Annuity

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Fixed Rate Annuities

Index Annuities

Immediate (Income) Annuities

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Annuities
Prior to the late 1970s annuities were primarily used as a retirement income vehicle and the textbook definition of an annuity was a periodic income for a specified length of time, for life, or a combination of the two. But…

An annuity can provide a means of accumulating interest on a tax-advantaged basis.

An annuity can provide an estate instrument that preserves and protects assets. And

An annuity can provide a guaranteed income for life that also lets you access the principal.

Today, most people do not convert the money they have built up in their annuity into a guaranteed income stream (converting an annuity’s value into an income is called annuitization). Instead, they treat the annuity value they have accumulated as any other asset and anecdotal evidence suggests that almost all of these accumulated annuity values are passed onto the heirs in a big lump sum and not turned into an income stream by the buyers of the annuities. The consensus is less than 2% of deferred annuities are annuitized.

Minimum Guarantees
Tax Advantages
Minimum & Maximum Premium
Liquidity & Penalties
Death Benefit
Maturity Date
Fees & Charges
Safety of Principal
How Fixed Rate Annuities Earn Interest
How Index-Linked Annuities Earn Interest
Questions To Ask

Fixed & Variable Annuity Differences
There are variable annuities and fixed annuities. When newspapers and magazines mention annuities they are almost always talking about variable annuities. In a variable annuity, income or account value is based on the value of the stocks or bonds backing the annuity assets, so the income and/or account values fluctuate. Unlike fixed annuities, the investment risk in variable annuities is borne by the annuity owner; so variable annuities are considered investment securities and would be a risk money place.

	Fixed Rate	Fixed Index	Variable
Management Fees	No	No	Yes
Registered as Security	No	No	Yes
Guaranteed Prior Earnings	Yes	Yes	No
Guaranteed Principal	Yes	Yes	No *
Minimum Interest Guarantee	Yes	Yes	No
		*yes in time of death

Fixed Annuities
Fixed annuities provide a guaranteed minimum interest rate and are considered savings instruments. All fixed annuities are issued by insurance companies and are not government or bank obligations so naturally they are not FDIC insured. However, fixed annuities have an extraordinary record of safety and offer other benefits. Annuity Safety

Interest Earned & Minimum Guarantees
Fixed annuities provide a minimum guaranteed return, which is a safe money feature annuities have in common with Series EE Savings Bonds, but unlike Savings Bonds you do not need to wait 20 years for the annuity's guarantee to kick in.

If the insurance company believes they can pay extra interest from their general account, above and beyond this minimum guarantee, they will declare a fixed rate of interest and pay the annuity owner a stated interest rate for a period. Or, in the case of a fixed index annuity, they could use the extra interest to link the earning of interest to the performance of an external index for a period. The major difference between a fixed rate annuity and a fixed index annuity is in the crediting of excess interest above the minimum guarantee.

More On How Fixed Rate Annuities Earn Interest More On How Index-Linked Annuities Earn Interest

Tax Advantages
Money remaining inside an annuity grows without being taxed until withdrawn. Unlike qualified retirement accounts where you must begin taking out money around age 70½, most annuity contracts permit the owner to enjoy the advantage of tax deferral until age 85, 90 or even later. Tax deferred does not mean tax free, interest is taxed when withdrawn. Also, the Treasury charges a 10% penalty on interest, in addition to regular taxes, if withdrawals are made before age 59½.

Annuity Tax Deferral In Qualified Plans
Annuity interest grows tax-deferred. Money in qualified plans grow tax-deferred. An annuity inside, say, an IRA is already growing tax-deferred because it is in a qualified plan, which leads some people to say a fixed annuity should not be used in a qualified plan. This assumes the main reason one buys an annuity is for tax-deferral; however, our research indicates people buy an annuity primarily for the potentially higher yield.

If your IRA choice was an annuity yielding 6% or a similar non-tax-deferred vehicle yielding 5%, which one would you pick? The decision to buy an annuity is primarily based on return, not tax benefits.

More On The Power Of Tax-Deferral

How Much Can I Put Away?
Although one can find fixed annuities with a minimum premium as low as $50, typically an annuity requires a $5,000 initial premium ($2,000 for IRAs). Some annuities are single premium - meaning that you cannot add to them, and others are flexible premium - meaning you may contribute more in the future if you wish. Many carriers require advance notice if you are going to put away more than a million dollars at a time. Advantage Compendium reports the average annuity premium is around $50,000.

