If you have a 401k or Roth IRA, you probably feel like you’re doing everything you can to be financially prepared for retirement, right? Maybe you are, but you might also benefit from incorporating an annuity into your savings plan.
So how do you know if you need an annuity?
Let’s look at the basic characteristics of these unique savings vehicles, how they work, and most importantly, if you would benefit from having one.
What Is an Annuity?
An annuity, by definition, is simply an agreement to make a series of payments of a certain amount of money to a specified party for a predetermined period of time. Annuities also refer to a commercial insurance contract offered by a life insurance company.
Purpose of Annuities
Annuities are designed to insure the contract owner against the risk of superannuation, which means outliving one’s income. Older investors who run out of money to support themselves face a dire dilemma. Annuities were therefore created in order to mitigate this risk.
These contracts are guaranteed to pay out at least a certain minimum amount on a periodic basis to the beneficiary until death, even if the total payments exceed the amount paid into the contract plus any accrued interest or gain. Because of this type of protection and the fact that you cannot withdraw funds penalty-free until you are age 59 1/2, annuities are considered retirement savings vehicles by nature.
History of Annuities
Annuities have existed in one form or another since the Roman Empire. Citizens at that time would buy annual contracts from the Emperor. They would pay a lump sum to the Roman government in return for receiving an annual payment for the rest of their lives. European governments also offered a series of payments to investors in return for a lump sum investment now as a means of funding their wars during the 17th century.
Annuities came to America in the 18th century as a means of supporting church ministers. A Pennsylvania life insurance company was the first insurance company to market commercial annuity contracts to the public in 1912. Fixed annuities grew in popularity over time and have become a mainstay of conservative investors. Although the first variable annuity was created in 1952, they did not become commonplace until the ’80s, and were followed by indexed contracts in the ’90s.
Basic Characteristics of Annuities
Although there are many types of annuities, all annuity contracts are alike in several respects.
- They stand alone as the only commercially-available investment vehicle that grows on a tax-deferred basis without having to be placed inside any type of IRA, qualified or other retirement plan.
- Unless the contract is held in an IRA or qualified retirement plan, there is no limit to the amount of money that may be invested and contributions are non-deductible. (Of course, most annuity carriers have proprietary limits on the amounts that they will accept, but this is usually somewhere around 5 million dollars or so.)
- Most annuity contracts also contain a declining surrender-charge schedule that eventually disappears after a given period of time, such as 5 or 10 years. For example, a 10-year fixed annuity contract may assess a 7% early withdrawal penalty for money taken out during the first year of the contract, a 6% penalty for money taken out during the second year and so on until the surrender charge schedule expires. Variable and indexed annuities usually levy similar charges for early withdrawals. However, many contracts will allow the investor to pull out 10-20% of principal each year without penalty as a means of easing this restriction as long as the investor is at least age 59 1/2.
Annuity contracts can be purchased either inside or outside of an IRA or qualified plan. A check is written to the annuity carrier in either instance. They can also be acquired via 1035 exchange, where a maturing contract in a previous annuity policy, life insurance policy, or endowment policy is moved tax-free into an annuity policy with your preferred company. As far as life insurance, any type of cash value life insurance, such as whole, universal, or universal variable insurance can also be exchanged into an annuity.
How Annuities Work
The way these products were originally designed, the contract owner made either a lump-sum payment or a series of payments into the contract and then began receiving payments at retirement. The payments into an annuity are used to purchase accumulation units inside the contract, which, as their name implies, accumulate inside the contract until the time that payments to the beneficiary must be made.
Then a one-time event known as annuitization takes place. This event marks the conversion of accumulation units into annuity units, which annuity contracts can pay out to beneficiaries in several different ways. Either way, the contract owner essentially exchanges the dollar amount in their annuity for a series of guaranteed payments. This means they give up access to the larger, lump-sum, amount in order to receive a guaranteed lifetime income. Beneficiaries can choose among several types of payout options, including:
- Straight Life. The contract will pay out an actuarially-calculated amount to the beneficiary based upon his or her life expectancy alone. This amount will be paid even if the total payout exceeds the amount paid in plus interest or other gains. However, payments stop upon the death of the beneficiary, even if less than the value of the contract is paid back out. Theoretically, the insurance company keeps the contract value even if the beneficiary dies after receiving only one payment.
- Life with Period Certain. The contract will pay out either for life or for a certain amount of time, such as 10 or 20 years. This prevents the possibility described above from happening. If the beneficiary dies soon after payments begin, then the insurance company must pay out the period certain’s worth of payments to the beneficiary, either as a series of payments or a lump sum.
- Joint Life. Similar to straight life, joint life annuities will continue to pay as long as one of the two beneficiaries is alive.
- Joint Life with Period Certain. Combines the period certain payout with joint life expectancy.
Or, without annuitizing, contract owners can withdraw money in the following ways:
- Systematic Withdrawal. A simple payment of either a fixed dollar amount or percentage of contract value paid out each year, either monthly, quarterly or annually.
- Lump Sum. As the name implies, lump sum is a single payment of the entire contract value. This payment can either be taken as a distribution or rolled over into another annuity contract.
