Chapter 14
TAX-DEFERRED ANNUITIES
Deferred annuities have been used for years, but they are becoming more popular since past tax reforms.
Deferred annuities can serve as an alternative to the IRA. Some individuals lost some of their incentives to continue making IRA contributions following tax reform. Although annuity contributions are not tax deductible (unless used to fund a qualified account), earnings do accumulate tax deferred. One advantage of an annuity over an IRA is the fact that there is no limit to the amount of money that may be invested in an annuity. An IRA is limited.
Deferred annuities may be considered to be part insurance and part investment, although there is no actual life insurance involved. The accumulating funds would be the investment portion and the available guaranteed regular monthly income payments for life would be the insurance component. There are several payment options available. Guaranteed lifetime income is only one option available.
The popularity of annuities seems to go up and down depending upon current trends. During times of inflation and high interest rates, tax-deferral is more important to consumers. As a result, when interest rates are high, annuities should be one logical investment choice. Many people use annuities as a pension for varied reasons. IRAs and Simplified Employee Pension Plans (SEPP) work well when placed in annuities.
While annuities may seem confusing to many consumers, they actually have many of the same properties as a bank loan. A bank deals in credit, as we previously stated. A bank lends money because it expects to be paid back, with interest, over a set period of time. When a consumer deposits money into an insurance company's annuity, he or she expects to receive back all of their principal, plus interest. The insurance company issuing the annuity invests in long-term investments which earn a higher yield than the rate of interest they are paying the depositor. Since the company invests in long-term investments, penalties are imposed if the depositor withdraws their money early.
Annuities have many variations, but they do all fit into one of several basic forms. Annuities may be paid in (or loaned to the insurance company) by:
Of course, the investor will receive a return on their investment in the annuity. How that return is received may also vary. An annuity may be used as the vehicle for an IRA (Individual Retirement Account) or a Keogh Plan with all the advantages of an IRA or Keogh plan. Otherwise, only an annuity's interest earnings are tax deferred. The principle would not be, unless, as stated, the annuity is used to fund such things as IRAs and Keogh plans. Traditionally, an annuity is a tax-deferred investment.
To many Americans, the term "annuity" is a hazy concept. While they have heard the word and may even know that it has to do with an insurance company, relatively few understand any of the features involved. Many people are not sure whether to classify an annuity as an insurance policy or an investment.
The word "annuity" means "a payment of money". The insurance industry designed them to do just that. Although the deferred annuity was originally designed with income features in mind, today they are looked at more for their ability to accumulate and less so for their ability to distribute income at a later date. Since it is important for the consumer to have confidence in the safety of the company, it is important to recommend investment grade annuities to potential clients.
As with all insurance products, due diligence is essential when recommending a product to a client. This is certainly true of annuities also. There can be differences in annuity products that may be critical to the needs of the client; especially when establishing and maintaining an estate.
An annuity is often used as a safeguard against living too long; outliving one's income or savings. Although we are dealing with setting up an estate in this course, it would certainly be foolish to overlook one's needs before death!! Annuities have a minimum interest rate in most policies. When interest rates dive, as we saw in late 1992, this minimum rate becomes advantageous. The minimum rate is the lowest rate of interest that would be paid to the annuitant no matter what else happens. Of course, the annuitant prefers a higher rate than the minimum, but that may not always be realistic.
Most annuities have a 100 percent guarantee of principal and an ongoing guarantee of all accumulations. Since contracts do vary, however, it cannot be stressed enough that the writing agent must read the contracts in their entirety before recommending a product or stating how it operates.
Annuities are used for many purposes besides retirement, although that is a common use. They are used for business partner buy-outs, education needs (such as college) and deferred compensation plans.
The history of a company's investment portfolio should be considered before recommending a company to a client. So should the quality of bonds and investments in the portfolio. As an agent, you will also want to be aware of the length and amount of surrender penalties involved. It is not unusual for those penalties to have a direct relationship to the commissions paid. To be ethical, commissions paid should be at the end of the list when considering products for your clients.
Charge-backs of commissions may vary greatly from company to company. Many will charge-back the commissions if the annuity is surrendered in the first year. Some will charge their agents a charge-back if the client dies within a set period of time. Some charge back commissions if the client annuitizes their contract within the first five years. Some insurance companies impose charge-backs by graduation into the second and third years. This is something that the agent will certainly want to be aware of and investigate, if necessary.
Annuities are an extremely useful estate planning tool. Annuities are a form of capital that the individual cannot outlive. Since annuities give the ability to have a monthly income, it allows other wealth to be distributed if so desired for the pleasure of giving or to reduce taxable assets. In some of the larger estates, the freedom to dispose of taxable assets (while enjoying the pleasure such gifts bring) can virtually eliminate taxation. Annuities can also cut down the expense and delay of probate if the contract names beneficiaries other than the estate.
