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Annuities Explained – What is an Annuity? Here’s An Easy-To-Understand Full Rundown on Annuities


Introduction

There’s a long-standing debate on the merits of annuities – a financial landscape where opinions clash. What we can unanimously agree upon, though, is their inherent complexity. Deciphering sales materials can be daunting in a market flooded with diverse annuity products. Even seasoned finance professionals grapple with intricate insurance terms, let alone the average consumer.

As time has passed, annuities have transformed from straightforward retirement planning tools, guaranteeing a steady income stream, into intricate products often presented with hypothetical scenarios. This complexity leaves many uncertain about the outcomes and what to anticipate.

The result? Some consumers who may benefit from an annuity miss out, while others unknowingly commit to products that could detrimentally impact their retirement plans.

So what is an annuity and how do they work? This post will provide you with an all encompassing rundown of the ins and outs of annuities.

Is an Annuity an Investment or Insurance?

Given that annuities frequently find their way into retirement plans, there’s a common misconception portraying them as formal investment products.

In reality, they are insurance products issued by life insurance companies.

Although they come with stipulations, these serve a distinct purpose.

So let’s dive in!

What is an Annuity?

According to Investopedia.com the formal annuity definition is “a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.”

In layman’s terms, it’s what I like to call “income insurance.”

Why? Because it’s insurance that provides guaranteed income, even if you’ve depleted the assets within the annuity.

By paying a “premium” or “premiums” to the insurance company, you’re electing to transfer the risk of “outliving” your assets in exchange for a guaranteed income stream.


Types of Annuities

There are only two types of annuities, but many product types. Sounds confusing, right? You’re not alone. I’ve had many conversations where clients simply want to know which type of annuity they own, and who can blame them for being confused when product names sound something along the lines of “Deferred fixed index variable annuity – Retirement Bonus 17!”

So let me rephrase what I said above…

There are 2 categories for annuities but there are many product types. What determines which category that product falls under?

The income start date.


Annuity Categories


  • Immediate Annuities
    • Payments must start within 12 months of issue date.
    • Product type(s): Fixed Annuities 
  • Deferred Annuities (most popular)
    • Payments can be deferred as far out as age 115.
    • Product type(s): Fixed annuities, fixed index annuities, variable annuities, variable index (hybrid) annuities, QLACs.

Now with that being said, there are many types of annuity products. What sets them apart?

The growth aspects.

See below:

Types of deferred annuity products
Quick Overview – Looking to learn more about annuity products? Click here

How Do Annuities Work?


Phases of an Annuity 

There are two main phases of a deferred annuity. The formal terms are the “accumulation phase” and the “annuitization phase,” which are better known as the “growth” phase and the “income” phase.


Growth Phase

This is the phase where your money grows. As referenced earlier, the growth aspects vary between each type of annuity product (Fixed, Fixed Index, Variable, etc.), and the growth is tax deferred. Therefore, no tax is due on the gains until you withdraw or formally start your income stream.

Income Phase

There’s no hidden meaning here. Once you activate your income stream, your annuity is officially in the income phase. This does not apply if you are making a one-time withdrawal. Starting the income stream can either mean you’ve formally annuitized your contract or activated your “Living Benefit Rider.”


Annuity Income Options


What is Annuitization and What Does it Mean to Annuitize an Annuity?

Ironically, annuitization is not popular among contract owners. In fact, less than 5% (an increase from previous years) of contract owners end up annuitizing their contracts.

Once you annuitize your contract, you are trading your cash value for guaranteed payments based on your selected payment period (lifetime, joint lifetime, period certain, etc.).

*Insurance companies will consider various factors to determine the payment amount, such as the annuitant’s life expectancy, the cash value, selected payment period, etc.

The benefit? Your income will continue for the requested period (lifetime, joint lifetime, or a specified period). For example, if you choose the single-life payout, then payments will continue no matter how long you live.

The risk? Suppose you chose the straight single-life payment option and suddenly passed away shortly after, before your original investment (premium) was paid out. In this case, any remaining payments or premium(s) stay with the insurance company and will not be distributed to the contract owner’s beneficiaries.

Therefore, you should consult your advisor or annuity specialist before starting payments because they cannot be reversed once annuitized.

When do payments stop? It depends on the payout option you selected; see below:

Annuity payment options

Living Benefit Riders aka Income Benefit Riders

A living benefit rider is an additional income option apart from annuitization.

Many of my past clients often confused living benefit riders as a type of death benefit; so instead of using it’s formal term, I refer to this rider as an “enhanced income option,” which seemed to resonate better.

Similar to other optional riders, this benefit is often added at purchase for an additional fee, but some annuities have built-in living benefit riders at no extra cost.

A majority of these riders provide options for a guaranteed income stream without having to forfeit the liquidity of your cash value in exchange for a guaranteed income stream.

