Designing Our Future

Chapter 6

Annuities

  An annuity is a contract between the annuity owner and the insurance company. The insured is called the annuitant. The annuitant (the investor) invests in the contract by paying in a sum of money either in one lump payment or through a series of payments.  At some point, often retirement, the insured begins to withdraw the principal deposited and the interest earned. Interest earned in an annuity accumulates on a tax-deferred basis, meaning no tax is due on the interest earnings until they are withdrawn from the contract.  When money is withdrawn, the IRS considers the first money out to be interest rather than principal. Therefore, there will be taxes due on the interest earnings withdrawn.

Retirement Risks

  We know there are many risks associated with retirement:

· How long will I live?

· How long will my spouse live?

· Have I saved enough money to live on after I retire?

· Have I planned adequately for special needs, such as prolonged care in a nursing home?

· What costs might develop in retirement that I may not have considered prior to retirement?

· What will it cost to live at the same standard in ten, twenty or thirty years (inflation)?

· Will the annuity that is paying five percent today be far below the rates paid in the future (investment risk)?

  There are ways to estimate some of the previous factors, but there is no way to know for certain what elements may affect our retirement years. It is possible, for example, to estimate how long an individual will live by considering current statistics and family history. If most family members lived past eighty years old, it is likely that others in the family will do so as well. Therefore, family members can plan based on that lifespan but with the realization that he or she may die sooner or live much longer.

  Statistically about 11 percent of men and 7 percent of women who live to age 65 will die prior to their 70^th birthday, but 6 percent of men and 14 percent of women will make it to their 95^th birthday. Everyone else will fall between those two extremes.

  The longer an individual lives, the more money will be needed over the span of retirement. Certainly, it is better to save too much than too little, and it would be safe to say most of us would prefer to be the individuals that live to age 95 and beyond.  Even modest increases in living costs can erode the ability to live at the same standard of living throughout retirement. While many individuals probably continue working for other reasons, at least some of those who do so must work because they did not adequately save. If costs rise by only 3 percent per year, it will mean that $100 today will be worth only $74 in ten years.  After 25 years the same $100 would be worth only $45 – less than half the same value. Obviously, a fixed income, such as a pension or annuity, cannot adequately fund the costs of living when inflation erodes their value to this extent.

While many individuals probably continue working for other reasons, at least some of those who do so must work because they did not adequately save.

  Social Security income will protect against inflation to some extent since it offers costs-of-living increases, but seldom are they adequate say the recipients. Since most retirees do not want the volatility of stocks or other risk investments, what are their options? Perhaps the best option is the most basic: save as much money as possible for retirement.

A Payment of Money

Annuity means “a payment of money,” which is an adequate description. Insurers designed annuities to function in the same way a pension fund would: a vehicle to distribute funds in a periodic manner.  Initially annuities were thought of as a distribution vehicle but today they are more often used as an accumulation vehicle, since people often do not ever annuitize (withdraw the funds on a contractual basis). 

  Depending upon the source quoted there are either two or three types of annuities: immediate and deferred or immediate, deferred, and accumulation. 

· Immediate: an individual deposits a lump sum of money into the annuity and then immediately begins withdrawing income, usually on a monthly basis. There are variations on the withdrawal provisions with the policyowner selecting the type of withdrawals based upon their needs or desires.

· Deferred: an individual deposits one deposit, but payments are postponed for some future date.  The actual date does not have to be stated and many of these annuities are never annuitized at all. Upon the annuitant’s death the funds will pass on to the listed beneficiaries.

· Accumulation: An individual pays into the annuity account on a systematic basis over a period of years. At some point it is assumed that withdrawals will begin (after age 59½ to avoid IRS penalties). The shift from accumulation to monthly payout is called annuitization.  During accumulation, periodic withdrawals may be made, subject to the terms of the contract. Usually, up to 10 percent is allowed without insurer penalties, although younger policy owners would be subject to IRS penalties.

  Annuities provide two elements that are favorable to long-term investing for those who are risk adverse: (1) deferred taxation and (2) growth without undue risk.

The Single Pay Deferred Fixed Annuity is the oldest type of annuity.

  The oldest type of annuity is the Single Pay Deferred Fixed Annuity.  The owner deposits a lump sum into the annuity (most insurers require at least $5,000) but does not immediately begin withdrawing.  The contract owner may add to the initial deposit prior to the start of annuitization. Once annuitized, deposits are no longer allowed.

  The annuity payout rate rises based on the insured’s mortality risk and the rate of return that the annuity contract earns on the invested assets. As a result, younger individuals earn more because there is more time allowed for growth.

Annuity History

  Annuities are sometimes called “reverse life insurance” since the goal is to provide lifetime income for the insured while he or she is still living rather than provide income to beneficiaries upon their death. Some types of annuities do not have accumulation periods, such as the single premium immediate annuity, but they were designed with accumulation and then payout in mind. Annuity business for insurers was a small share of the market until the Great Depression. According to the Temporary National Economic Commission (TNEC), from 1866 to 1920, annuity premiums averaged only 1.5 percent of life insurance premiums. The Great Depression and the financial panic that followed led many investors to seek reliable investment vehicles for their savings, including annuities with their long, stable history. As a result, annuities experienced tremendous growth in the 1930’s, with the majority occurring between 1933 and 1937. From 1934 to 1936 the premium income on newly issued individual annuities exceeded that of newly issued ordinary life insurance policies for the 26 companies TNEC studied. Small investors were able to receive earnings in annuities, which was not necessarily possible elsewhere. Even the severe surrender penalties that existed at that time for those who did not allow their annuities to mature did not prevent the rapid expansion of the deferred annuity market in the 1930’s.

The annuity business for insurers was a small

share of the market until the Great Depression.

  Annuity sales continued throughout the postwar period. Individual annuity sales increased almost every year. Eventually, their popularity declined, however, but resurfaced in the 1960’s, with much of the renewed growth continuing from the 1970’s through today.

  While there will always be investment firms that seen to dislike annuities for their failure to show large growth, there is also many professionals who see the value of annuities. According to a July 2021 article in Insurancenewsnet.com, in the first half of 2021, annuity sales were up by 23 percent, for a dollar amount of $67.9 billion in the second quarter. That is up 39 percent from the same quarter in 2020.

  COVID-19 brought out many fears in our population, and financial security was one of them. Annuities are among the safest financial vehicles so, despite their inability to compete with risk investments that could produce higher gains, annuities continue to be the vehicle safety investors seek.

  There are several factors for the continued use of annuities in investment portfolios. Of course, safety of principle is a major reason for increased annuity sales, especially in COVID times. Additionally, strong equity market gains and lower volatility played a role in annuity sales. Variable annuities and equity indexed annuities were especially sought out by investors.

  Registered index-linked annuity sales, called RILA products, exceeded record levels in 2021. If interest rates for these annuities improve along with an improving economy, we can expect even higher interest in them.

  These expectations are not from a single investment company, since many investment firms are gaining respect for annuities of various kinds. While some annuities see higher sales than other types, all annuities continue to be popular. The competitive intelligence firm called Wink Intel reported annuity sales in 2020 (the first year with COVID-19) reported deferred annuities sold totaled $209.1 billion. Twenty-seven percent of that occurred in the fourth quarter of 2020. However, they reported that indexed and variable annuities outsold other annuity types. Some non-variable annuity sales were down, so not every annuity type rose in sales. The lesson, investment professionals say, is that all annuities are not the same and the investor is wise to look at the types that have a higher degree of risk over the fixed rate traditional annuities which have virtually no risk, other than inflation that robs the annuity of value over time.

  Of course, annuities are most likely to appeal to older investors facing retirement, since annuities have the potential to provide lifetime incomes, depending on which payout method the annuitant selects. While annuities certainly have a place in an investment portfolio, it is not always right for everyone. Due to the lifetime income option, they are typically offered to provide income throughout retirement. An added benefit is that annuities can usually be purchase without a medical exam or medical qualifications. However, again, annuities are not right for every investor.