Recent trends brought the annuity into the 1990's with gusto. Retirement trends are focusing on annuities in growing numbers as workers become more and more fearful of inadequate pension funds. Annuities are also being marketed more and more by individuals in banks and other firms.
An annuity is simply a periodic fixed payment for life or for a specified period, made to an individual by an insurance company. In the last few years everyone from bankers, stockbrokers, accountants and even attorneys have acquired insurance licenses. Probably the most notable industry to go into the insurance business are the banks and savings and loan institutions.
Many insurers are jumping through hoops to provide contracts and assistance which enable the banks to sell their products. There has been some very successful marketing done through the banking and savings and loan institutions. Some have noted, however, that many of the sales of insurance products have also experienced a loss of earning potential (for the client) due to expenditures and costs attributed to banking activity. These expenditures can sometimes attribute to the banking industry's "invisible profit". Even so, the sale of insurance products, primarily annuities, has been a success.
It is interesting to note that the experience of insurance companies show that those who purchase annuities do, in fact, tend to live longer than the general population. While we do not know why that is, it could probably be safely assumed that it has something to do with less stress about financial matters. Perhaps there is less concern by the annuitant that, in their old age, they will do something foolish with a bulk sum of money since, once annuitized, there will simply be a monthly income set for life. Perhaps there is actually more monthly income available enabling them to take better care of themselves. No one really knows why this interesting fact exists.
Annuities have long been noted for their stability. Finding a safe investment while still obtaining a decent interest rate is often the objective of investors. For the client, an annuity may not look much different than a Certificate of Deposit. Therefore, many people may prefer the certificate since it is generated from their local bank. The fact that they can go stand in the middle of their bank (and cannot go stand in the middle of the insurance company) may cause them to continue in their Certificates of Deposit. However, upon closer evaluation, an annuity is a much better buy. While the interest rates may appear similar, when taxation is factored in, the annuity offers much more return assuming that the money is being left in the policy to multiply.
In the early 1920's, the United States government began using annuities to fund government retirement plans, as did labor unions. Due to the requirements the government mandated, the insurance industry came up with two safety features:
A reserve system for annuities was first introduced during the 1920s (backed by the insurance companies' financial reserves). The legal reserves system required then, and still requires today, that insurance companies keep enough surplus on hand to cover all cash values and annuity values that may come due at any given time. It is these reserves that enable the minimum interest rate guarantees to exist.
The reinsurance network was designed so that if there was a large run on the money in the insurance industry, no one particular company would be required to take the brunt of the loss. The insurance companies spread the risk out among all of the companies offering similar products.
Although annuities have been around for a long time, it took the October 19th, 1987 stock market crash (referred to as "Black Monday") to bring them back to prominence. Annuities were primarily unaffected by this event. Investors and investment counselors were quick to take note of this.
When the great depression hit the country in the late 1920s, over 9,000 banks went under (bankrupt). Certainly the stock market was devastated. Stocks and bonds simply were not worth anything. There was no money and no way to obtain any money. The exception to the utter economic disaster the country experienced were insurance companies. They had enough cash on hand to pay their policyholders. The companies continued to pay their guaranteed minimum interest rates that had been established years earlier. After the depression hit new laws passed by Congress required many of the other financial industries to provide some of the same safety features on their products.
Certainly a lot has happened since the 1920s. It is not unusual to hear dire predictions for life insurance companies. However, clients do not lose money with life insurance products. Baldwin United is an example of a serious failure. Even in this event, investors did not lose their money, although delays in receiving their funds did occur.
Annuities have an interesting history which few agents happen to look at. From 1973 to 1978 the most popular annuity products carried a permanent seven percent surrender charge. Yes, that is right: a permanent surrender charge. The only way to avoid this charge was to annuitize.
Then a few innovative companies began to add other features such as bailout options and limited surrender penalties. Bailouts allowed the client to withdraw their money without penalty charges if the interest rate on their annuity fell below the initial rate. Once the bailout feature hit the market, a new generation of products developed.
In the 1980s, the New York Stock Exchange member firms began to aggressively market bailout annuities. As interest rates hit all time highs, insurance companies quickly had to become superb asset managers rather than just good risk managers.
It was at this time, when record high interest rates fueled uncontrolled growth, that the insurance industry experienced significant setbacks. One such setback was Baldwin United. Their internal investments and questionable accounting procedures eventually resulted in their block of annuity business being sold to Metropolitan Life.
