ANNUITIES 

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Note: Any reference to the word guarantee is based on the claims paying ability of the underlying insurance company.

An annuity is a contract between you and an insurance company.  Although annuities can serve various needs, its primary purpose is to help people meet their long-range financial retirement requirements and goals. 

It is a unique financial product that provides guaranteed minimum interest rates and tax deferral of interest and capital gains, and it is the only retirement vehicle that can provide a guaranteed income for life

As most people are aware, a Life insurance product protects individuals against the risk of death.  An annuity, on the other hand, is sometimes referred to as the opposite of life insurance because it insures individuals against the risk of living too long.  

Fixed annuities provide safety to your retirement money.  As long as you do not withdraw more than your allowed annual free withdrawal amount, you will not incur surrender charges and will never lose any of your principal and interest earnings.

HOW ANNUITIES WORK 

You make a “Single Premium” one-time payment, or you make recurring periodic payments known as “Flexible Premiums” to an insurance company and, in return, the insurer agrees to make payments to you for a determined period, beginning immediately or at some future date.  It is not always mandatory, however, to choose “annuitization” (pay-out options) at the end of the “accumulation phase” (contract period) and you may, instead, have the option of simply cashing out your annuity.

With a "deferred annuity" your cash or income pay-outs are delayed until later when the contract period (the accumulation phase) ends. 

With an "immediate annuity" you pay a single premium amount and your annuity income starts immediately.

ACCUMULATION PHASE 

During the “accumulation phase” the fund grows tax deferred similar to other retirement accounts, such as IRAs or an employer’s retirement account; it does not grow tax free.   

Most contracts provide liquidity of either interest only or a 10% free annual withdrawal.  If you withdraw more than your allowed free withdrawal amount, you may pay substantial surrender charges to the insurance company, as well as tax penalties if you are under age 59-1/2 (with certain exceptions).  

If a premature death should occur during the accumulation phase, the accumulated funds within the annuity are transferred to the named beneficiary, avoiding probate costs.

DISTRIBUTION PHASE

As part of the annuity’s distribution phase the owner has two options; he or she can withdraw cash either in a lump sum (and can also put that money in another tax-deferred account to avoid paying taxes all at once), elect a systematic withdrawal plan, or “annuitize” it (purchase an annuity pay out plan). 

If the annuity was purchased as part of (or the money was deposited from or rolled over from) a qualified retirement program such as an IRA, 401K, TSA, or 457 plan, the entire fund is subject to income taxes as it is withdrawn. 

If the deposit came from non-qualified money and was not part of a retirement account (qualified), income taxes are paid only on the earnings when the money is ultimately paid out.  

All interest gains are taxed at ordinary income rates, and not at capital gains rates.

THE THREE TYPES OF ANNUITIES 

Fixed Annuity

The insurance company agrees to pay you no less than a specified (declared) rate of interest during the time that your account is growing (the accumulation phase).  In a fixed annuity, the insurance carrier:

  • Declares a current rate of interest for a specified time period. Once the time expires the company will set a new rate which may be higher or lower than the original rate.
  • Guarantees a minimum interest rate of return which is specified in the contract, and at no time may the current or renewal interest rate fall below it.
  • Guarantees the principal and locked-in interest earnings.

Fixed Indexed Annuity (FIA) 

The insurance company credits you with a return that is based on changes in an index, such as the S&P 500 Index, and it also provides that the contract value will be no less than a specified minimum, regardless of index performance.  The annuity owner enjoys the upside potential of equities but is not exposed to downside risk and can never lose his or her principal and earned interest (although surrender charges will apply if more than the allowed free withdrawals are withdrawn before the contract period ends).  There are many variations in product design and index crediting strategies, and no two Indexed Annuities are exactly alike. 

Fixed and Fixed Indexed Annuities provide safety to your principal and earnings.

Variable Annuity

The annuity owner bears the investment risk. Policy values vary directly with market performance and may result in a loss of principal and prior earnings. Earnings are tied directly to the performance of various underlying investment vehicles which are available within the variable annuity and are selected by the owner.

Variable products are subject to mortality and expense charges and administrative fees not typically found with other investments.

ANNUITY PAYOUT OPTIONS --  "Annuitization"   

With annuitization the issuing insurance carrier guarantees a payout for a stated period of time or for the life of the annuity owner, bearing all of the investment and longevity risk on the guaranteed payout — which means that the consumer is completely protected from these risks. 

Generally speaking, the two most common methods to receive cash payouts are the annuitization method and the systematic withdrawal schedule.  The other is taking a lump-sum payment.  The annuitization method gives you some guarantee of monthly income for a determined period.  Under the systematic withdrawal schedule, you have complete control over the timing of distributions but no protection against outliving annuity assets. 

Below are some different options you have with the annuitization method.   

Period Certain Option 
With this option the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15 or 20 years. Should you elect a 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years. 

Life Only Option
The life option typically provides the highest payout because the monthly payment is calculated only on the life of the annuitant. This option provides an income stream for life, which is an effective hedge against outliving your retirement income.

Life with Guaranteed Term
Many people like the idea of income for life (which they get with the life option), but they are afraid to choose that option in case they die in the near future. The life-with-guaranteed-term option gives you an income stream for life (like the life option), so it pays you for as long as you live. But with this option, you can select a guaranteed period, such as a 10-year or a 20-year guaranteed term, for which your annuity is obligated to pay to your estate or beneficiaries the remainder of the payments for the time you have selected if you die before that guaranteed period is over. The guaranteed monthly payments will be less than "life only." 

Joint-Life Option
This common option allows you to continue the retirement income to your spouse upon your death. The monthly payment is lower than that of the life option because the calculation is based on the life expectancy of both the husband and wife. 

LIFETIME INCOME "RIDER" OPTIONS 

Income “Riders” can be attached to certain annuities (an additional cost may apply) providing you with a guaranteed income for life (similar to what annuitization provides), but without having to give up access to remaining principal.  

How Income Riders Work

The annuity has an accumulation value to determine the death benefit or annuitization.  The “Rider” adds a second value: the income value. 

The accumulation value works just as it always does on a fixed annuity. The annuity owner’s premium earns additional interest that is declared and guaranteed in advance or guaranteed through a calculation of the performance of an index (or indices), while at all times promising a minimum guaranteed interest.  The unique benefit of a fixed indexed annuity (FIA) is that it has a built-in inflation hedge because interest is calculated based on a formula tied to the designated index, e.g. S&P 500 (so you have an opportunity to earn higher interest than with the traditional fixed annuity) .  

With income riders, the income value is completely separate from the accumulation value. It typically grows at a fixed rate of interest, and when the retiree elects to start taking lifetime withdrawals, a payout factor is applied to the income value to determine the guaranteed annual withdrawal. If the accumulation value is higher than the income value when the policyholder decides to withdraw the income, then the accumulation value is used in the payout calculation instead. Once the amount of guaranteed withdrawal is calculated, the retiree may withdraw that amount from the annuity every year for life.

While taking these withdrawals, the retiree is provided with two very valuable guarantees.

  1. Although the annual withdrawals are deducted from the accumulation value, the additional interest (declared or indexed) continues to be credited to the accumulation value, and the retiree retains access to the remaining accumulation value at all times.
  2. Even if the annual withdrawals ultimately deplete the accumulation value, the issuing carrier must continue making the annual payments as long as the retiree lives.

Some annuity carriers even provide for the income to substantially increase in case the annuity owner is confined to a nursing home, further sheltering the annuity owner from risk. In addition, the annuity owner retains access to the annuity’s remaining value and continues to reap the benefits of interest credits to the annuity’s value.