  The obvious question then becomes: “Who should buy an annuity?”

  Individuals in poor health with a short life expectancy may not be the best candidates for buying an annuity, unless other factors indicate otherwise. Individuals having short life expectancies are probably not concerned with getting a lifetime income. However, most people do not know how long they will live, so a lifetime income is desired.

  A 65-year-old couple can plan on having a 50 percent chance that at least one of them will live past the age of 90, according to statistics. So, while an individual may not know how long they will live, he or she must plan on living past age 90 if they want to be financially prepared.

  Of course, insurance companies must have some people that do not live past age 90 for them to promise lifetime incomes. It is the nature of the insurance industry. Those that die young fund those that die old. For individuals who live into their nineties, more funds will be received under a lifetime income option than the amount of money they invested in the annuity. That means the annuitant wins and the insurer loses. Insurers know math, though, so they know enough people will die younger to fund the ones that live longer.

  Individuals who select lifetime incomes must realize that if they die young, there are no beneficiaries except the insurer. In other words, the issuing insurance company keeps any remaining funds. Selling annuities means the seller must know who is and who is not suitable for annuities, since not all people live a long time.

  Under the fiduciary standard, consultants, advisors, and insurance representatives must take certain steps to ensure compliance with fiduciary requirements, including acting in the best interests of those buying annuities. Without the fiduciary requirement there is no legal requirement, unless the state has one in place. There is a suitability requirement in many states, but the legal yardstick is not as strong as a fiduciary requirement would be. This allows those marketing many vehicles greater freedom, not just with annuities.

  Regardless of whether the state of residence has an annuity fiduciary rule, the goal is always the same. Regulators, as well as investors and insurance representatives must recognize the financial issues and determine if an annuity is right for the buyer, because some buyers may want an annuity even when it is a poor choice for them. While everyone has a right to buy an annuity if they want to, insurance producers must at the very least discourage the purchase if it does not meet the needs of the buyer.

  Today annuities are more likely to be used in conjunction with other types of savings. As every insurance producer knows, it is not wise to put all money in the same vehicle, but annuities may be a good choice for some of an individual’s retirement dollars.

Group Annuities

  Group annuities often have variations. The first type to achieve popularity was the deferred group annuity contract. The employer purchased the contract and made periodic payments to the issuing insurer. These were applied to the purchase of deferred annuities for the covered workers. The purchase price was specified by the employer’s contract with the insurance company, so the insurer indemnified the employer against changes in rates of return, mortality risk, and other factors that might alter pricing. These could be structured so that the employer received a dividend from the insurance company if mortality experience or investment returns proved more favorable than the initial contract anticipated. The employer would not pay more, however, if supplying deferred annuity contracts turned out to be more expensive than the insurer had thought. This type of contract covered 71 percent of the workers with group annuity contracts in 1950 but declined to only 48 percent in the 1960s.

  The deposit administration contract was the second type of group annuity contract. It grew in popularity during the 1950’s. This offered more flexibility in the timing of employer contributions and offered a more direct link between employer cost and the mortality or turnover experience of employees, when compared to the deferred group annuity contract. The insurer held contributions to the deposit administration plan in an unallocated fund. The insurer promised a minimum return on the fund. When an employee retires, the insurer would withdraw an amount sufficient to purchase an immediate fixed annuity for the amount of the retiree’s assured retirement benefit from the fund account. The insurer did not indemnify the employer against changes in the price of fixed annuities. The insurer bore all the risk of mortality and rate-of-return fluctuations for retired employees, while the employer bore the risk for employees who had not yet reached retirement.

The third type of group annuity contract, first offered in 1950, became the most popular. It was the immediate participation guarantee (IPG) contract. This was a variant of the deposit administration contract, with a fund account maintained by the insurer, but with more direct links between the mortality experience of covered employees, returns on investment, and the pension costs of the employer. Under an IPG, if the employer maintains a fund account balance large enough to fund the guaranteed annuities for all retirees, the employer’s account is credited with the actual investment experience of the insurer, and the actual payments to retirees are withdrawn from this account. Therefore, the employer is essentially self-insuring the mortality experience of retirees and receiving actual rather than projected investment returns. If the employer’s fund balance drops below the amount needed to fund the guaranteed annuities, however, the plan becomes a standard deferred annuity contract. The insurer uses the account balance to purchase guaranteed individual annuities for all participants in the pension plan. As long as the account balance is high enough, the employer bears the investment and mortality risks associated with the plan. If the account balance falls below the necessary levels, then the insurer assumes the risks.

Do Annuities Make Sense?

  Like all financial vehicles, annuities are not right for everyone or in all situations. There are advisors who think annuities are always right and advisors who would seldom place an annuity. In reality, annuities are sometimes a good choice and sometimes a poor choice. The popularity of annuities fluctuates with current financial climates. When the stock market is performing well, annuities lose favor but when the stock markets are poor, annuities suddenly become a great financial vehicle.

  Traditional annuities have not changed much over the years, but there are many newer annuity types that are innovative. Even the newer varieties have the same general traits: an individual deposits money and at some point, begins withdrawing the funds plus any interest earned.

  There are many reasons why a person considers the use of an annuity. The security annuities offer is a widely stated reason, but the tax status is also considered. There are two basic tax elements to annuities:

1. Tax qualification. The majority of annuities are not tax-qualified, although they may be under the right circumstances.

2. Tax deferred compounding. Annuities compound tax-deferred, which is not the same as tax-free. At some point taxes will be paid on the interest earnings.

  If a person has the option of depositing into a tax qualified vehicle it would certainly make sense to do so, but when no such vehicle is available, annuities are a good second choice. Since annuities are designed to be long-term financial vehicles in most cases (there are immediate annuities that pay immediately) only top-rated insurance companies should be used. Of course, this is probably true for most insurance products, but especially when payout will not occur for twenty or thirty years it is important that the insurer last as long as the policyowner does.

  Although insurance companies back annuities the annuity itself does not contain any life insurance death benefits. There are products that do combine the two aspects, but the annuity itself does not contain any death benefits. An annuity is designed to store principal, and then pay out benefits at some point.

  Deferred annuities could be considered as having an insurance aspect in that guaranteed regular monthly income exists for as long as one lives, if that payout option is selected upon annuitization. However, this is not really due to life insurance, but rather a structured payout formula based on such things as age, duration of distribution, and the amount of money in the annuity.

  In many ways, annuities are like bank loans. A bank deals in credit. It lends money because the bank expects to be paid back with interest over a set period of time. When a consumer deposits money into an insurer’s annuity, he or she expects to receive that money back plus interest.

Because insurers must invest in long-term vehicles annuities

 have early withdrawal fees.

  An insurer expects to use the money deposited in long-term investments that will pay them more than the interest they are paying the annuitant. It is due to this long-term investing that annuities have early withdrawal fees. Insurers could not earn adequately if their investors continually withdrew their funds.

  Annuity deposits are made in either a lump sum, called a single premium annuity, a series of fixed installments, called a fixed premium annuity, or by a series of installments of varying sizes, called a variable premium annuity. These deposits may be either tax qualified or non-tax qualified, depending upon the vehicle used. If an annuity is used to fund an Individual Retirement Account (IRA), it will be tax qualified. If the annuity merely receives deposits as an ordinary annuity, then it would not be tax qualified. Tax qualified vehicles receive greater tax benefits than would non-tax qualified.

  Whether the annuity is tax qualified or not, the accumulating interest is tax deferred.  This means that it is not taxed until withdrawn. The hope is that the annuitant will withdraw in some method that minimizes their taxation on their earnings. Statistically, most annuities are never annuitized, so the earnings remain untouched.

  Like most financial products, not all annuities are created equally; some are better than others. Since an annuity is designed to financially protect the policyowner from outliving their assets, due diligence is essential when choosing an insurer from which to purchase the annuity. Obviously, a company that is not financially stable would be a bad choice. Even though most people do not annuitize, the intent is often to have a lifetime income available. The annuitant does not have to select a lifetime income, since there are other payout options, but that is what the annuity was designed for.