Charter Oil suffered from the 1981-82 oversupply of oil and gas that crippled the entire industry and resulted in Charter Oil selling their annuity block to Metropolitan Life also. There is one very important point to make note of: in both cases, the contract-holders did not lose any of their investment. Policyholders continued to earn tax-deferred interest in the 7 to 8 percent range. The system worked--without a government bailout. The savings and loan industry has proven the benefit of the insurance system.
The early 1980s 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.
The two-tiered annuities were designed to reward the consumer who decides not to surrender their annuity by offering a higher first tier interest rate. If the policy was surrendered or transferred to another carrier, a lower interest rate (which is the second tier) was retroactively applied. The two-tiered has, in effect, a second and permanent surrender charge in the form of the lower interest rate. The two-tiered annuity never did gain the popularity that the other annuities enjoyed.
The two problem companies previously mentioned, Baldwin and Charter Oil, and the passage of TEFRA, caused annuity sales to drop. During this time, new annuity products emerged. Surrender periods were reduced, bailout provisions improved and a move towards multiple year guarantees developed. It was not unusual for three and five year guarantees to be offered by the major companies. Many of these new annuities were specifically designed to compete with Certificates of Deposit. It was also during this time that banks and savings and loan institutions began to market their own annuities.
As we have moved into the 1990s, annuities have played a larger and larger role. Although there certainly are products which will take the consumer on either a long ride (due to longer surrender periods) or an expensive exit (due to high penalties), many of the products now offered are very consumer oriented. If interest rates continue to stay low, the sale and promotion of indexed rate products will grow. This will be a reflection of the consumer's fear of rising future interest rates and their desire to have upside protection. In other words, if the interest rates rise, the consumer wants to be sure that his or her annuity yields wills also rise.
It is possible that the agent will begin to see some changes in commission schedules in the future. There is talk of spreading out the commission over the life of the annuity contract (during the surrender years). Chances are that commissions will also become lower as companies try to stay competitive in the marketplace.
As annuities become more competitive, insurance companies may be tempted to over-extend themselves. Due Diligence requires that the agent evaluate the carriers that they represent. An agent should know where their carriers are investing their money. An agent should know for how long the money is invested. Most importantly, an agent should know the ratio of assets to liabilities in the companies they represent. Remember that the size of the assets alone means very little. If liabilities outmatch assets, trouble could possibly develop.
One of the major reasons that our savings and loan institutions came into such trouble was due to the competition which drove the interest rates up that were offered on Certificates of Deposit. The rates simply went higher than the institutions could afford. Certainly other factors were also a part of the problem, but interest rates that were too high was a major problem. Now every savings and loan institution is regulated by the United States government. If the insurance industry wishes to remain outside of further government regulation, it is important to understand that bad products cannot exist if agents and brokers do not sell them.
Annuity sales (investments) have nearly tripled over the last decade. In 1989 alone, about 30 billion was invested in annuities. The trend appears to be continuing. Tax deferred earnings, guaranteed interest rates, safety of principle, liquidity and freedom from probate are good reasons for looking towards annuities in record numbers. Most annuities do not have any sales charges deducted.
While there are many reasons to purchase an annuity, the most stated reason is the tax deferral advantage. Tax deferral makes a difference in several ways:
Taxes will eventually have to be paid. However, since the annuitant is in the position of deciding when to withdraw funds, the annuitant also decides when the taxes will be paid. This can be most beneficial.
A part of each payment received by an individual from his or her annuity is considered to be a return on his or her original investment and is, therefore, excluded from their gross income. The amount of this exclusion from the gross income is determined by the "ratio of the investment" to the total expected return under the contract. The "return" is the amount of each annual payment times his or her life expectancy. This "exclusion ratio" remains fixed, despite the fact that the annuitant may die before or after their normal life expectancy.
As an example: an annuity contract which will pay $100 per month based on a deposit of $12,650. Assuming the expected return under this contract is $16,000, the exclusion ratio to be used would be:
| $12,650 | [cost] |
| 16,000 | [expected return] |
That would be 79.1 percent which is 79.06 rounded to the nearest tenth. If twelve such monthly payments are received during the taxable year, the total amount which may be excluded from the gross income in that year is $949.20 ($1,200 times 79.1 percent). The balance of $250.80 ($1,200 less 949.20) is the amount to be included in the gross income. If he or she had instead received only five payments during the year, then he or she should exclude $395.50 ($500 times 79.1 percent) of the total amounts received.
When an annuity contract provides for two or more people, such as a survivorship annuity option, an exclusion ratio is determined for the contract as a whole by dividing the investment in the contract by the aggregate of the expected returns under all the annuity elements.