Income options are the meat and potatoes of an annuity contract. Still, it’s also the most convoluted portion of an annuity, which is why I dedicated a whole post to income riders. Click here to learn more.


Annuity Death Benefit


Annuity Death Benefits are proceeds distributed by the insurance company to the designated beneficiary/beneficiaries when the annuitant dies.

The owner of the annuity will name an annuitant and designate a beneficiary. More often than not, the annuity contract owner is also the contract’s annuitant.

Still, it’s noteworthy that contract owners can list someone other than themselves as the annuitant. Additionally, beneficiaries can be someone or something (ex., charities, trusts, churches, schools, etc.)

Annuity contracts have built-in “standard” death benefits. However, the details of standard death benefits vary between each type of annuity product.

For example, the standard death benefit on Fixed and Fixed Index Annuity products is simply the contract value plus pro-rated interest minus any distributions and applicable fees.

In other words, it’s essentially the same aspect as what a beneficiary would receive from any other account that contains a cash value, such as a checking, savings, or traditional investment account.

Therefore, there is no added life insurance aspect to the standard death benefits on these annuity products because the death benefit value is not more than the contract’s cash value.

Now, in terms of Variable Annuities, the standard death benefit will be the higher of two values at the time of death:

The contract value or the total premiums paid minus any withdrawals.

Assuming no withdrawals were taken, there is a little bit of a life insurance component here, but you would have to time your death during a market downturn for it to be applicable.

Another difference between the standard death benefits in Fixed and Fixed Index Annuities vs. Variable Annuities is the fee; see the comparison chart below:

Annuity death benefit options for Fixed Annuities, Equity Index Annuities, and Variable Annuities
Annuity Death Benefits

As you can see, the only annuity product that charges a fee for a standard death benefit is Variable Annuities.

Death Benefit Riders


Some annuity products also offer the option to add on an “enhanced” death benefit, also known as a “Death Benefit Rider.” These options generally allow your beneficiaries to inherit a value other than the current contract value at the time of death.

Suppose the Annuity Death Benefit is the main feature that piques your interest. In that case, it is vital to understand the critical differences between an Annuity Death Benefit and a formal life insurance policy. Learn more here.


Qualified vs Non-Qualified Contracts


You may have heard some annuity contracts referred to as a “Qualified Annuity” or a “Non-Qualified Annuity.” These terms often get misinterpreted as a type of annuity product, but they actually reference the tax status of the money held in the annuity.

Why is the Tax Status Important?

The tax status determines how the funds are taxed once a distribution/withdrawal is made. Understanding how each tax status is taxed will help eliminate any unexpected surprises when tax season arrives.

Qualified Contracts

Qualified contracts mean that the contract was funded with “pre-tax” dollars or before-tax funds. These contracts fall under the umbrella of a retirement savings plan such as an IRA, Roth IRA, 403B, 401k, etc.

All distributions from a “qualified” account, whether under the umbrella of an annuity or a traditional retirement account, will be taxed at your ordinary income rates. *Distributions taken before age 59.5 will be subjected to an additional 10% tax penalty.

Non-Qualified Contracts

Non-Qualified contracts are funded with “post-tax” dollars or after-tax dollars. Unlike traditional investment products, the funds in a Non-Qualified annuity are tax-deferred, and you won’t have to pay taxes until you withdraw.

This is why they’re often viewed/sold as an additional option for long-term retirement savings plans.

Tax implications to consider for Non-Qualified Contracts

Withdrawals from Non-Qualified annuities are taxed on a “Last in, First out Basis” (LIFO). In other words, any withdrawals made will automatically be considered gains and are taxed at your ordinary income rates, not capital gains rates. This, however, does not apply if the contract is annuitized, which follows the “exclusion ratio.”

Consumers should also be aware that distributions taken from a Non-Qualified Annuity are also subjected to the same 59.5 rule as a qualified account, where an additional 10% tax penalty will apply if a withdrawal is made before age 59.5. This rule does not apply to Non-Qualified accounts in a traditional investment account.

Pros and Cons of Non-Qualified Annuity Tax Deferral Feature

Compared to individual stocks, the tax deferral benefit on Non-Qualified annuities can be appealing because you can change your investments within the annuity without incurring a taxable gain.

However, suppose the annuity was established to simply take advantage of the tax deferral with the intent to move the assets from the annuity into a more traditional investment vehicle down the road. In that case, you could be faced with a large tax bill.


Pretend you surrendered an annuity you’ve owned for 25 years to purchase a 2nd home. The gains on the annuity have accrued to 200k at the time of the cash surrender.

Since annuities are taxed at ordinary income rates instead of capital gains, you’ve just realized 200k additional income for that tax year. How would $200,000.00 of additional income affect you for that tax year? Don’t know? Neither do I. That’s why you should always consult your tax advisor before making any withdrawals.