  Annuities generally have a minimum guaranteed interest rate. Annuities may pay higher than this guaranteed rate, but never less.  The guaranteed rate prevents the interest earned from ever dropping below that specified point. With the low interest rates in recent years those who invested in annuities have come out ahead of many other types of investments. However, industry professionals believe we will see current annuities issued with lower guaranteed rates as a result.    While there are multiple types of annuities, most have a 100 percent guarantee of principal and an ongoing guarantee of all accumulations.

Commission Surrender Periods

  Annuities carry surrender periods. Although annuities vary, it is common for the surrender period to be nine or ten years. The insurance producer will also surrender his or her commission if the annuitant terminates the annuity within a specified time period. In some contracts, insurance producers will also forfeit their commission if the annuitant dies within a specified period, often within the first contract year or on a graduated basis for the first three to five years. Even premature annuitization, which is allowed under the annuity without penalty, may cause the producer to lose part or all of his or her commission.

An Estate and Retirement Planning Tool

  Annuities are used for many financial goals. They are often used for retirement and estate planning, although they may also be beneficial for other reasons. Annuities are often used for corporate partner buyouts, for example, and deferred compensation.

  Annuities may be constructed as a form of income that cannot be outlived. Choosing the lifetime income distribution option often benefits those who have a family history of long lives. While the monthly amount may be less, the duration of collection can far exceed what was deposited or earned. When annuities have been established that will secure lifetime income, other assets may be freed up for other goals, such as charitable donations or family gifts. When other assets would bring taxation, donating them during one’s life may be a tax benefit for the estate.

Choosing the lifetime income distribution option often benefits those who have a family history of long lives.

  During the last twenty years insurance agents are not the only ones who have sold annuities. Today many others sell annuities, including banks, savings-and-loan institutions, stockbrokers, accountants, and even attorneys. Anyone selling annuities must carry an insurance license and meet all state requirements.

  Annuities have proven a stable investment. While it is true that they are not going to experience sudden growth, as stocks might, they also will not experience sudden loss. Annuities are a steady-growth vehicle with all the guarantees offered by insurance companies, which are seldom available in other financial vehicles. Since the interest grows tax-deferred they also allow taxation to be delayed until some point in the future – when funds are withdrawn.

  In the early 1920’s the United States government even began using annuities to fund government retirement plans. Labor unions followed their lead funding union retirement plans through annuities. Due to the requirements the government mandated; the insurance industry established two safety features:

1. A guaranteed minimum interest rate built into the annuity contract, and

2. The reinsurance network to ensure safety.

  At this time insurance company reserves were introduced. From this point on the legal reserves system has required insurers to keep enough surpluses on hand to cover all cash values and annuity values that may come due at any given time. It is the reserves that enable the minimum interest rate guarantees to exist.

  The reinsurance network was designed to keep the industry solvent should there be a run on cash values in contracts, including annuities.  No individual insurer would be required to take the brunt of the loss since the companies spread the risk out among all insurers offering similar products. In addition, when a state’s insurance commissioner steps in to prevent an insurer’s financial collapse, he or she freezes the operations. Those who are already receiving income from annuities will continue to receive them, but anyone who has not annuitized will not be able to access their cash values until the state’s insurance commissioner releases them. Hardship withdrawals are usually possible, but the hardship must be proven and approved.

  Although insurance companies can experience financial difficulties the reasons are not necessarily the same as those affecting banks or savings-and-loan associations. When the great depression caused 9,000 banks to close their doors, insurers continued to operate. They did experience vast numbers of policy lapses, as their policyholders were unable to pay premiums, but insurance companies were able to continue operating. Insurers also had large numbers of policyholders withdraw their cash values, but because they had enough cash on hand, they were able to handle it.

Annuity Facts

  Annuities have existed for a long time. Over the years, they have experienced many changes. From 1973 to 1978 the most popular type of annuity carried a permanent seven percent surrender charge. This charge never disappeared. Only annuitization bypassed it.

  Competition is often the consumer’s best friend. Although there has been valuable state legislation, some of the most favorable changes in financial vehicles are due to competition. A few companies began to add consumer-favorable features, such as bailout options and limited surrender penalties. Bail-out options allowed policyholders to withdraw their money without penalty charges if the interest rate on their annuity fell below the initial rate at application (usually within specific time periods). This brought about a new generation of consumer-friendly products.

  During the 1980s the New York Stock Exchange member firms began aggressively marketing bailout annuities. As interest rates hit unexpectedly high figures, insurance companies quickly had to become superb asset managers rather than just good risk managers in order to continue competing in the marketplace. The record high interest rates fueled uncontrolled growth, which caused the insurance companies significant financial setbacks. Companies that had been considered strong, even by most rating companies, suffered severe losses.  Some insurers were forced by financial conditions to sell their blocks of annuity business to other insurers. Even in these harsh financial conditions, however, the insurers did not need or seek financial assistance from the government as the savings and loan institutions did.

  The 1990s saw the introduction of indices and two-tiered rates. The index rate annuity is a fixed annuity whose renewal rate fluctuates during the surrender charge period based upon some independent market indicators. It might be treasury bills or any variety of bond indices. This type of indexing is designed to protect the consumer in a low interest rate environment. These products do not tend to have bailout options since they are designed to accurately reflect the changing financial climate as it occurs. It appears that the insurers learned from their previous mistakes.

Two-tiered annuities were designed to reward consumers that did not surrender their contracts prematurely by offering a higher first tier interest rate. If the policy were surrendered or transferred to another carrier, a lower interest rate (the second tier) was retroactively applied. Although it is not called a surrender charge, the two-tiered annuity has effectively activated a second and permanent surrender charge in the form of the lower second tier interest rate. These products did not do well. Perhaps the buying public wanted more freedom to surrender or move their contracts.

Two-tiered annuities were designed to reward consumers that did not surrender their contracts prematurely by offering a higher first tier interest rate.

  After insurance companies experienced problems in the 1980’s the buying public seemed to be wary of purchasing annuities. Sales dropped dramatically. As a result, insurers looked for new ways of attracting policyholders. Surrender periods were reduced, bailout provisions improved, and there was a move towards multiple year rate guarantees, often between three and five years. Many of the new annuity products were specifically designed to complete with Certificates of Deposit. At this time banks and savings and loan institutions also began marketing annuities.

Tax-Deferred Status

  While tax deferral is not the same as tax free, it does still benefit the investor. Under tax deferral status taxes will be paid when funds are withdrawn. Even though annuities are not tax-free (unless they are qualified accounts) delaying taxation benefits the investor. It allows more of their money to earn interest, with interest earning interest as time progresses. Financial instruments that are taxed yearly have less accumulation ability because some portion is withdrawn for payment of taxes. No, the money is not literally pulled from the account to pay taxes, but taxes are paid from the income of the individual in some way.

Under tax deferral status taxes will be paid when funds are withdrawn.

  When a financial instrument is not tax deferred it is easy to lose sight of the loss to taxation. Since the money is not specifically withdrawn for taxes (they are paid at year’s end through federal taxation forms in combination with all other pluses and minuses that exist at that time) it is easy for investors to overlook the impact that yearly taxation has.

  The average annuity buyer is over the age of 60, which is past the IRS penalty age of 59½ for withdrawal purposes. Since growth requires adequate time, it is likely that these depositors are not concerned with vehicle duration or even taxation. It could be assumed that these depositors are moving into annuities for their ability to distribute funds during retirement.

“Time Is Money.”

  The average investor is seeking security rather than risk. While there are those investors who have a high-risk tolerance the majority of consumers still state that security is a high concern. It is not possible to have low risk and high return in the same financial vehicle. Lower risk means lower returns. Since annuities have minimal guarantees, they are considered a secure safe way to accumulate funds.  When returns are relatively safe, as they are in annuities, time is necessary for adequate growth.