The average annuity buyer is over 60 years old (past the IRS penalty age of 59 1/2). All the talk about the "graying of America" is true. Senior Americans control over fifty percent of all discretionary income. There are over 52 million people in our country over the age of fifty with over 18 million of them over the age of 65. Of the money held in banks and savings and loan institutions, 80 percent are held by the 65-plus age group. The retirement age is also moving downward. People are retiring younger and younger and they are able to do so as a result of various savings vehicles.
In the eighties, risk seemed adventuresome to many investors. The nineties are seeing a new outlook on investing. The risk taking of the eighties saw the collapse of the junk bond market, the immense savings and loan crisis as well as an emerging bank crisis. There have been Wall Street scandals. There have been bankruptcies of giant companies such as PanAm. The crash of the stock market (Black Monday) in 1987 hurt many investors. The over-all volatility experienced has brought about a new conservatism in investing.
Investors now look largely at stability and guarantees. Many say they are willing to take less returns for stronger guarantees. Certificates of Deposit have long been what the investor considered safe because they are Federally insured. However, as the banking industry continues to experience problems, we must ask who it is that backs that insurance. The answer is obvious: it is the American taxpayer. We pay the insurance in higher taxes. According to Veribanc, Inc., the number one bank monitoring firm in the United States, during the last decade, there have been times when at least 20 of the largest 50 S&Ls were in serious trouble.
Commercial banks are also a concern. Many of the banks have experienced yellow coding which means, according to the system used by Veribanc, that these banks needed to be "watched". The safest banks are coded or rated with the color blue or green. Those banks experiencing a yellow coding have included Citicorp, Chemical Bank, Chase Manhattan, and Manufacturers Hanover. Dr. Warren Heller, research director at Veribanc, Inc. has put out a reference book titled "Is Your Money Safe?" It contains interesting concepts.
All of these situations promote annuity sales. Annuities now offered are second, third and even fourth generation. They offer creativity and flexibility. There is no one annuity that is right for everyone, but there is enough variation available so that every person can find the right one for them. There are products that work well for divorce settlements or child support payments, products for terminated pension plans, for charitable giving and just about anything else that may come up. The nineties have been the decade of the annuity. As we enter into the next century, this trend is likely to continue.
The role of the agent in the coming years will be more complex than in the past. Often it involves a knowledge of recent tax legislation since many clients are now coming to the career agent with specific goals in mind. Solving needs becomes a bigger and bigger part of the agent's job.
One of the first things that must be stressed is the fact that more money now means more money later in life. This is directly related to taxation. For someone in a 31 percent tax bracket, $100,000 and ten years to allow for growth, having deferred taxation amounts to a difference of almost $4,000 per year in annual income. In other words, the earnings that can be drawn off each year would be $4,000 more as a result of deferred taxation. It is true that the money will be taxable when it is withdrawn. However, who would not prefer to pay taxes on $17,000 per year rather than only $13,000 per year? More is till more even after taxation.
Because the money in the annuity accumulates on a tax deferral basis, inflation is better controlled. Inflation is with us no matter what investment tool is used. If, however, taxes can be put off to a later date, inflation is lessened.
As always, when it comes to compounded growth, the more time available, the better the results will be. Probably the largest problem Americans have is not saving soon enough. Procrastination costs the American citizen thousands of dollars in lost interest gains. Only a few dollars saved early in life would have resulted in greater returns than does more dollars saved late in life. The old saying "Time is money" certainly applies when it comes to compounding interest.
Annuities have been suggested for many uses for many years. In September of 1990, Money magazine recommended using annuities in addition to an IRA and a 401(k) plan. Money magazine stated that those in tax brackets between 28 percent and 33 percent would especially benefit.
The average buyer is looking for security--not a gamble. Most agents hopefully work only with companies that they feel will treat their client (the annuitant) well. Sometimes, however, the agent may fail to see clauses in the annuities that may cause problems later on. Annuities are certainly safety oriented products as a whole and these are simply some points that you, as an agent, may wish to check out with the companies that you represent.
Simply put, an agent who sells annuities is foolish if he or she has not read the entire annuity contract personally. Furthermore, if any part of the contract was not completely understood, then questions need to be asked of the insurance company. Make sure the answers received are clearly understood and acceptable to you, the agent.
Many agents say that, while they do occasionally sell an annuity contract, they do not feel as comfortable with it as they would like to. Every article warns agents that they must be careful to check out every product and understand every feature before handling the sale of a product. We realize that this would surely be a full-time job in itself. Therefore, it is often a wise idea to contract with a brokerage or agency that specializes in annuities if that is not your full time area of expertise. Chances are, they can steer you to the best products for your clients.