Taxation of Annuities
As mentioned previously, all money placed inside an annuity contract grows tax-deferred until it is withdrawn, provided the beneficiary is at least age 59 1/2. If not, then a 10% penalty is assessed upon the withdrawal, just as with an early distribution from an IRA or qualified plan.
All distributions, whether early or normal, are also taxed as ordinary income to the recipient and reported on Form 1099-R. The exclusion ratio is used to calculate the taxation of annuity payments. This formula allocates a proportionate amount of each payment made as a tax-free return of principal.
For example, if an investor places $100,000 inside an annuity and it grows to $400,000 and then receives monthly payments of $500, then $125 of each payment will be considered a return of principal and therefore be tax-exempt. The $125, which is 25% of $500, arises out of the fact that the original principal amount, $100,000, makes up 25% of the current value of the contract, $400,000.
However, annuities are not subject to ERISA (Employee Retirement Income Security Act) regulations unless they are placed inside an IRA or qualified plan.
Other Benefits of Annuities
Although their tax-advantaged status is one of their biggest advantages, annuities offer several other unique benefits as well. Annuity contracts are exempt from probate; that is, upon the death of the contract owner, the contract value will pass to the beneficiary without going through probate.
Annuity contracts are also largely exempt from creditors in many cases, although the exact rules for this vary somewhat from one state to another. Texas is one state that unconditionally exempts these contracts from creditors; O.J. Simpson lived on money he had in annuities after the civil judgment against him in 1994 (but before his more recent incarceration).
Types of Annuities
There are three main types of annuities: fixed, indexed, and variable.
- Fixed Income Annuities pay a guaranteed rate of interest like a CD or bond.
- Equity-Indexed Annuities promise some portion of any growth in the stock market while guaranteeing principal.
- Variable Annuities contain mutual fund sub-accounts that invest in stocks, bonds, real estate, and commodities such as precious metals and energy. Unlike the other two types of annuities, the principal is not guaranteed in variable annuities, which means that these annuities may lose value.
Annuities can also be categorized as either immediate or deferred.
- Immediate annuities start paying a stream of income to the beneficiary as soon as the contract is purchased
- Deferred annuities do not begin paying out until a later time.
All three types of annuities can fall into either of these categories; a fixed annuity can be either immediate or deferred, and so can an indexed or variable contract.
Do You Need an Annuity?
The broadest answer to this question is that anyone who wishes to save more for retirement than they are allowed to in their IRAs or company retirement plans should consider an annuity as a supplemental funding vehicle.
There are also a few other reasons why those whose employers offer annuity contracts inside their retirement plans should consider them. For example, annuities can be used as tax shelters by the wealthy and as sources of guaranteed income by the risk-averse.
With all this said, the restrictions inherent to annuities may make them inappropriate for some investors.
- Fees and Expenses. In variable annuities, the investor pays a mortality and expense (M&E) charge, the sub-account’s expenses, and fees for additional benefits that are selected upon opening the account. Because these fees can take a chunk out of earnings, variable annuities are often not appropriate for younger investors who are less likely to need the insurance benefits.
- Money Locked Up. When you invest in an annuity, you commit to keeping your money in one until the surrender period expires and you’re at least 59 1/2. The insurance company will charge surrender fees to withdraw more than an allowed percentage during the surrender period, and the IRS will take 10% if you withdraw before 59 1/2. Make sure you have an emergency savings fund available to you (without penalty) if you decide to invest in an annuity.
- Financial Guarantee. Annuities don’t carry FDIC insurance which means they’re not guaranteed by the federal government like bank CDs. The promise to guarantee an investor’s principal is only as good as the insurance company’s financial strength. Prospective investors should research an insurance company’s financial standing with an independent ratings agency such as www.weissratings.com before investing.
- Taxes. When earnings are withdrawn from an annuity, they’re taxed as ordinary income and are not eligible for the lower long-term capital gains rate.
- Commissions. Unfortunately, even good-hearted financial professionals can be swayed out of their client’s best interest by a large commission. Annuities offer some of the largest in the industry. An investor should feel confident in her financial advisor and weigh pros, cons and other options before investing.
- Annuitization. This is a pro as well as a con. While annuitization can guarantee a lifetime stream of income, it comes at the cost of irrevocably handing over the larger account value to the insurance company.
How Should Annuities Be Used In an Investment or Retirement Portfolio?
There is no single right answer to this question. Not only should the investor’s age, time horizon, investment risk tolerance, and other objectives be weighed, but the specific type of annuity in question should be considered as well.
Some types of investors may be better off with only guaranteed fixed annuities, while others should seek the growth potential of a variable contract. There is also no set recommended investment portfolio allocation percentage for these vehicles, as some investors can get along fine with every cent of their savings locked up inside these vehicles while others should restrict their contract holdings to only a small percentage of their total portfolio value.
The proper use and allocation of these products can only be done effectively on a case-by-case basis. There is no one size that fits all. Make sure you take ample time to weigh the pros and cons with a trusted financial advisor.
Annuities, like retirement accounts, are a form of insurance to make sure you receive a steady flow of money well after your working years are over. There are many benefits to annuities, and they provide secure retirement savings for millions of Americans each year.
If you’d like more information or want to know if an annuity is right for, talk it over with your financial advisor. The more financially prepared you are for retirement, the happier your golden years will be.
What are your thoughts on annuities? How much of one’s portfolio do you think they should make up?
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