While there are those investors who have a high-risk tolerance the majority of consumers still state that security is a high concern.

  Compounding power is the ability to create growth over time by earning interest upon interest. Inflation and interest earnings work exactly the same way, only in opposite directions. Inflation removes earning while interest adds earnings.

  Twenty-five years ago, a study regarding the investment priorities of Americans demonstrated the average person’s desire for safety. Other studies since then have consistently demonstrated that buyers have different priorities than agents and investment advisers may believe.  It found that investors listed their priorities as follows:

Interest earned:15% of those surveyed

Deferred taxation: 20% of those surveyed

Total safety of Investment: 76% of those surveyed

  Over the years, multiple surveys show that insurance agents think interest earnings is the investor’s primary concern. In reality, interest earnings were a lesser concern (coming in third), which demonstrates how easy it is for agents to misunderstand their client’s investment priorities.

  Companies have spent thousands of dollars trying to determine what their clients want. Older Americans often purchase annuities not as a new way to save, but as a means of repositioning current assets.  Certificates of Deposit are a prime source of annuity investments.  There can be many reasons for moving money from a Certificate of Deposit to an annuity, but often the goal is monthly income. This is especially true if the investor is nearing retirement or has retired.

  Safety of investment is a primary goal since we know retirees can live another thirty years. Annuities should never be placed with an insurer that is not top-rated. Never is an additional interest point worth utilizing a lesser-rated insurance company. Certainly, a higher commission is not worth placing annuity business with a lower-rated insurer. An insurance producer has a professional duty to know the financial rating of the insurers they place business with.

The Legal Reserve System consists of two elements:

 the portfolio and the net worth.

  Annuities are backed by the Legal Reserve System. The Legal Reserve System consists of two avenues: the portfolio that backs the annuity and the net worth, which is capital and surplus, of the issuing system.

Periodic Annuity Withdrawals

  Annuities usually allow policyholders to withdraw once or twice each year without penalty as long as they do so within specified parameters. Typically, the policyowner can withdraw up to 10 percent of the account value without insurer penalty. The policyowner will have to declare the income under the last-in, first-out rule, which says that all withdrawals are considered interest until no more interest earnings are left. This is an IRS rule, not an insurer rule. If the policyowner wishes a larger withdrawal than the 10 percent of the account value would allow, the additional funds may be subject to surrender penalties, depending upon the age of the policy. The policyowner should refer to his or her contract for exact information. Most insurer surrender penalties begin around nine or ten percent and decline one percent each year. For example, if the first year of the policy begins with a nine percent surrender penalty, the second year it drops to eight percent, the third year it drops to seven percent, and so forth. Eventually there is no insurer penalty applied at all.

  Internal Revenue Service penalties may also apply if the policyowner is under the age of 59½ when he or she withdraws funds from their annuity. When IRS penalties apply, it is always ten percent of the amount withdrawn, regardless of the age of the annuity contract. IRS levies these penalties because annuity money is considered retirement funds. The point of the penalty is to discourage individuals from withdrawing from their annuity prior to retirement, defined for the purpose of the penalties as age 59½.

  Annuities should not be used for short-term goals. The penalties involved would remove any financial advantage if funds were routinely withdrawn. Older people primarily purchase annuities, but annuities can be a valuable financial tool for younger individuals as well when utilized for long-range goals ending after age 59½ (typically retirement). Disciplined savers in their mid-30s who seek tax relief for a long-range goal should consider annuities. In fact, annuities might actually be one of the best financial vehicles for long-range goals since annuity penalties will discourage withdrawals.

  Although annuitization is always an option, it is not required. If the annuity is never annuitized and the insured dies, listed beneficiaries will receive the funds in the contract, bypassing probate. It is very important that beneficiary designations be kept current since the annuity will bypass probate. If no living beneficiary is indicated on the contract, funds will then go through the probate process.  The value of the annuity may still be included in probate values for taxation purposes with or without a listed beneficiary.

  Variable annuities are different than fixed annuities in several ways; one notable difference is how minimum rates are guaranteed. In fixed annuities, there is a guaranteed minimum interest rate that will always be paid regardless of how low other interest rates may go. Under a variable annuity there is no minimum interest rate guarantee. What the annuity earns is directly related to the earnings of the assets that are invested in. The investor selects from an offering of stocks, bonds, or money-market securities. These annuities are designed to combat inflation through the possibility of higher earnings. Of course, there is no guarantee that the investor will actually earn higher earnings.

  When selecting an insurer from which to buy an annuity, little attention should be paid to first year earnings. Many contracts pay a higher first-year rate only to dramatically drop the rate offered in subsequent years. Insurance producers should look at the most recent ten-year history of the product to determine the average interest rate paid. While history does not guarantee the future, it will provide an idea of what may be expected.

Many annuity contracts pay a higher first-year rate only to dramatically drop the rate offered in subsequent years.

  There are several companies that compare annuities, and it is always wise to consult several when comparing different insurers’ ratings, interest rates and charges. The various companies provide their opinions as to quality; be aware that the companies may sell annuities or receive payment from insurers to recommend their products. It is necessary to consider any of this when reading their comments.

Annuitization Options

  Annuities typically have multiple annuitization options available to the contract owner. Although most annuities are never annuitized, they were designed specifically with this feature in mind. Annuities were considered a retirement fund geared towards providing a steady income for either a specified time period or until death, depending upon the payout option selected by the contract owner.

  Since annuities are tax deferred, not tax free, upon withdrawal funds will be taxed at whatever rate applies, based on the recipient’s entire financial picture. There was a time when it could be stipulated that principal (which had already been taxed prior to deposit) was withdrawn first, so that tax payments were delayed. Of course, today that is not allowed. As of August 1982, IRS utilizes the last-in, first-out rule, which means that interest is withdrawn prior to principal. The Internal Revenue Service calls the last-in, first-out rule the “interest first rule” also known as IRS Sec. 72(e)(5).

The Internal Revenue Service calls the last-in, first-out rule the “interest first rule” also known as IRS Sec. 72(e)(5).

  Of course, it is not necessary to annuitize an annuity contract (and most are not annuitized), since up to ten percent of the account value may be withdrawn periodically without insurer penalty. Once the insurer’s surrender period has passed, more than ten percent may be withdrawn without insurer penalty.  At all times, the IRS penalty would apply if the annuity owner were under age 59½ at the time of withdrawal.

  At the time of annuitization, the actual amount received on a periodic basis, usually monthly, is derived from a formula using age, gender, principal, interest earned, and any other statistics that might be applicable. In some payout options, estimated length of life would not apply whereas it would in others.

  Although there can be variations, most payout options are fairly standard. They include:

1. Single Life: Payments will be received for a single listed annuitant for the remainder of their life. For as long as the annuitant lives, he or she will receive a monthly check for a specified sum of money. It is possible to use a format other than monthly, such as quarterly, but most annuitants receive a monthly income. The periodic payment will never change. If it happens to be $1,000 per month when first annuitized, it will continue to be that amount throughout the duration of payments during their lifetime. The insurer is considered the beneficiary under this payout option. It is not possible for remaining funds to go to any other heir. If the annuitant outlives the funds accumulated, he or she will continue to receive the same payments even though funds have depleted.

2. Joint-and-Survivor: Two or more individuals are named jointly in the annuity contract. Periodic payments will continue until all named surviving annuitants are deceased. Married couples primarily use these. Ages of all listed annuitants are considered when determining the amount of the continuous payments. Since payments will potentially continue for a longer period of time, the monthly amount is usually less than it would have been for a single individual under the Single Life option.

3. Life and Installments Certain: Payout will be for the life of the annuitant although installments are guaranteed for a certain specified time period, either to the annuitant or their named beneficiary. Although the specified time period may vary, it is usually ten or twenty years. The amount of the installment payments will be less than they would have been under the Single Life option since the insurer is not the named beneficiary in this payout option. That means that the insurer may have to pay out more than the account value if the annuitant lives longer than the insurer expected.

