An annuity is a contract where an insurance company agrees to pay the holder of the annuity either a lump sum or a regular series of payments over time. The two broad types of annuities are Immediate and Deferred. As implied, the immediate annuity begins or makes the payments immediately, and the deferred annuity defers those payments and has a period of accumulation and deferral.
Most people save for retirement through a qualified retirement plan, like 401(k)s and IRAs, but when you retire, you need to convert that retirement savings into income, and annuities can be a good way to both save for retirement and then at retirement, create an income stream to support you in retirement.
Annuities are unique, in that the income stream that is generated can be structured to be guaranteed for the life of the annuitant, regardless of the underlying value of the annuity. They have been described as a “personal pension” in which the income stream is guaranteed by the insurance company, regardless of what might happen to the invested principal.
There are three types of deferred annuities:
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. Fees and expenses for fixed annuities are generally limited to surrender penalties and optional rider charges.
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. 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 annuities have a menu of financial indexes to select from, like the S&P 500 or the Russell 1000. The account value and performance of the annuity are measured by the performance of the index. If the index is positive, a portion of the gain is credited to the account. This portion that the investor receives is unique to the insurance company and usually involves a calculation that can include cap rates, spreads, moving averages, threshold rates, or participation rates. If the index is negative, with most index annuities, the account value remains the same, there are no losses.
Some of the newer indexed annuities are considered variable indexed annuities in that the caps and participation rates are higher in return for the investor taking on some of the potentials for loss. For example, the insurance company will offer a “buffer” rate in which any losses incurred by the index are covered by the company, but any losses in excess of the buffer are incurred by the investor.
For example, a buffer of 10% means that the investor will be protected from any losses between 0% and 10% but will suffer a loss of any incremental amount over the 10% for the period chosen. With most indexed annuities, 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 potential than fixed annuities while still offering guarantees. Calculating how the gain is credited, however, can be complicated depending on the method used.
According to FINRA, one of the most confusing features of an index annuity is the method used to calculate the gain in the index to which the annuity is linked. There are several different ways that this can be calculated which makes it difficult to compare one indexed annuity to another. Fees and expenses for indexed annuities are generally limited to surrender penalties and optional rider charges.
One of the more attractive features of newer annuities is the “Living” benefit riders. Instead of offering a death benefit (which annuities still offer) that protects the investor against premature death, the new riders protect the investor against living too long and outliving their money. Riders are optional benefits the insurance company offers at an additional cost and generally protect and guarantee income but can also protect and guarantee principal. The most 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.
Annuities can be a great way to participate in stock market returns while protecting against loss. They can also provide a guaranteed, lifetime stream of income that is difficult to replicate anywhere else.
It’s important to note that while an annuity can be an important part of a retirement plan, there are complexities that need to be understood and an annuity may not be for everyone. Not all annuities are created equal and not all situations would benefit from an annuity. The investor needs to understand the factors involved in using an annuity, including cost, methods of growth calculation, surrender schedules and penalties, income features, and tax consequences, and generally make sure the annuity “fits” their needs.
Regulators are keenly aware of the increased use of annuities and are becoming more vigilant in making sure that annuity investors are aware of the risks, costs, and suitability of each individual annuity investor. However, the regulatory environment is not consistent, and investors need to be careful. Some annuities are considered both insurance products and “securities”, and the regulatory component falls to FINRA (Financial Industry Regulatory Authority) and the SEC (Securities and Exchange Commission), as well as individual state insurance departments.
Other annuities are considered to just be insurance products and are regulated solely by individual state insurance departments. Because of this, agents and advisors that sell and recommend annuities can be, and frequently are, licensed differently depending on whether they are selling securities or insurance products, and therefore held to different standards. The term Buyer Beware applies to annuities maybe more than any other financial product.
Lane Reynolds
Senior Financial Advisor