Often annuity contracts are merely a repositioning of client assets from one investment to another. It is, so to speak, a transfer from one investment vehicle to another. There are many reasons why people buy annuities. Often it involves pension and exchange sales which is a repositioning of retirement money. CD rollovers represent some of the most common annuity sales that involve a repositioning of assets. Since the annuity is able to offer a tax incentive that CDs can not offer, this is not surprising. There are multiple charts out that emphasize the difference in compounding tax deferred over taxable investments. Financial data indicates there is over $1-TRILLION currently held in CDs with between $3- and $5-BILLION coming up for renewal daily. This is one reason that banks now tend to have an insurance agent on staff to handle CD investors who are considering a change to annuities with their tax deferral advantage.
In 1990, an informal survey was taken to establish the priorities that investors considered of primary importance:
| Interest Paid: | 15% |
| Deferred Taxes: | 20% |
| Total Safety of Money: | 76% |
It is interesting to note that agents who participated in the same survey rated Interest Paid as the most important feature (65 percent listed it as the number one reason their clients purchased an annuity). This simply proves the point made by Peter Drucker, a financial specialist, when he stated: "The buyer rarely buys what the seller thinks he or she is selling."
Thousands of dollars have been spent in an attempt to define the buying motivations of our older citizens. It is generally felt that they are conservative, risk adverse, often skeptical of new avenues of investment, and they will nearly always select quality over price. With annuities, we would consider price to equate to the interest rate paid. Seniors purchase over 70 percent of the non-qualified deferred annuities. Despite this fact, most agents do not understand the consumer's motivation to purchase them.
Annuities will continue to play an important part in the investor's overall financial picture. However, interest rates paid must take a back seat to the security and financial stability of the insurance company used. Agents must begin to be as seriously concerned about safety as is the client.
There was a time when many agents were careful not to mention the words "life insurance" when presenting an annuity product to a consumer. As a result, many people have thought that an annuity was essentially a Certificate of Deposit. The major differences were not always discussed or disclosed by the agent. That was unfortunate since those major differences were what made the annuity a sound investment.
It is not a difficult thing to present annuities correctly and will not even cause the loss of sales. As was stated previously, safety is the main concern of the majority of annuity buyers. Therefore, the safety of the product should be correctly addressed.
The Legal Reserve System consists of two lines of defense which includes the portfolio that backs an annuity and the net worth (which is capital and surplus) of the issuing system. It only makes sense to completely lay out to a client where the money is invested, how the insurance company makes money (so that it will survive as a company in today's market), and the capital safeguards available as an offset to any market volatility. Giving the client all of this information up front not only sets a foundation of security for the investor, but also makes sense from a sales standpoint. Our industry (insurance) is a valuable and needed occupation. The amazing record of solvency, which many older Americans remember from the days of the depression, is explainable and should be explained.
Although an annuity is, in a true sense, the opposite of life insurance, it is still an insurance product. That fact carries with it many additional benefits that other products lack. A Certificate of Deposit (CD) cannot boast such features and that is where much of an agent's annuity business is currently residing.
Annuities have definite estate advantages. If properly set up, an annuity will eliminate the delays and cost of probate. The annuity gives the owner of the contract control of his annuity assets through restrictive beneficiary designations. For example, by adding the words "per stirpes" (which is Latin for "through the blood") to the beneficiary listing, the owner's annuity assets will never be distributed outside of his own bloodline even if the beneficiary listed has died before the owner. "Per Stirpes" is sometimes referred to as an "inlaw-avoidance clause" for this reason.
It is also possible to restrict the ways in which a beneficiary may receive the annuity funds. It may be set up in a variety of ways, as the contract owner sees fit. Also, an often overlooked feature of an annuity is the privacy it affords. Just as a living trust is private, so too is an annuity. Only the insurance company and the beneficiary knows what the conditions of the contract are.
There are numerous living advantages that are often overlooked by the agent as well as the annuitant. Social Security benefits may actually be increased when funds are transferred to an annuity since annuity accruals are not minifying factors the way alternative investments often are. Many states also consider the annuity to represent what is called "beneficiary-designated money". Under such a definition, this investment may be much more difficult to attach in some states, should any future litigation occur.
Many older Americans have a fear of living too long which means outliving their assets. There are settlement options which offer the senior citizen the right to convert their core savings at any time into tax favored, monthly income that can last for either a specified time period or for the annuitant's lifetime. Although many, many annuities are never annuitized, the fact that this feature exists should not be overlooked.