Liquidity & Penalties
Fixed annuities offer a wide variety of term choices. The fixed annuity selected may have a penalty for early withdrawal ranging from as short as a year to as long as twenty years, although most permit the withdrawal of at least the interest earned each year without penalty. These penalties, also known as surrender penalties or charges, are used by the insurance company to recoup initial costs if an annuity is cashed in prematurely.

A surrender penalty only becomes a charge if the policy is surrendered, therefore you need to determine whether the term of the annuity and liquidity provisions match your liquidity needs.

Market Value Adjustment (MVA)
An MVA feature means changes in the interest environment are taken into account if and only if the annuity is surrendered prematurely. What this can mean is if rates have risen since you started the annuity the penalties for cashing out could be higher than the schedule stated in the policy and if rates have fallen since you took out the annuity the penalties could be lower or even zero.

The reason behind Market Value Adjustments is found in the Buyer’s Guide To Fixed Deferred Annuities produced by the National Association of Insurance Commissioners which states “Since you and the insurance company share the risk, an annuity with an MVA feature may credit a higher rate than an annuity without that feature”. If you don't surrender the policy during the period you never pay the MVA and might get a little better rate.

Death Benefit
In the event of death the vast majority on fixed annuities pay the account value to the named beneficiary and no penalties are charged. Some annuities do assess surrender penalties at death while a few others require the account value to be paid out over time, so determine if the annuity's terms meet your needs. If desired, an annuity can be initially set up so that the surviving spouse may keep the annuity in force.

The California Insurance Department recently released an annuity report that says "in a fixed annuity the amount remaining in the annuity at the annuitant ’s death stays with the insurance company." This is WRONG - it would only be true if you chose the most restrictive annuitization payout option. The insurance company DOES NOT KEEP YOUR MONEY IF YOU DIE when you own a deferred fixed annuity. We hope California fixes this incredible misstatement in their report soon.

Maturity Date
Not to be confused with the surrender period, the maturity date is the longest one can keep annuity interest deferred before it must be taken out. Maturity dates usually occur when the annuitant celebrates their 80^thto 90^th birthday, but some new policies may be kept until after age 100 (the annuitant is the person upon which the annuitization life income is based). A maturity date is not life without parole. The maturity date is not how long you must keep your annuity, but how long the insurer will let you keep your money with them. To repeat, the annuity owner may take their money out or annuitize the contract prior to the maturity date. The maturity date is the longest an annuity owner may force the carrier to keep the contract, not the other way around.

Fees & Charges
There are always costs, but fixed annuity fees and expenses are not charged in the same way that a variable annuity or mutual fund does, but more like the way a bank does it.

Say the bank says they will pay 4% interest on their CD. Okay, what are the bank’s fees and expenses on this CD? If your answer is you can’t tell and it doesn’t matter because all you really care about is the final rate you get on your money, the same logic applies to fixed annuities.

The insurance company doesn’t deduct a management fee and share a net return with the customer. Instead, just like the bank, the insurer pays a fixed return, and this may be stated as a fixed rate or as fixed participation in an index.

Might some banks have lower operating costs or higher revenues than another and thus offer a higher rate? Yes, and an insurer could spend less on office supplies than another insurer and thereby ultimately be able to pay a higher rate on fixed annuities. But I don’t know how you translate all of this into fees?

Annuities do have penalties for early withdrawal if the annuity is surrendered early, which is why one needs to match the period with their goals, keeping in mind that all annuities are designed to be long term savings instruments.

States permit annuities to charge annual contract fees of up to $50 a year and many variable annuities do charge annual fees, but I am unaware of any fixed annuities charging this fee.

Safety of Principal
Fixed annuities do not subject principal and credited interest to market risk. A fixed annuity is as safe as the insurance company issuing the annuity and insurance companies have an exceptional record of safety, which is why they are a safe money place.

More on annuity safety

Fixed Annuities – Fixed Rate or Linked Rate
There are two ways fixed annuities credit interest. They either pay a stated interest rate that you know in advance of each period, or they link the interest paid to performance of an index and state the what your participation in the index will be.

More On How Fixed Rate Annuities Earn Interest More On How Index-Linked Annuities Earn Interest

Questions To Ask

What is the initial rate and how long is it guaranteed?

Does the initial rate include a bonus?

Are there any special requirements to receive the bonus or to cash out the annuity?

What is the guaranteed minimum return?

Are there any fees?

Are there surrender or withdrawal penalties or charges?