4. Cash Refund: This payout option guarantees that either the annuitant or their beneficiaries will receive the full account value during annuitization or receive a cash refund if the annuitant dies prematurely. The periodic payment will be less than the Single Life option since the insurer is not the listed beneficiary of any remaining account values.

  It is important to realize that annuities, once annuitized, are no longer considered beneficiary-designated money. Once annuitized, they are purely intended for the annuitant as income.

To recap the payout options:

Single Life means only the annuitant will receive payments after annuitization, not any beneficiaries (the insurer is the listed beneficiary in the contract).

Joint-and-Survivor means nothing is paid after the death of two or more named annuitants, not their beneficiaries (the insurer is the listed beneficiary in the contract). 

Life-and-Installment-Certain means payout will last the annuitant’s lifetime or at least the length of the certain time period selected (usually ten or twenty years). If the annuitant had received payments for the selected certain time period beneficiaries would receive nothing more; if the annuitant had not reached the certain time period, then the listed beneficiaries would continue receiving payments until the stated period of time was reached.

Cash Refund means either the annuitant or his or her beneficiaries are guaranteed to receive the annuity cash values.

Annuity Models

  While annuities may be either immediate or deferred, there are multiple annuity models within those two categories.

Accumulation deferred annuities are often the annuity of choice for younger individuals who need time to accumulate contract values.  The contract owner regularly deposits some amount of money into the annuity for use at a later time, usually at retirement. Most insurers require regular installments, so agents prefer to set these annuities up with a monthly draft deposit from the owner’s bank account.  Accumulation deferred annuities are often used by employers to automatically deposit a predetermined amount from the employee’s paycheck.

  Single pay immediate annuities (SPIA) receive a lump sum deposit with payout beginning immediately (usually within 30 days of the actual deposit) if desired by the annuitant. If immediate periodic payments are taken it is likely that the annuitant annuitized the contract. However, this annuity does not need to be annuitized since the annuitant may elect to wait until a later date to begin receiving payments or they may choose to withdraw only interest earnings at regular intervals (never annuitizing at all).

  Variable annuities are different than fixed-rate annuities. Fixed annuities have a minimum interest rate guarantee not shared by variable annuities. In a fixed rate annuity, it is the insurance company that shoulders the investment risk, which is why they may not earn as highly as other investments, such as stocks. With a variable annuity it is the investor that takes on the investment risk. The annuity may perform better than a fixed-rate annuity but there is no guarantee that this will be the case. Both individual and group annuity contracts have seen a growing use of variable annuities.

  Variable annuities, by their design, address the risk of purchasing-power erosion normally associated with fixed nominal annuities.  Variable annuities, unlike their fixed rate cousins, offer an opportunity to select a payout that bears a fixed relation to the value of an asset portfolio. If the assets rise in value with the nominal price level, then the payout on the variable annuity will adjust to mitigate, at least in part, the effects of inflation. Because variables are defined in part by the securities that back them, they are more complex than fixed annuity contracts are. Despite their complexity, they have become one of the most rapidly growing annuity products.

  Like fixed-rate annuities, variable annuities may be annuitized but the amount the investor receives is formulated differently. In a variable annuity the insurer guarantees to pay an unchanging percentage of the value of an unchanging number of investment units. This means that the periodic payment is not “fixed” as it would be in a fixed annuity. The payment is “variable” based on the performance of the selected investments. Therefore, the annuitant (not the insurer) is taking on the investment risk. This does not necessarily mean that the variable annuity is a risky investment. The amount of risk depends upon the type of investment made. Many variable annuities invest in mutual funds, which are not generally considered to be high risk. In fact, since the insurers specify the group of investments available, any mutual funds offered are usually of high quality, which lowers the investment risk. Even so, there is risk for the investor since there are no minimum guarantees as seen in fixed annuities. The goal, of course, is higher returns than those available in fixed annuities.

Investment and Insurance Component

  Variable annuities are structured to have both an investment and insurance component. During the accumulation phase, premium payments are used to purchase investment units, with the price depending upon the value of the variable annuity’s underlying asset portfolio. The quantity of units bought will depend upon unit pricing at the time of purchase. Variable annuities resemble mutual funds during the accumulation phase (although there are differences between the two). Mutual fund providers manage the assets in many recent variable annuity products. The dividends, interest, and capital gains on the assets that underlie the investment units are reinvested to buy additional investment units.

  Once the accumulation phase ends, the variable annuity’s accumulated value of the investment units is transformed into “annuity units.” This transformation happens as if the accumulation units were cashed out and used to purchase a hypothetical fixed annuity. The annuitant does not receive a stream of fixed annuity payments, but this hypothetical annuity plays an important role in computing actual payouts. The payout amount for the hypothetical annuity is used to credit the annuitant with a number of annuity units.  Many variable annuities allow annuitants the option of choosing a fixed annuity stream, or some combination of a fixed stream of income and a variable stream of payouts.

  Actual payouts from variable annuities will depend upon the number of annuity units that the annuitant is credited with and the value of the assets it contains. If the value of this portfolio rises by more than the increase implicit in the assumed interest rate, after the annuitant has converted to annuity units, the payout might rise during the payout phase. The opposite could also happen. If the values decline, payout could decrease. The potential payout variability is called an advantage by some (protecting funds against inflation), and a disadvantage by others (making retirement income both impossible to determine and impossible to depend upon).

  The past years have expanded the menu of investment options available for variable annuities. The range of portfolio investments available has certainly increased. The first variable annuities focused exclusively on diversified common stock portfolios. Today’s policies offer variable annuities tied to more specialized portfolios of equities, as well as bonds and other securities. Usually, policyholders may move their assets among various policy sub-accounts, offering different investment objectives, without fees or penalties. Virtually all variable annuities now offer lump-sum withdrawal options after the policy has reached a specified maturity date and there may be the possibility of withdrawing the principal in a set of periodic lump-sum payments. As a result of these features, it is possible to use variable annuities as an asset accumulation vehicle without necessarily purchasing an annuity-like payout stream once the accumulation phase ends. That is because it contains a purchase rate guarantee. Some no-load mutual fund families now offer variable annuities in conjunction with some insurance companies. There are fees connected to variable annuities due to the types of investments and investment features involved.

The Variable Annuity’s Introduction

  The Teachers Insurance and Annuities Association-College Retirement Equity Fund (TIAA-CREF) first introduced variable annuities in the United States in 1952. The first variable annuities were qualified annuities that were used to fund pension arrangements. Their growth was slow up into the 1980’s because regulatory approval was needed from many state insurance departments before new variable products could be introduced.

  Although variable annuities have seen much growth over the last twenty years, there is still heated debate over their use. In other countries variable annuities are selected much more often by investors than in the US. Over the last several decades their popularity has gone up and down like a roller coaster. Since all types of investments need to be considered on an individual basis, it is wrong to vilify one type, since its consideration should be based on the situation.

  Variable annuities are professionally managed (a plus) and usually funds can be easily transferred between funds but there may be a narrow selection of funds to choose from (a negative). Variable annuities are protected and regulated by various state and federal agencies, such as the SEC and the NAIC.

Wrap-Around Annuities may also be called Switch-Fund Annuities.  A life insurance company joins a mutual fund organization managing several mutual funds with different goals and investment policies. The insurer provides the annuity contract, and the mutual fund company provides the investments. The annuitant has greater investment choice since there is the freedom to specify which mutual funds, they invest in. Taxation is different in this type of annuity since the investor maintains so much investment control. It is important to seek professional tax advice when considering this annuity. The IRS terms wrap-around annuities “investment annuities.”