Having stated all of the features that make an annuity so important to an investor, the interest rate paid should not be the primary feature promoted by the agent. Safety, security and the emotional considerations all are above the rate of interest paid.
Mutual fund investors have begun to move a record number of their assets over to annuities. While mutual funds have been, and still are, a major investment area, many people have experienced a loss or a lowered interest rate. Often these people are ready for a change to something stable and growth oriented. Mutual funds do vary, but generally speaking, over the past ten years, annuities have had equal growth in comparison to mutual funds. An investor would have had little difference in growth between the two. Some experts feel that the annuities have done slightly better than the mutual funds have. Although there are some investments that may out-perform annuities for short time periods, for long-term safety and return of an investment, annuities continue to be one of the best places a person can invest.
According to Daniel M. Perkins, the president of Pinnacle Sales and Marketing, Inc. in New York City, many agents do not understand the advantages of marketing Variable Annuities over mutual funds. He feels that many agents sell what they prefer to sell; not what the client would prefer to buy. The advantages of the variable annuities over mutual funds have to do with taxation. When people reinvest their income, taxes can take a bigger bite. For a person who is saving for retirement, taxes can easily take a bigger bite than inflation in some situations. Therefore, it is important to minimize taxation.
Every so often, one hears the argument that, since taxes are going up, it is better to pay the taxes up front. That is a sales ploy! While nobody can tell what direction tax rates will go, certainly we can assume that taxes will go up instead of down. In addition, the bracket of taxation that one finds themselves in at retirement is more likely to be lower than the bracket they found themselves in during their working years. In illustration after illustration, regardless of the company, tax-deferral is always shown to be beneficial.
Lipper Analytical Services of Denver, which monitors mutual fund and variable annuity performance, states that a review of fixed income mutual funds and equity mutual funds show that they have under-performed when compared to similar groups in variable annuities. Almost every major mutual fund complex is now in the variable annuity business.
To recap:
Having recapped the annuity features, another point needs to be observed: features are not usually the actual reason that a person buys an annuity. Although this may initially sound odd, it is really not. Let us illustrate this point by looking at why a person might choose a doctor. Often such a choice merely considers his office location or whether he or she accepts Medicare assignment or a particular insurance plan. Whatever the reason for CHOOSING the doctor, the reason the doctor is SEEN has nothing to do with the factors used to actually select the doctor. The doctor is seen because an illness or injury exists. Choosing the doctor was secondary to the NEED of seeing a doctor. So it often is with the annuity buyer. SELECTING the annuity is secondary to the reason the annuity is NEEDED. The need may be the tax shelter offered, estate planning reasons, or any number of other goals. The point is, there was a need first and a decision to purchase an annuity second. It is the actual NEED that should be addressed by the agent before the specific annuity is recommended.
Most annuities are purchased individually from insurance companies. Insurance companies are required by law to maintain certain reserves, so an individual purchasing an annuity is virtually certain of receiving the stipulated amount in the contract. All the insurance company's activities are under supervision of state regulatory agencies. A very different situation exists in the case of annuity arrangements with private parties.
If a person transfers property to a private party (such as a relative) in return for the promise of payment of a stipulated annual payment for life, the annuitant may be parting with property worth more than the value of the annuity. In that case, he or she has made a taxable gift.
The Internal Revenue Service has published tables for valuing private annuities since there is certainly not the same assurance that the private annuities will be paid. A loss under a private annuity is disallowed for federal income tax purposes where the other party is a spouse, brother, sister, ancestor or lineal descendant. Various fiduciary relationships between the parties also can result in automatic disallowance of any loss.
Many people utilize annuities for retirement. There are three basic types of annuity contracts:
Annuities provide a life-time income and do combine the two desirable features of investing: (a) deferred taxes and (b) growth without undue risk. An annuity is a contract between a life insurance company and the contract owner.
It is becoming increasingly popular to list the annuitant as one person and the owner another person. Agents often use this technique to maximize commissions when the owner of the policy is in the older age brackets. Even though a life insurance company is involved, an annuity is not life insurance. AN ANNUITY IS, IN FACT, THE DIRECT OPPOSITE OF LIFE INSURANCE. Life insurance is designed to provide money at death; an annuity is designed to provide money UNTIL death.
The oldest type of annuity is the Single Pay Deferred Fixed Annuity. The owner pays the insurance company a certain amount of money. Generally, companies require that it be no less than $5,000. The owner may add to the initial amount invested anytime prior to the start of annuity payouts (prior to annuitization, in other words). The company guarantees that when the annuitant reaches an age of their choice that the insurance company will send the contract owner a fixed dollar amount for as long as the person lives. In some payout options, each side is gambling. The contract owner is gambling that he or she will live long enough to make a substantial profit; the insurance company is gambling that the annuity owner will die soon enough for the company to make a profit. There are generally multiple payout options available. Some guarantee that the principal and interest will be paid out to SOMEONE: either the contract owner or a listed beneficiary. Others stop paying at the death of the annuitant.
