deferred interest, make annuities a competitive risk adjusted investment vehicle. In this time of falling interest rates, it is worth pointing out that most insurance companies do have a contractual minimum level of interest that they will credit, regardless of current rates. These rates generally fall between 3.5% to 4.5% and should be considered before you buy.
For the most part, people who have not made the maximum contribution to their qualified plans (IRAs, 401(k)s, Profit Sharing, etc.) should not invest in an annuity. Because, while an annuity does offer tax deferred accumulations, the qualified plans offer that, plus a current tax deduction. The qualified plan investment will usually lead to a higher after-tax rate of return than any non-qualified annuity. Consult your tax advisor or financial consultant for more details.
Tax Deferred Accumulation - Whether buying an immediate, deferred, or variable annuity, the reason most people buy an annuity is because of its preferential tax treatment. As mentioned earlier, interest that accumulates on an annuity does so on a tax deferred basis. So every year as your account values grow there is no tax to be paid. This allows more of your money to work for you during the accumulation phase and ultimately greater total accumulations.
Tax Preferred Payouts - During the distribution phase there can also be some favorable tax arrangements. If over age 59 1/2, an individual can take penalty free distribution from his annuity. Of course, if an annuity is surrendered on a lump sum basis, all gains will have to be realized at that time. However, many annuitants take either periodic withdrawals, or "annuitize" with an immediate annuity. Either of these will allow the gain to be realized over a longer period of time, hopefully minimizing taxable income in any given year. It is important to note that when withdrawals are taken from an annuity, the IRS requires earned interest to be withdrawn before any principal can be distributed. The original investment, however, is considered return of premium and therefore not taxable to the recipient.
What is the Correct Annuity for Me?
Fixed vs. Variable - The potential annuitant must first decide whether to purchase a fixed or a variable annuity. The main driving force here has to do with risk tolerance and market expectations. Younger, or more risk tolerant annuitants should give strong consideration to the variable annuity. Investors with a shorter life expectancy or high risk aversion should look more toward fixed annuities.
Guaranteed vs. Promises - For most annuity policies there are contractual guarantees. However, if these annuities only perform as guaranteed, they will generally be poor investments. For this reason, annuity consumers should look beyond the guarantees and try to determine what is the likely performance for the various annuities. Consumers may want to discuss historical interest payments of different companies with their insurance broker.
Fees- No matter which type of annuity you choose, projected and guaranteed charges are an important consideration. The first fee to consider is the surrender charge. Most annuities do not have front end fees, but nearly all have some back end fee. A very common annuity surrender charge would be a 7 year, 7% decreasing surrender penalty (7%,6%,5%,4%,3%,2%,1%,0%). In a contract such as this, you would pay a 7% penalty for surrendering the policy in year one, a 6% penalty in year two, 5% in year three and so on. The bottom line here is this: the longer and higher the surrender penalty, the worse the value to the consumer.
"Administrative Charges" can also be an important consideration, especially for annuities of a smaller amount. These fees vary from $0 to $50, with most fees falling between $12 and $30 per year. Remember that with a $5,000 annuity, a $25 annual fee represents 1/2% point off the yield.
Interest Rates - The biggest problem that consumers face with most fixed annuities is uncertain renewal rates. Because of severe early year surrender penalties, annuitants are left at the mercy of the insurance company. Before buying an annuity, it is very important to look at the interest rate crediting history of the carrier. Ask yourself (or better, the selling party) the following questions:
- Has the carrier consistently paid a fair return given the then present market conditions?
- Do existing contracts and new contracts receive the same rate of interest?
- If buying a bonus annuity, ask what the second year's rate will be if everything remains static? (Remember, high first year rates usually mean lower rates in subsequent years.)
- What is their portfolio currently yielding? Can they "afford" to pay current rates?
- Do you have to annuitize in order to receive the projected (or current) rate?
If you do not like the answers to the above questions, or you don't feel comfortable trusting the insurance company, you might be interested in a "guaranteed" annuity. These annuities usually guarantee an interest rate for a period of years and this period is equal to their surrender penalty. For example, you might buy a 5 year annuity that guarantees a 6.25% rate of return for each of those five years. The surrender penalties on this annuity could be 5% per year, but at the end of year five the penalty would equal 0%.
Carrier's Financial Strength - Unlike a bank CD, annuities are not Federally insured. There may be some State guarantees against carrier insolvency, but they would only be a line of last defense. For this reason, it is important that annuities be purchased from companies with excellent financial ratings. Consumers should determine the financial ratings with a least two different rating services before purchasing.
We recommend against purchasing annuities from carriers not rated in the top 10% in their industry. Some of the most popular rating services are A.M. Best Company, Standard and Poors, and Moody's. If you click the financial ratings hypertext link, you can check some of these services free of charge right now! Further, if you should have any further questions about annuities in general, feel free to either e-mail John Garven at john.garven@benico.com or call him at 888-669-4883, ext. 202.
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