TLC Magazine has published annuity related editorial in past issues. The following comprehensive discussion of annuities shows how they might be utilized in an investment portfolio and is being provided once again because of the secure investment feature they provide and great flexibility they offer. An investment portfolio might contain a number of investment products. In the uncertain and highly volatile financial marketplace we are experiencing today, annuities offer a very important option.
ANNUITIES
WHAT IS AN ANNUITY?
In its most general sense, an annuity is an agreement for one person or organization to pay another a stream or series of payments. Usually, the term “annuity” relates to a contract between you and a life insurance company, but a charity or a trust can take the place of the insurance company.
There are many categories of annuities. They can be classified by:
An annuity can be classified in several of these categories at once. For example, you might buy a nonqualified single premium deferred variable annuity.
WHAT ARE THE DIFFERENT TYPES OF ANNUITIES?
Fixed vs. Variable Annuities
In a fixed annuity, the insurance company guarantees the principal and a minimum rate of interest. In other words, as long as the insurance company is financially sound the money you have in a fixed annuity will grow and will not drop in value. The growth of the annuity’s value and/or the benefits paid may be fixed at a dollar amount or by an interest rate, or they may grow by a specified formula. The growth of the annuity’s value and/or the benefits paid does not depend directly or entirely on the performance of the investments the insurance company makes to support the annuity. Some fixed annuities credit a higher interest rate than the minimum via a policy dividend that may be declared by the company’s board of directors, if the company’s actual investment, expense and mortality experience is more favorable than was expected. Fixed annuities are regulated by state insurance departments.
Money in a variable annuity is invested in a fund like a mutual fund but one open only to investors in the insurance company’s variable life insurance and variable annuities. The fund has a particular investment objective, and the value of your money in a variable annuity, and the amount of money to be paid out to you is determined by the investment performance (net of expenses) of that fund. Most variable annuities are structured to offer investors many different fund alternatives. Variable annuities are regulated by state insurance departments and the federal Securities and Exchange Commission.
Types Of Fixed Annuities
An equity indexed annuity is a type of fixed annuity, but looks like a hybrid. It credits a minimum rate of interest just as a fixed annuity does, but its value is also based on the performance of a specified stock index usually computed as a fraction of that index’s total return.
A market value adjusted annuity is one that combines two desirable features:
Other Types Of Annuities
All of the following types of annuities are available in fixed or variable forms.
DEFERRED VS. IMMEDIATE ANNUITIES
A deferred annuity receives premiums and investment changes for payout at a later time. The payout might be a very long time; deferred annuities for retirement can remain in the deferred stage for decades.
An immediate annuity is designed to pay an income one time period after the immediate annuity is bought. The time period depends on how often the income is to be paid. For example, if the income is monthly the first payment comes one month after the immediate annuity is bought.
FIXED PERIOD VS. LIFETIME ANNUITIES
A fixed period annuity pays an income for a specified period of time such as ten years. The amount that is paid doesn’t depend on the age or continued life of the person who buys the annuity; the payments depend instead on the amount paid into the annuity, the length of the payout period, and, if it’s a fixed annuity, an interest rate that the insurance company believes it can support for the length of the pay out period.
A lifetime annuity provides income for the remaining life of a person called the “annuitant”. A variation of lifetime annuities continues income until the second one of two annuitants dies. No other type of financial product can promise to do this. The amount that is paid depends on the age of the annuitant or ages if it’s a two life annuity, and the amount paid into the annuity, and, if it’s a fixed annuity, an interest rate that the insurance company believes it can support for the length of the expected pay out period.
With a “pure” lifetime annuity the payments stop when the annuitant dies, even if that’s a very short time after they began. Many annuity buyers are uncomfortable at this possibility so they add a guaranteed period, essentially a fixed period annuity to their lifetime annuity. With this combination, if you die before the fixed period ends, the income continues to your beneficiaries until the end of that period.
QUALIFIED VS. NONQUALIFIED ANNUITIES
A qualified annuity is one used to invest and disburse money in a tax favored retirement plan such as an IRA or Keogh plan or plans governed by Internal Revenue Code sections, 401(k), 403(b), or 457. Under the terms of the plan money paid into the annuity called “premiums” or “contributions” is not included in taxable income for the year in which it is paid in. All other tax provisions that apply to nonqualified annuities also apply to qualified annuities.
A nonqualified annuity is one purchased separately from, or “outside of,” a tax favored retirement plan. Investment earnings of all annuities, qualified and non-qualified, are tax deferred until they are withdrawn; at that point they are treated as taxable income regardless of whether they came from selling capital at a gain or from dividends.