Until an annuity is annuitized, the annuity will be paying a rate of interest which may vary greatly from company to company. The interest accumulating will be taxed deferred. The term says it clearly: taxes are deferred. That means that some day, taxes will have to be paid on the interest earned. The annuitant will not be taxed on the interest earned until such interest earnings are withdrawn.
There was a time when it could be stipulated that principal was withdrawn first to further delay tax payments. No longer. Amounts received, which are allocable to an investment made after August 13th, 1982 in an annuity contract entered into before August 14th, 1982 are treated as received under a contract entered into after August 13th, 1982 and are subject to the interest first rule (IRS Sec. 72(e)(5). It is no longer possible to withdraw principal first.
To the extent the amount received is greater than the excess of cash surrender value over investments in the contract, the amount will be treated as a tax-free return of investment. These amounts are, in effect, treated as distributions of interest first and only second as recovery of cost. Of course, annuities are also penalized by the IRS if they are withdrawn prior to the age of 59 1/2. The amount of the penalty is 10 percent. If funds are withdrawn while the contract is in the early years, there may also be a penalty imposed by the insurance company.
Money may be withdrawn prior to annuitization. Many contracts allow 10 percent per year to be withdrawn without any penalty being imposed by the insurance company. It is not necessary to ever actually annuitize the contract. Many people never do annuitize their contracts. Taxes are paid on the taxable portions of the annuity (the interest earnings) for the year in which they were received. When the contract is annuitized the insurance company determines the amount to be received in the monthly check. The amount of money that will be received is derived from a formula that uses such factors as age, principal, plus interest earned, and the payout option selected.
There tends to be some standard payout options offered:
In each of these options, the insurance company pays nothing beyond the agreed period of time. Therefore:
SINGLE LIFE = nothing is paid after the death of the annuitant;
JOINT-AND-SURVIVOR = nothing is paid after both named people have died;
LIFE-AND-INSTALLMENT-CERTAIN = nothing is paid after the death of the annuitant or until the stated time period, whichever comes last; and
CASH REFUND = nothing is paid after the full account has been paid out whether to the annuitant or a beneficiary.
On all of these options, nothing beyond the terms of the contract would be paid to the estate. Remember that an annuitant could live to be extremely old and still receive monthly income equaling far more than the amount ever paid into the annuity. Unfortunately, many people never realize that annuities, while marketed by life insurance companies, are actually the OPPOSITE of life insurance. Annuities pay in life while life insurance is designed to pay at death.
Annuities pay in life while life insurance pays at death.
While all types of annuity contracts tend to have these basic options in them, there are various annuity models from which to choose, which is somewhat of a repeat of the basic types of annuities. However, annuity models are variations of the basic types available.
ACCUMULATION DEFERRED ANNUITY: This model is often used by young people who need time to be able to save. Rather than depositing a lump sum of money into the annuity, they agree to make regular installments for a minimum period of time.
SINGLE PAY IMMEDIATE ANNUITY (SPIA): A lump sum of money is paid to the insurance company and annuity payments begin right away (generally 30 days from the date of deposit). Realize that this option gives up the tax shelter that deferred annuities offer. The annuitant may elect to actually annuitize their money or they may simply elect to take the interest earnings never actually annuitizing the contract at all.
VARIABLE ANNUITY: The main difference between a fixed annuity and a variable annuity lies in who takes the investment risk. When a fixed annuity contract (policy) is annuitized, the insurance company commits to a fixed monthly amount of money that they will pay no matter how long the annuitant may live. The company has invested the money in a number of income producing vehicles and expects that their investments will produce enough income to both make the payments and provide a profit for the company. With the variable annuity, the company guarantees to pay an unchanging percentage of the value of an unchanging number of investment units. In other words, the annuitant is taking the risk rather than the insurance company. Often the units are shares of a mutual fund. This is not generally considered to be a high risk since the insurance companies tend to be conservative investors. Even so, it would be wise to investigate what types of investments the company being considered tends to make. Normally, the chances are that the units will increase in value. Many investors prefer to use variable annuities since they tend to pay better than fixed annuities.