  CD-Like Annuities are a hybrid of the single premium deferred annuities.  These were developed to compete with the Certificates of Deposit that banks sell. The policyowner receives a greater liquidity and rate of return similar to Certificates of Deposit. There are typically very short insurer surrender penalties, although any IRS penalties would remain. Even though there is greater liquidity in CD-like annuities, they still provide the safeguards of other annuities, including minimum rate guarantees when they are fixed annuities. Commissions are typically very low since liquidity and other features allow a shorter time period for the insurer to make a profit. Most of these products run for periods of one, three, or five years. Availability to add deposits or withdraw funds generally exists for 30 days at specified time periods. These time periods are called “windows of opportunity” and occur after each guaranteed interest period.

Retirement Advantages

  Several factors have contributed to the growth of individual annuity products, especially variable annuities. These factors are likely to continue to generate annuity sale growth. First is the tax-deferred status of annuities. While there are other financial vehicles that provide this, continually fewer opportunities exist as Congress seeks greater federal income. The Tax Reform Act of 1986 limited the opportunity for tax-deferred savings through individual retirement accounts and other tax changes have further eroded the effectiveness of some financial vehicles.

  Perhaps one of the largest factors in annuity growth has to do with our retirement funds. As fewer companies offer the types of pension plans seen in past years, workers are becoming increasingly aware of the need to set aside funds. While there are many homes for savings, few offer the advantages an annuity does. Additionally, the ability to set up a lifetime income at some point makes retirement sense.

  The demographic trends and the nature of the country’s budget policy also suggest a need to save for our retirement. When the baby boom generation hit middle age (traditionally the age when retirement funding seems to loom over us) they looked around for financial vehicles that would suit their needs. Annuities seemed a perfect fit.  There is some statistical evidence that the baby boom generation is attracted to variable annuities more than previous generations have been. Furthermore, no one is especially confident in the Social Security system, although it is unlikely that funding will cease, despite some dire predictions. We certainly question how many dollars will be available from the program as more and more people crowd into it.

  Variable annuity growth is probably related, at least in part, to the increase in stock prices and the coincident decline in long-term interest rates, which has stimulated investor interest in annuities in general.  There is less fear regarding the uncertainty of variable annuity payouts than there used to be. The generation entering retirement is more concerned about inflationary factors that would erode their income.

Estate Advantages

  Annuities have estate advantages in most cases. When properly set up, an annuity will eliminate the delays and costs of probate, though it will not necessarily prevent taxation on the invested money. An annuity will give the contract owner control of the assets through restrictive beneficiary designations. For example, by adding the words “per stirpes” (Latin for “through the blood”) to the beneficiary listing, the owner’s annuity assets will never be distributed outside of his or her own bloodline even if the listed beneficiary dies prior to the policyowner. This is often used for assets acquired prior to a second marriage, where the policyowner may want to be certain that his or her assets stay with their own children if both partners are killed in the same accident. Per stirpes is often referred to as the “in-law-avoidance clause.”

  Policyowners can restrict the ways in which their beneficiary is able to receive their annuity funds. If beneficiaries have had difficulty managing their money, a monthly income is often preferable to simply giving a lump sum inheritance.

  Annuities are private contracts. Like the living trust, they are not open to the public. For those who do not have need of a trust, an annuity may be able to accomplish the same goal without the expense and upkeep that a trust would require. Only the insurance company, the writing agent, and the policyowner have access to the annuity terms. This enables the owner to provide differently for each of their beneficiaries without each of them knowing what the other received.

For Example:

  Jackson has three sons. Jeff went to college, acquired a high-paying job and has good earning potential. Jason entered a technical school. He has two years remaining, but his earning potential is also very good if he graduates with good grades. The third son, Joseph, is still in high school. Even though Jackson is in good health he initially sets up his beneficiary designations in the following way:

a. Jeff receives 10 percent of the account value,

b. Jason receives 40 percent of the account value, and

c. Joseph receives the balance (50 percent) of the account value.

  Since Jackson may change his beneficiary designations as needed, he knows that he can equalize the beneficiary percentages once all three sons have completed college or vocational training. His sons will not know what the other received unless they choose to tell each other.

  Many states consider annuities as “beneficiary-designated money.”  When such definitions apply, annuities are usually safe from creditors.  Add to this the ability to keep the contents private and annuities are certainly a key part of any estate-planning blueprint.

While there are various annuity settlement options available,

many choose to receive a lifetime income.

  One of the greatest fears of retirees is outliving one’s money.  While no one wants to die sooner than necessary, if funds have been depleted it is likely that the final years will be marked by poverty.  While there are various settlement options available, many choose to receive a lifetime income. This is a gamble since the annuitant is gambling that he or she will live long enough to collect more than their account value while the insurer is gambling that the annuitant will die sooner than expected. When a lifetime settlement option is chosen, no remaining funds will be given to beneficiaries. Even if the annuitant received only one payment, under a lifetime settlement option, all remaining funds would stay with the insurer. This is not the insurance company being greedy; it is how the insurer is able to pay for the lifetime of all their policyholders. Those that die prematurely are paying for those who live far longer than expected.

  Most annuities are purchased from insurance companies, although this is not always the case. Private annuities may also be purchased from a private individual. While annuities purchased from an insurance company are required by law to maintain certain reserves, this is not the case for private annuities. When two parties create their own annuity contract, there are no reserves required and no state regulatory oversight.

  The Internal Revenue Service has published tables for valuing private annuities since there is certainly not the same assurance that funds will be paid. A loss under a private annuity is disallowed for federal income tax purposes when the other party is a spouse, brother, sister, ancestor or lineal descendant. Various fiduciary relationships between the parties may also result in an automatic disallowance of loss.

  Why would an individual use a private annuity? In most cases they are used between family members, business associates, or others that have a personal relationship of some kind. These annuities are often a contract for special circumstances. 

For Example:

  Margaret knows her health is deteriorating. She should have purchased a long-term nursing care policy, but now that she is sick, no insurer will accept her as an insured risk. She discusses this with her granddaughter, Melody, who is a single person with no dependents. Her granddaughter agrees to quit her job and live with Margaret, caring for her until she dies. Melody must receive income since she has her own financial obligations.  To cover the needs of both, Margaret sets up a private annuity.  She deposits a lump sum into an account that is set up to pay Melody a specified amount each month for as long as Margaret lives.  If Margaret should die prior to using the account balance Melody will receive the remainder of the funds. Although the private annuity is sufficiently funded to provide Melody with ten years income, the contract still requires Melody to continue Margaret’s care even if the funds deplete. If Melody does not fulfill her contract obligations during the ten-year funding period, monthly payments will stop.

   There are several problems with private annuities. One of the most obvious problems is that of performance. There is usually no way to assess whether Melody adequately performs her duties. If she continues to live with Margaret, who will determine the level of care provided? Who determines if Margaret is getting any care at all? If an outside agency is contracted who pays those bills? If Margaret has allotted all the assets she has to Melody, she may or may not have adequate funds for her other health care needs. Additionally, since full time care is very demanding, what happens if Melody becomes ill? Does she still have a right to receive her monthly income? If she does not continue to receive a monthly income that could force her to seek employment elsewhere once her health resumes. In that case, Margaret would have no one to care for her, she still would not qualify for a long-term care insurance policy and there is no guarantee that she would qualify for Medicaid (the joint state and federal program for the poor). Most professionals recommend that each party’s lawyer review private annuities. This may prevent errors that would render the contract useless.

Competition

  Annuities have always competed with other types of investments. In fact, different types of annuities may even compete against each other. Since each type of investment has both strengths and weaknesses the various annuities often work well as one of several financial vehicles. It is important to note that different annuities are designed with different goals in mind. There may be a trade-off when selecting one annuity product over another or even when selecting one financial vehicle over another.

  When an investor is considering an annuity product, he or she will be considering such factors as the costs of any insurance involved, the costs of surrender charges if the annuity is withdrawn prior to the end of the contract, potential tax advantages, any transaction costs that might be involved, and the investment options associated with the various financial vehicles. Sometimes an annuity will be a good choice, but other times some other financial vehicle will be the better choice.