SINGLE PREMIUM VS. FLEXIBLE PREMIUM ANNUITIES
A single premium annuity is an annuity funded by a single payment. The payment might be invested for growth for a long period of time-a single premium deferred annuity, or invested for a short time after which payout begins-a single premium immediate annuity. Single premium annuities are often funded by rollovers or from the sale of an appreciated asset.
A flexible premium annuity is an annuity that is intended to be funded by a series of payments. Flexible premium annuities are only deferred annuities; that is, they are designed to have a significant period of payments into the annuity plus investment growth before any money is withdrawn from them.
In general, annuities have the following attractive features:
Tax deferral on investment earnings
Many investments are taxed year by year, but the investment earnings, capital gains and investment income in annuities aren’t taxable until you withdraw money. This tax deferral is also true of 401(k)s and IRAs; however, unlike these products, there are no limits on the amount you can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for 401(k)s and IRAs.
Protection from creditors
If you own an immediate annuity, that is, you are receiving money from an insurance company, generally, the most that creditors can access is the payments as they’re made since the money you gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities. And your money in tax favored retirement plans, such as IRAs and 401(k)s, are generally protected whether invested in an annuity or not.
An array of investment options, including “floors”
Many annuity companies offer a variety of investment options. You can invest in a fixed annuity which would credit a specified interest rate similar to a bank Certificate of Deposit (CD). If you buy a variable annuity your money can be invested in stock or bond or other mutual funds. In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point. For example, the annuity may offer a feature that guarantees your investment will never fall below its value on its most recent policy anniversary.
Tax free transfers among investment options
In contrast to mutual funds and other investments made with “after tax money,” with annuities there are no tax consequences if you change how your funds are invested. This can be particularly valuable if you are using a strategy called “rebalancing,” which is recommended by many financial advisors. Under rebalancing, you shift your investments periodically to return them to the proportions that you determine represent the risk/return combination most appropriate for your situation.
Lifetime income
A lifetime immediate annuity converts an investment into a stream of payments that last as long as you do. In concept, the payments come from three “pockets”: your investment, investment earnings and money from a pool of people in your group who do not live as long as actuarial tables forecast. It’s the pooling that’s unique to annuities, and it’s what enables annuity companies to be able to guarantee you a lifetime income.
Benefits to your heirs
There is a common misconception about annuities that goes like this: if you start an immediate lifetime annuity and die soon after that the insurance company keeps all of your investment in the annuity. That can happen, but it doesn’t have to. To prevent it, buy a “guaranteed period” with the immediate annuity. A guaranteed period commits the insurance company to continue payments after you die to one or more beneficiaries you designate; the payments continue to the end of the stated guaranteed period, usually 10 or 20 years measured from when you started receiving the annuity payments. Moreover, annuity benefits that pass to beneficiaries don’t go through probate and aren’t governed by your will.
WHY SHOULD I CONSIDER PURCHASING AN ANNUITY?
Annuities can serve many useful purposes.
If you are in a saving money stage of life a deferred annuity can:
Help you meet your retirement income goals. Employer sponsored plans such as a 401(k), 403(b) or Keogh are an important part of planning for retirement. However, contributions to these plans and to IRAs are limited, and they might not add up to enough for the retirement income you need, especially if you started saving for retirement late or had contributions interrupted, perhaps, due to job changes and/or family responsibilities. Moreover, your social security and defined benefit pension, if you have one, may provide less than you need to retire. Remember that the purchasing power of defined benefit pension income is eroded by inflation.
Help you diversify your investment portfolio. Investment experts routinely advise that, to get the best return for a given level of risk you should diversify your investments among a number of asset classes. Fixed annuities, in particular, offer a unique asset class, an investment that is guaranteed not to decrease and that will actually increase at a specified interest rate and, often, potentially more. The guarantees are supported by the claims paying ability of the insurer.
Help you manage your investment portfolio. Investment experts routinely advise that, whenever your investments in various asset classes get too far from the percentage allocations you prefer, you “rebalance” to the original formulation by shifting funds from the classes that have grown faster to the ones that have grown more slowly. If you do this with mutual funds you pay capital gains taxes; if you do it in a variable annuity, you don’t pay capital gains taxes. When you eventually withdraw money from the annuity, which could be many years after the rebalancing, you pay tax then at the ordinary income rate.
If you are in a need income stage of life an immediate annuity can:
Help protect you against outliving your assets. Social security pays retirement income for as long as you live as do defined benefit pension plans. But the only other source of income available that continues indefinitely is an immediate annuity.
Help protect your assets from creditors. Generally, the most that creditors can access is the payments from an immediate annuity as they’re made since the money you gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities.