My Comments: This post is for those of you who might be considering an annuity to help fund your retirement. It appears here as Part One with Part Two and Part Three to follow this week. It’s long and detailed so you’ll likely find yourself in the weeds from time to time. My source of this material is from a Continuing Education course I took recently as required by the Florida Department of Financial Services to maintain my insurance license in Florida.   

For a huge segment of our aging population, annuities exist to solve financial needs as the years roll by. However, for those of you in the upper income classes, it’s a less chosen option for many reasons. Virtually all annuities are associated with retirement, the point in time when someone stops working for money and money starts working for them.

by Tony Kendzior, CLU, ChFC / 29 AUG 2023

Today’s retirees and those on the verge of retiring, face a number of financial challenges. Participation in defined benefit pension plans continues to dwindle, life expectancies continue to increase, and uncertainty surrounds the future of Social Security. One of the leading issues that drives planning for retirement in today’s world is how to make retirees’ money last as long as possible, at least until their days end.

For many, the answer is an annuity. Transitioning from pre-retirement earnings and savings to post-retirement income and distributions can be less daunting when supported by one or more products that can effectively address two basic retirement targets:

• before retirement: the accumulation of funds on a tax-favored basis
• after retirement: the delivery of an income stream that is guaranteed for life

These two reasons suggest why annuities have become popular retirement planning tool. The need for lifetime guaranteed income has grown in recent years  as more consumers recognize this need and realize that Social Security is under threat. More agents like me are including annuities when talking with potential clients about meeting the financial challenges they face.

As a result, more and more consumers are learning about these products and are adding them to their retirement plans. Annuities have been around for centuries, and many producing agents see them as a meaningful way to help clients meet their coming financial challenges.

They are unique financial instruments, contracts issued by insurance companies that can provide a way to both accumulate funds for the future and systematically distribute those funds over a given period.

Annuity buyers deposit money into the annuity contract in the form of premiums, either in a lump sum, or incrementally. These funds are then invested by the host insurance company, and then credited with a certain rate of interest. The objective is grow value in relation to the performance of the investments in which they are deposited.

Funds accumulate in an annuity contract (policy) on a tax-deferred basis, which enhances the annuity’s ability to increase in value. Some of this growth results from compounding at a greater rate because none of the earnings are taxed until monetary distributions are taken.

By design, annuities can operate as both asset accumulation vehicles and asset distribution vehicles. There is no other financial product that can serve these purposes on a guaranteed basis. For this strong reason, annuities are well suited for retirement planning as they can provide tremendous value as individuals become increasingly reliant on adequate cash flow to maintain their lives in retirement.

The 2 fundament types of annuities.

1. Immediate annuities

Immediate annuities are issued when someone hands an insurance company a block of money in exchange for a stream of payments to be used in the coming years. These payments are calculated actuarially to extend for a certain number of years or for the owner’s lifetime, guaranteed by the insurer. This is the process of annuitization, applying capital to purchase income. Through ongoing income payments, annuitization serves to systematically liquidate a set amount over the length of the annuitization period, however long that may be.

• Deferred annuities

A deferred annuity, by contrast, does not create an immediate income. Rather it’s designed to accumulate funds for the long term. Accordingly, it is characterized by an accumulation stage. The accumulation stage is the period during which funds are deposited into the contract and are credited with a certain rate of interest earnings or grow in relation to the performance of the investments in which they are deposited.

The accumulation stage is when the annuity’s account value grows. Usually, this stage includes an initial holding period, which is typically seven to ten years, sometimes more. If withdrawals are made during this period, contract owners may be assessed a fee or penalty if they withdraw funds in excess of an allowed amount. This is usually a time frame from day one and with high quality contracts, typically lasts from 5 to 10 years during which time any fee, or penalty per withdrawal shrinks to zero.  

Many deferred annuities allow the owner to withdraw up to 10% of the accumulated value every year and not be subject to a fee. Anything beyond that is typically subject to what is known as a “surrender charge” or fee, that starts at perhaps 10% and shrinks every subsequent year until it reaches 0%. Absent any withdrawals to that point, the contract owner can explore every option available.

At the point in time when the owner decides an income is necessary, usually thought of as the end of the accumulation stage, the owner has several options. He or she can:

• withdraw the funds in whole or in part
• leave the funds in the contract to continue accumulating
• annuitize the contract

Any interest or growth earned by the annuity during the accumulation stage is not taxed as long as those funds remain in the contract. Regardless of whether premiums were paid with either before-tax dollars or after-tax dollars, this tax-deferred growth feature represents a distinct advantage over other investment products.

A deferred annuity can be funded with a single lump-sum premium deposit or with a series of premium deposits over time, as and when the owner chooses.

Why are you considering an annuity at all? Are You Looking for Accumulation or Income or both?

Choosing the right type of annuity always begins by making a choice between an immediate or deferred annuity. This choice is based on the buyer’s perceived need going forward. If the buyer wants an annuity to save and accumulate tax-deferred funds, the choice is the deferred annuity. If the individual is ready to turn his or her savings into income now, the choice is the immediate annuity. If the individual wants to lock in a future income stream today for a known payout years into the future, the choice would be a deferred income annuity.