  The insurance feature of annuities distinguishes them from many other types of financial products. Even though fixed annuities do not have any actual life insurance involved, they still use an insurance feature, which is the guaranteed lifetime income option. Annuities insure against the risk of living too long (living longer than our money). Some annuities may offer insurance with respect to the rate of return on the invested capital as well. Both fixed and variable annuities insure mortality risk, and they are the only products that permit buyers to contract for a guaranteed lifetime income. Only fixed annuities guarantee the amount of periodic lifetime income. Variable annuities merely guarantee an income, not an amount of income.  Some specific annuity products may use aspects of insurance besides those we have mentioned.

Even though fixed annuities do not have any actual life insurance involved, they still use an insurance feature, which is the guaranteed lifetime income option.

  Individual annuities provide insurance features regarding changes in the insurance market. For example, deferred annuities must guarantee the participant the right to purchase an annuity on particular terms years ahead in the future. This insures against changes in aggregate mortality risk that results in changes in the pricing of annuities, as well as against changes in expected rates of return that could result in modified terms in newly issued annuity contracts.

  Providing these insurance features affects the cost of annuities. The insurance value must be considered when choosing an annuity product since the costs of these features is built into the performance of the product. The management cost associated with variable annuities usually average between 100 and 150 basis points per year. This is much higher than comparable expenses for many mutual funds.  Considering this, why would an investor choose a variable annuity over a good mutual fund account? The variable annuity is chosen because the investor wants the insurance features involved and is willing to pay for those features. Tax deferred status is likely to have also played a role in the decision.

  Annuities have surrender penalties (charges) for withdrawing principal prior to the contract’s end. These penalties would not apply if the annuity were annuitized, nor would they apply if principal were part of the allowable 10 percent yearly withdrawal features. Most annuities have a maturity date of at least five years. A few may be as little as one year.

Annuities have surrender penalties (charges) for withdrawing

principal prior to the contract’s end.

  Insurers justify the use of early surrender penalties or fees as a necessary element in order to recover the commission and other production costs associated with annuity products. The insurer is able to recover these costs when the funds remain in the vehicle until the maturity date.

  The Internal Revenue Service may also charge a 10 percent early withdrawal penalty on annuity products, but for a different reason.  The IRS is not compensating for commissions and management fees; they want the funds left in the annuity until age 59½ because the monies are considered retirement funds. The tax-deferred benefit is granted for this goal, so an individual who withdraws funds prematurely should not, in their view, escape penalty. This IRS view of annuities is one of the major reasons annuities are primarily marketed to those who are older. While younger investors may also benefit, they are less likely to be saving for retirement during their twenties and thirties.

  While there are product variations, most annuities have surrender charges between 5 percent and 10 percent lasting for five to ten years. A typical 10-year contract annuity might look like this:

First year principal withdrawals:	10 percent fee
Second year principal withdrawals:	9 percent fee
Third year principal withdrawals:	8 percent fee
Fourth year principal withdrawals:	7 percent fee
Fifth year principal withdrawals:	6 percent fee
Sixth year principal withdrawals:	5 percent fee
Seventh year principal withdrawals:	4 percent fee
Eighth year principal withdrawals:	3 percent fee
Ninth year principal withdrawals:	2 percent fee
Tenth year principal withdrawals:	1 percent fee

  There would be no insurer surrender fees in the eleventh year and thereafter. If the investor were not yet age 59½ there could be IRS penalties for withdrawal.

  Companies were most likely to use surrender penalties in the 1930’s and 1940s, although most products still contain them today. It should be noted, however, that not all annuities include surrender penalties, and they tend to be used for a shorter time period than in the past. In the 1940s some annuity products also contained a loading charge.

  Other products may contain surrender charges. Some mutual funds impose a special charge on investors who withdraw funds prior to a specified holding period. It may not be called a surrender penalty, but it functions the same way. Most investors understand the purpose of surrender penalties and similar charges. Since the investment is intended to be a long-term vehicle, the consumer generally accepts these fees.

  Most annuities are tax-deferred vehicles, meaning the interest earned is not taxed until withdrawn. Currently, the IRS considers the first money out to be interest; it is not possible to specify principal as being withdrawn first.

There are both “tax-qualified” and “non-tax qualified” annuities.

  There are both “tax-qualified” and “non-tax qualified” annuities.  Those that are qualified are part of a qualified retirement plan and are purchased with pre-tax dollars. Annuities that are non-tax qualified are purchased with after-tax dollars.  Between the time that the dollars are deposited and the time they are withdrawn, usually no taxes are due on the earnings. Once payout begins, whether through annuitization or lump-sum withdrawal, taxes are due on the difference between the annuity payouts and the annuitant’s policy basis. The key tax principle is the derivation of an exclusion ratio, an estimate of the ratio of the contract owner’s investment in the contract to the total expected payouts on the contract. The exclusion ratio is multiplied by the annuity payout in each period to determine the part of the payout that can be excluded from taxable income.[1]

  Mutual fund investors pay taxes when their fund receives dividends or realizes capital gains. Mutual fund investors are liable for both dividends and capital gains taxes even when no shares are sold. In contrast, annuity investors do not deal with taxes unless interest is withdrawn. The liquidity of annuities is limited since a loan, pledge, or assignment of an annuity is treated as a taxable event.

  Annuity payouts are typically taxed as ordinary income rather than capital gains. This often means a lower taxable rate. These taxation features are not necessarily the reason investors purchase annuities, but they certainly help persuade them to do so. The ability to shield financial growth from taxation is a powerful asset-building tool.  While it is possible to show many examples of the mathematical difference this makes, the equations are often lost on laypersons. However, the disparities are largest when the investment is allowed to grow over a long period of time, when the rate of return is high (7 percent or more), and when the marginal tax rate is high. In some cases, the principal at retirement from investing in a tax-deferred account can be more than double that of investing through a taxable account.

Investment Expenses and Loads

  When considering any type of financial vehicle, it is important to consider the investment management fees associated with the product. Certainly, investment staff must be paid and there is overhead for any business, but the investor does not want to pay more than practical or necessary.

Variable annuities may include a contract expense fee,

as well as a fund expense fee.

  Annuity fees take the form of an expense charge that the insurer deducts each year.  Variable annuities may include a contract expense fee, as well as a fund expense fee. Mutual funds charge investors for management expenses, and possibly up-front loads or redemption fees. Other investments will have fiduciary fees or other types of expense fees or loads. It would be unrealistic to think that any type of investment could function without somehow receiving part of the pie.

  Measuring the effective load on annuity products is not a quick and easy process. Some types of vehicles, such as variable annuities can develop loads (costs) from adverse selection (the possibility that the mortality experience of annuitants is more favorable than that for the population in general). Statistically, annuitants live longer than do randomly chosen individuals from the population at large.  While no one can say why this is true, several studies have confirmed it.  As a result, it is likely that calculations that use the average population mortality experience to compute the expected present discounted value of annuity payouts will make annuities appear less financially attractive than they actually are. A person that lives longer than average collects more from a lifetime annuity than would a person who dies early or at the average lifetime age.

  As we know, the insurance industry is one of the most regulated in the country. The legal and regulatory climate for annuity products, especially variable annuities, is complex and constantly changing, as individual states continue to pass legislation. Most insurance regulation involves consumer protection. Annuities are long term commitments. Consumers make large up-front payments in return for promises of lifetime income. Obviously, it is important that the insurers making those promises to have the financial ability to fulfill them. Fixed annuities are regulated as insurance products, while variable annuities are regulated both as insurance products and securities. Therefore, variable annuities are subject to federal security regulation and state insurance regulation. When other institutions, such as banks, are eventually allowed to produce their own annuity products, additional legislation is bound to follow.