Is there a Market Value (MVA) Adjustment?

Do the surrender costs still apply at death?

What rate is being credited on similar annuities issued in the past?

Immediate (Income) Annuities
Instead of annuitizing a deferred annuity to receive a regular income you may simply purchase an income annuity, also known as an immediate annuity. Immediate annuities are designed to produce a stream of income usually beginning almost as soon as they are purchased. Although all deferred annuities may be annuitized and become immediate annuities, no immediate annuity may become a deferred annuity. Immediate annuity payments are usually fixed and unchanging, but payments may be variable or have both fixed and variable elements. Variable immediate annuities have a fixed number of income units with the value of those units fluctuating because they are based on the value of the underlying investments. The income you receive from a variable immediate annuity will go up and down. An index immediate annuity has a guaranteed payment with additional amounts dependent upon the performance of an external index.

Tax Deferral
Money that remains inside the annuity grows free from current income taxes. Not only does the principal earn interest (simple interest at work), and the interest earns interest (compound interest at work), but the money that would have gone to Uncle Sam also earns interest (tax-advantaged interest at work)

Annuities Get Triple Interest Crediting
Suppose you had $50,000 and were in a combined federal and state tax bracket of 33%. Say both a taxable account and the annuity are earning 6%. The annuity benefits from triple interest crediting and works with the full 6% interest. However, the taxable account produces a Form 1099 every year which says that part of the interest must be paid in taxes, whether it is being used or left for later. If you are earning 6%, but have a 33% tax rate, a third of that 6% - or 2% - goes for taxes. This means there is only 4% working in the taxable account. Here is what the accumulated values of the taxable account and the tax-deferred account look like down the road.

More Interest Income
The annuity advantage continues growing with each passing year. Tax-deferred growth means more money is available for future needs. If you kept earning 6% here’s the interest earned.

Comparison - Interest Earned
After Year	Taxable Account Interest	Annuity Interest	Annuity Advantage
1	$3,120	$3,180	2%
5	$3,650	$4,015	10%
10	$4,441	$5,372	21%
20	$6,573	$9,621	46%

Tax-deferral translates into over 20% more interest available to spend in 10 years and an amazing 46% more interest more than the taxable account provides in 20 years. One of the fears in retirement is outliving our money; an annuity can help overcome this fear. Tax-deferral means a higher accumulated value from which to draw.

Tax-deferred doesn’t mean tax free. Taxes have to be paid on the interest when withdrawn or paid out at death.. However, tax-deferral still means more dollars. Let’s look at the previous example and assume the annuity is cashed in and taxes paid. Here’s what we’d have in our hands.*

*In addition to regular income taxes there is a 10% penalty on withdrawals from an annuity before age 59 1/2. The penalty only applies to interest earned and doesn’t affect the premium, but withdrawals are taxed on an “interest out first” basis. The penalty does not apply upon the death or disability of the owner, or if substantially equal payments are made. Consult your tax advisor.

There are other ways to look at the power of tax-deferral.

Interest Free Loan
If someone said they would loan you $10,000 and that you didn’t have to pay it back for 10, 20 or 30 years and you wouldn’t have to pay any interest on the loan, but you could earn interest on the money Would you be interested?

Annuities offer tax deferral. In essence this means you are getting to use money that should have gone to pay taxes. Someday, that money has to be paid back. However, you get to keep the after-tax portion of the interest you earned from those tax dollars and, if you’re in a lower tax bracket when you do repay the “loan”, you could pay back fewer of them.

Finally, there’s no limit on the amount of taxes or the length of time you can defer, but interest is taxable when withdrawn or at death of the owner.

Tax Control
If you have a taxable account every January you receive a Form 1099 that says you must pay taxes on any interest earned, even if that interest is being saved for future use. An annuity gives you tax control. You decide when to take the interest and pay the taxes - not the IRS.

Avoiding SSBT
If your pension, taxable interest income, tax-free municipal bond interest and social security income is over a threshold amount you can be forced to pay taxes on your social security benefits. However, interest compounding within an annuity is not counted in the calculation. If you move dollars generating compounding interest from a taxable account to an annuity you may lower or avoid SSBT (Social Security Benefit Taxation).

Missouri Bucket
Having your money in a taxable account is kind of like putting it in a bucket. The problem is every year the IRS punches a hole in your bucket and drains off some of that interest in taxes. However, placing your money in an annuity is like adding a faucet to the bucket. The only time you pay taxes is when you decide to open the faucet and take out some of that interest.

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