Within the category of deferred annuities, you’ll find the term “annuitization”. This refers to the ability of the contract owner to effectively change the nature of the deferred annuity into an immediate annuity. Before that happens, the challenge is to understand the various crediting methods that apply to deferred annuities. They are as follows:

1. Fixed Annuities

A fixed annuity provides for:

• fixed levels of interest to be credited to the contract by the insurer during the accumulation stage
• a fixed, unchanging level of income to be paid upon the contract’s annuitization

As interest rates have become higher in recent years, with little expectation for them to return to levels seen as little as five years ago, this type of annuity is losing its appeal. But anyone reading this should be aware of how they differ within the fixed annuity world.

         Fixed Rate of Credited Interest

The rate of interest credited to a fixed deferred annuity during the accumulation stage is declared by the insurer, subject to periodic change, and is backed by a minimum guaranteed rate of return. For example, a fixed annuity could provide for an initial 4.5 percent declared rate of return for the first two years after contract issue and a minimum guaranteed rate of 2 percent for the contract’s term.

An application of these variables might play out like this: after the first two years, the insurer declares another rate of return that is to be credited to the contract. This renewal rate can be higher or lower than the initial 4.5 percent, but the owner is guaranteed that it will be no lower than 2 percent.

         Fixed Amount of Annuitized Income

A contract that is annuitized on a fixed basis will make the same income payment for the entire annuitization period. If, for instance, 60-year-old Charlie decided to annuitize his $200,000 annuity contract and selected a fixed monthly lifetime payout option, he would receive payments of about $1,000 every month for the rest of his life. Those payments will not increase or decrease and are guaranteed by the insurer. That could present a problem if inflation remains high.

Traditional fixed annuity products are conservative investment vehicles, appropriate for those who are strongly risk averse and who seek safety of principal, conservative returns, and minimum guarantees. Most require a holding period of a number of years before the owner can access the contract’s values without charge or penalty. Depending on the insurer and the product, this period may be as short as five years or as long as eight or ten years.

Fixed index annuities, often referred to as an FIA, are a form of fixed annuity. However, the interest to be credited to the contract is not declared outright by the insurer. Instead it’s based on the performance of a market index chosen by the buyer. Most indexed annuities are tied to either a stock market index, such as the S&P 500 or the Russell 1000, or a specific investment managers expertise and performance history. There are excellent money managers and there are less than excellent. That’s part of the difficult choosing process faced by potential buyers of fixed index annuities.

         Basis for Indexed Annuity Interest Crediting

The basis for the interest credited to an indexed annuity is the performance of the specific market indexes available from which to choose. Insurance companies are always looking to offer FIA contracts with a variety of choices, always trying to differentiate their contract from those offered by competing insurance companies. The fiduciary agent should always be able to explain and be able to offer good products to their prospective clients.

If the chosen index(s) rises during the contract’s interest crediting period, for example increasing 10 percent from a starting value of 1,000 to an ending value of 1,100 12 months later, that 10 percent increase will be the basis for the interest being credited to the contract for that crediting period.

In this way, indexed annuities allow some measure of participation in market-based returns: the increase (or decrease) in the index(s) chosen reflect the aggregate characteristics of the index’s underlying securities, and that increase (or decrease) is the basis for the amount of interest that will be credited to the annuity.

FIAs also provide for a minimum guaranteed interest rate, which protects the values in the contract against market downturns. At the end of each interest crediting term, the greater of the indexed interest or the minimum guaranteed rate will be credited to the contract. In this way, an indexed annuity buyer’s principal is protected from loss.

Keep in mind that often a buyers decision is based on the perceived credibility, or rating earned by the insurance company involved. One thing to remember here is that it’s not the insurance company that’s being invested but funds that represent your money. As Its’ your money, know that insurance companies of consequence only invest their money in Federal bond funds, as an example.

• Variable Annuities

Unlike a fixed or FIA that typically includes a minimum guaranteed return, deposits made to variable annuities are almost always placed into nonguaranteed investment portfolios maintained by the insurer. These separate account portfolios consist of a variety of stock, bond, and money market accounts and are similar to mutual funds. The performance of a variable annuity’s underlying investments determines the growth of the variable annuity. If the underlying investments perform well, the contract’s values increases; if the underlying investments perform poorly, the contract’s values may decrease.

For this reason, the variable annuity owner bears all the investment risk for the contract’s performance. With a variable annuity, the attraction is a perceived potential for growth that is associated with the contract’s underlying investments, a potential that is generally greater than what can be obtained with fixed annuities or other conservative investments, such as certificates of deposit or government bonds.

Beginning in the late 1990s and early 2000s, insurers began designing riders for their variable annuities. The riders included guaranteed living benefits, available for an additional cost. These riders provide some level of guarantee of the variable annuity’s values, to be used for accumulation, withdrawals, or annuitization. They have proven to be very popular in the variable annuity market but they can be costly and very complex.

         Variable Annuities Are Considered Securities as Well as Insurance

Due to the nature of their investment feature and the risks they pose, variable annuities are considered securities as well as insurance products. Accordingly, these products and those who sell them are subject to federal and state securities regulation as well as state insurance laws. Variable annuities must be sold with a prospectus, and all sales and marketing activity must conform to the standards and requirements of all associated regulatory bodies. Producers who sell variable annuities must be securities licensed as well as life licensed.

In Annuities: Part Two, we’ll start to explore any of what we’ve seen so far in terms of whether they are purchased with before-tax dollars or with after-tax dollars.