  Annuity regulation in closely tied to life insurance regulation. Until 1850 there was little regulation of the insurance industry in the U.S. It is not surprising that there were several scandals involving invested funds.  As a result of those scandals, in 1850 New Hampshire became the first state to appoint an insurance commissioner, with other states soon following. By the early 1870’s virtually all states had insurance regulatory control. In 1945 the United States Congress passed the McCarran-Ferguson Act confirming the need for insurance regulation. State insurance regulation is not uniform, so there are variances from state to state.

  Especially in the early years of annuities, buyers had little knowledge of the insurance industry. They certainly did not understand annuities.  Insurance regulation came about because this lack of understanding led to serious consumer issues. Many types of annuities involve investment decisions and even decisions relating to mortality risk.  Few consumers are educated enough to fully understand the complexities involved. Regulation often involves restrictions on the types of policies that can be offered, constraints on how contracts must be explained to buyers, limits on what constitutes an acceptable expense, and regulations on the capital that insurance companies must have, and the types of investments insurers may utilize.  Insurance regulation is intended to protect consumers by increasing the safety and security of the promises they receive from insurers.

  There is no doubt that investment regulations affect insurance companies. They are regulated in virtually every area of business, including how they may invest consumer funds. So-called “legal lists” describe the set of securities that insurers may invest in and the fraction of their assets that may be held in different securities. The rates of return insurers may offer on fixed annuity products are directly affected by these regulations since they usually restrict the amount of high-risk securities in insurance portfolios. It is the high-risk investments that are most likely to offer high return. Of course, these same investments also have the potential for loss. Group fixed annuities are subject to additional regulations from the provisions of ERISA, which mainly affect the structure of contract terms.

  Variable annuities are regulated differently than fixed annuities. The insurers must maintain separate asset pools as reserves against variable annuities. The goal is to prevent poor variable annuity returns from affecting the capital base of other types of insurance products. As we said, variable annuities are also regulated under the federal securities law, under the provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. The first two acts concentrate primarily with the prevention of fraud in the issuance and trading of securities while the ICA of 1940 empowers the Securities and Exchange Commission to regulate the insurance industry’s sales of insurance products containing a substantial equity component, such as variable annuities.

Variable annuities are regulated under the federal securities law.

  Annuities are both an investment and an insurance product. As a result, other financial institutions have long felt that they should be allowed to develop and market products similar to annuities that would qualify for the same tax treatment. Why are only insurers currently allowed to underwrite and sell annuities? The historic rationale was that annuities relied on such things as risk sharing and indemnification that insurance companies were already expert at. Annuities have been viewed as very similar to standard insurance contracts. However, with the evolving nature of annuity products this may no longer be true.  There is now debate as to whether there is a large enough insurance component in today’s annuity products to continue restricting who can develop and market similar contracts.

  There are two issues, one of which has already been settled.  NationsBank v. Variable Annuity Life Insurance Company (VALIC) concerned the right of national banks to sell annuities as insurance producers of insurance companies. The Supreme Court’s decision upheld the authority of banks to sell both fixed and variable annuity products. The second issue concerned who may underwrite (develop) annuity products. In late 1994 the United States Comptroller of the Currency (who regulates the products that banks may offer) approved the offering of some annuity-like products by some banks. Most professionals feel banks and other financial industries will eventually begin to develop and market similar products in the future. This will especially be true if the products enjoy similar tax advantages as those currently granted to annuities.

Similarities

  The IRS defines pensions as a series of definitely determinable payments made to an individual after he or she retires from work.  Pension payments are made regularly and are based on such factors as years of service and prior compensation. Annuities are defined by the IRS as a series of payments under a contract made at regular intervals over a period of more than one full year. They may be either fixed or variable. An annuity may be purchased by an individual or with the help of an employer.[2]

  Pensions and annuities are similar vehicles, even in the view of the Internal Revenue Service. Recently many types of retirement vehicles, including annuities, have come under fire for various reasons: some feel annuities offer too little growth, some feel they are not fully understood by those who buy them, and some feel agents sell more on the basis of commission than value. Of course, many others recognize the potential of annuities when properly included in the overall retirement portfolio. According to U.S. News & World Report[3] academic research shows investors can afford to withdraw only four percent to five percent of their savings annually in order to ensure their money will last 30 or more years. Therefore, annuities may be especially valuable when interest rates fall below this level. When annuitized for a lifetime income, retirees can be sure that they will continue to have income no matter how long they live.

  Fixed annuities are designed to produce stable income during retirement. Even the IRS defines annuities in comparable terms with pension plans. In its simplest form, a fixed annuity is a contract that allows an individual to receive an income for life. Of course, the amount of income is dependent upon the amount of money placed in the annuity. As is the case for pension income, there is no guarantee that the annuity lifetime income will be adequate. Individuals must plan throughout their working years to set aside enough income in all their retirement vehicles to add up to enough to live on during their retirement.

  Annuities are generally considered conservative vehicles performing modestly but stably over time. At times annuities may be a better investment, depending upon market conditions. Baylor University Professor William Reichenstein studied various portfolios between 1972 and 2000. Although this is an older study, there is no reason to believe that changes the results. He reported that a 65-year-old retiree with a $1 million portfolio invested in a mix of 40 percent stocks and 60 percent bonds withdrawing $45,000 each year from his account would run out of money at the age of 88. This was due in part because of the poor performance of stocks in the early years, which can happen during any time period. Had the 65-year-old taken half of this portfolio and bought a fixed annuity, he would still have had $136,000 left by age 95. Since many people live beyond age 90, that is important.

At times annuities may be a better investment than stocks,

depending upon market conditions.

  Reichenstein says fixed annuities function like bonds in a portfolio, but with the added advantage of the lifetime versions available with annuitization. Bonds can lose risk, but annuities do not since most of them come with a minimum interest rate guarantee.

  Rande Spiegelman, Vice President of financial planning for the Schwab Center for Investment Research said: “If you think you need a million dollars to retire but saved only $750,000, you can annuitize a portion of the account to spend as much as someone with $1 million.” There is some disagreement if his statement is true, but it may be worth considering.

  Despite the advantages of annuities, they may not work well for everyone. For example, some individuals may already have enough guaranteed income through pensions and Social Security income. Few professionals would recommend that anyone place all their savings into an annuity, since diversity is key. There should always be a portion of the savings in some vehicle that allows easy and quick access in case of emergencies or other immediate cash-flow needs. An annuity locks away cash. This is especially true once the contract is annuitized.

  The first rule in financial planning is simple: avoid hasty decisions at all times. This is not a statement for or against any particular choice.  It simply makes sense to consider all financial options before jumping into any particular financial vehicle. Annuity payments, for example, are tied to long-term interest rates. If the investor believes they will soon rise, perhaps waiting to purchase the annuity would be wise.  Annuity payments are also tied to age, just as Social Security income is. Therefore, waiting to annuitize and begin withdrawing funds will increase the amount of monthly income received from the annuity.

  Some specialists suggest layering annuities, in the same way Certificates of Deposit are often layered. They feel this allows access to a portion of the money that has not yet been annuitized if necessary due to an emergency or cash flow crisis.

  Many annuities now come with inflation protection, but it is important to realize that any additional option that is purchased comes at a price – sometimes a high price. Annuities are intended to be part of, not the entire, retirement package. While company pension plans can no longer be relied upon, it would be foolish to think an annuity will automatically be adequate. Just as pension income may or may not be adequate for the long haul, annuity income will also depend upon the amount invested. Even when it seems adequate, as costs soar, the income may not cover every need that arises. No insurance producer should ever state or imply any guarantees of that sort.

  Annuities are valuable estate planning tools. Some professionals consider them an essential part of proper retirement and estate planning while others prefer other types of investment vehicles. Whether annuities are used or not will be a personal choice. However, there is no denying their importance. Annuities are used by lotteries, employers for retirement plans, and by government entities. Obviously, annuities will continue to play a role in our financial plans for some time to come.

End of Chapter 6

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[1] History of Annuities in the U.S. researched conducted by James Poterba

[2] IRS Publication 575 (Main Contents)

[3] U.S. News & World Report