Key Takeaway When it Comes to Tax Implications

Some may argue that taxes are easier to swallow if taken in the form of income, ideally when you’re in a lower tax bracket. However, the reality is that taxes are never easy to swallow but realizing you paid 28% in taxes when you could have gotten away with a 15% capital gains tax outside of the annuity is like swallowing a dry pill.

With that being said, everyone’s total financial picture is different. Some may find that their annuity didn’t negatively affect their tax bracket and that they could ironically use more income to combat inflation!

Therefore, the most important thing is having a cohesive strategy for your retirement plan. Preferably one that addresses your retirement goals (growth efficient) minimizes tax surprises (tax efficient), & with justifiable expenses (cost efficient).


Annuity Fees


Annual Fees

A handful of Fixed Index Annuities charge a “strategy fee.” Fortunately, that is not a very common fee. Otherwise, both Fixed & Fixed Index Annuities generally have no annual fees.

Unless of course, an additional feature (rider) is added on such as a Living Benefit Rider. 

Variable Annuities, on the other hand, have a layer of fees because it has both insurance and investment aspects. *Find details on fees for Variable Annuities here.*Find details on fees for Variable Annuities here.


Surrender Fees

What is a surrender fee? When you purchase an annuity, you’ve entered into a contract with the insurance company.

These contracts generally stipulate that you must own the annuity for a certain amount of time (specified by the insurance company). A penalty will be assessed if you choose to exit the contract before that period ends.

Surrender fees are typically on a decreasing schedule, where the charge decreases little by little each year.

However, I have seen some products where the surrender fee remains stagnant for a good portion of the surrender period or even the entire surrender period.

*Find more details here.

Potential fees in addition to the surrender fee

  • Pro-Rated Annual Fees: This fee applies only if you have riders in the annuity. It also applies whether you’re still within the surrender period or not. It’s essentially the cost of your rider pro-rated from the last date the fee was charged to the date of surrender.
  • Market Value Adjustment: Market Value Adjustment (MVA) can be applied during the surrender period for both Fixed and Fixed Index Annuities, but it’s more common for Fixed Index Annuities.
    • This figure is based on the underlying investment made when you purchased the contract. The insurance company must sell that underlying investment if you exit the contract earlier than expected (before the surrender period ends). If they sell it for a loss, they pass that on to you in addition to any applicable surrender charges. On the other hand, if they sell it for a profit, they also pass that on to you, which could offset any applicable surrender charges.
  • Premium Bonus Recapture Fee: Some insurance companies offer a premium bonus at purchase, where they would credit your contract value a certain percentage of your original investment amount. Bonuses range from 1% to as high as 20% of the total premiums paid.

Although the bonus is generally automatically reflected in your contract value, more often than not, it is not immediately yours. Bonuses tend to follow a vesting schedule that often coincides with the surrender schedule.
Therefore, if you choose to surrender the contract during its penalty phase, they will take back the unvested bonus amount in addition to any applicable surrender fee.


Annuity Advantages vs Annuity Disadvantages


Pros and cons of annuities


Is an annuity right for you?


If you planned on using it for income… Maybe? 

It all boils down to two main variables: your financial goals and the total assets at play to try and accomplish those goals. In other words, it depends on your entire financial picture. Therefore, no valid recommendations or decisions should be made unless there is at least a thorough understanding of those two variables at minimum.

Now, with that being said, what I often told clients who were just starting to scratch the surface of annuities is what I mentioned earlier in this post…

Annuities make sense for some individuals and not so much for others. Since annuities are insurance contracts, I’d start with determining whether or not you have an insurable need for income.

The principal aspect of an annuity is the guaranteed income stream. They were designed to provide income protection, similar to how life insurance provides asset protection.


The guaranteed income stream is an annuity’s main advantage against traditional investment products – especially if you need some sort of safety net to solidify your retirement plans.

There are so many variables that come into play when it comes to determining whether or not an annuity is right for you. Items to consider are your time horizon, spouse’s time horizon, cash flow needs from your portfolio, etc.

Your advisor will help you sort through all of that to determine whether or not there is an insurable need. But, again, annuities are complex and often have many stipulations to account for, so most advisors will ensure they have exhausted all options (such as delaying your social security payments) before formally recommending an annuity.


Takeaway


Planning your retirement is a two-way conversation.

Remember that it’s essential for you to be very candid about what you’re looking to accomplish and what you’re looking to avoid during retirement. You should also expect your advisor to be honest about what is and isn’t attainable.

Finally, remember that no portfolio is structured the same (or at least it shouldn’t be) because financial situations vary from person to person.

Annuities explained, annuity as an investment

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Disclaimer: The opinions expressed in this blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security, investment, or insurance product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.