WRAP-AROUND ANNUITY: These are sometimes called Switch-Fund Annuities. As insurance products go, this is a relatively new concept (and a seldom used concept). A life insurance company joins a mutual fund organization managing several mutual funds with different goals and different investment policies. The insurance company provides the annuity contract and the mutual fund company provides the investments. This type of annuity gives the freedom to specify which of the mutual funds are desired.
In 1982, the IRS issued a tax restrictive ruling on the wrap-around annuities.
The Internal Revenue Service may also refer to the Wrap-Around Annuity as an Investment Annuity. "Investment Annuity" and "Wrap-Around Annuity" are terms for arrangements under which an insurance company agrees to provide an annuity funded by investment assets placed by or for the policyholder with a financial custodian with assets placed in a specifically identified investment (the mutual fund). It is normally held in a segregated account of the insurer. IRS has ruled that, under such arrangements, sufficient control over the investment assets is retained by the policyholder so that income on the assets prior to the annuity starting date is currently taxable to the policyholder rather than to the insurance company. With the exception of certain contracts grandfathered under Rev. Rul. 77-85 and Rev. Rul. 81-225, the underlying investments of the segregated asset accounts of variable contracts must meet diversification requirements set forth in the regulations (IRS Sec. 817(h).
In the last few years we have also seen a number of annuity products developed that are very much like a Certificate of Deposit or CD. The volatility of the stock market, lowering interest rates and the mess of the savings and loan industry provided a perfect climate for such products.
The many factors seen today often produce what is referred to as "investment stress". Simply put, investors do not trust anyone at all. Consequently, it has become increasingly important to develop financial portfolios that include some type of middle ground for their assets. These investment products must also provide guarantees of principal, a fairly competitive interest rate and reasonable access to the investment funds. Certainly, the investment must also contain a very minimum level of risk. Insurance companies, in response to this marketplace, have developed what is called CD-Like Annuities. These annuities are a hybrid of the single premium deferred annuities (usually simply referred to as SPDA). However, the CD-like annuities give the policyowner the liquidity and rate of return most often seen with traditional Certificates Of Deposit that are marketed by the banks. Unlike CDs, however, these annuities have all the advantages of single premium deferred annuities, which includes tax-deferred growth, guarantees of principal, and the opportunity to convert the account value to a guaranteed income for life or specified period of time. Usually the commission base is lower for CD-Like Annuities in comparison to other annuity products.
As most agents realize, all single premium deferred annuities are designed to be used as tax-deferred investments for the long-term. CD-Like Annuities are geared for a shorter period of time. They normally offer longer guaranteed interest periods as well. Some of the CD-Like Annuities may also allow additional deposits. They may also allow partial penalty-free withdrawals from the account during a specified option period. The additional deposits and the withdrawal options are often referred to as "windows of opportunity." The most common CD-Like Annuities run for periods of either one, three or five years. The Window of Opportunity generally lasts for 30 days after each guaranteed interest period.
Certainly, the largest selling point of such CD-Like Annuities is the tax-deferred growth with liquidity coming after a relatively short period of time. For many clients, their assets have always been kept at the local bank in the traditional Certificates of Deposit that their bank offered. Being able to offer such clients a similar product that grows tax-deferred is a way of introducing them to the world of annuities. After the client is comfortable with the investment products annuities offer, they may venture into longer lasting (longer surrender time periods) annuities to gain higher interest earnings.
In past years, annuities were sold primarily on the basis of the rate of interest paid. All too often, the more important features of the annuity seemed to be ignored. In today's financial climate, the rate of interest is often the least important feature to the client.
Starting an annuity especially makes sense when time is on the investor's side. Due to penalties from the IRS (prior to age 59 1/2) and possible penalties imposed in the early years by the insurance company, it is sometimes considered a "forced" retirement fund once started. Depending on who is looking at it, this could be considered either a plus or a minus.
Once retirement comes, there are some decisions to be made regarding the annuity. Generally, the retiree annuitizes at this point and begins to receive their monthly checks. This is not always the best choice. If the check that will be received each month does not compare well with a yield that can be obtained elsewhere, the money should perhaps simply be withdrawn, the tax paid, and the money reinvested elsewhere. The insurance company can advise the annuitant how much the monthly would be.
Another reason the retiree may not wish to annuitize their annuity has to do with life expectancy. If neither the husband nor the wife would live long enough to get a good return before death, it may be wiser to simply draw off the 10 percent allowed each year without any penalties. Once annuitized, this option is no longer available. Also, if at retirement, the money in the annuity is not needed, then certainly it may not be wise to annuitize. The longer the money is tax-deferred, the better off the annuitant may be depending upon their financial situation. When annuity pay-outs begin, the tax shelter ends. The bottom line is simple: look at all options available before locking into any one option.