Below is an excerpt from the book Downsize Sooner than Later – 18 Rules for Retirement Success available on Amazon.com.
On a foundational level, annuities are a form of insurance. In the case of a life annuity, in exchange for a premium, an insurance company promises to provide a stream of guaranteed income payments for the life of the insured. Due to the nature of annuities as insurance, funds allocated to purchase annuities are properly called “premiums” and annuity contracts must be purchased from licensed insurance agents.
There are several financial and insurance products that bear the name annuity. Two general categories of annuities are called “immediate annuities” and “deferred annuities.”
• Immediate annuities. With an immediate annuity, a sum of money is paid as a premium to an insurance company in exchange for the promise of income for life. In most scenarios, monthly income payments can begin to the retiree in as little as 60 days. Sometimes immediate annuities are called “SPIAs.” This stands for “single premium immediate annuity.” Immediate annuities do the workhorse job of providing guaranteed lifetime income for seniors. They are uncomplicated and generally reasonable in terms of their overall cost in fees and commissions. Sometimes, they are erroneously confused with other higher cost annuities that put more emphasis on accumulation versus income. This is unfortunate as it draws attention away from the core and highly useful value that immediate life income annuities provide.
• Deferred Annuities. These are annuities in which a premium is paid (or incremental premiums are paid) in advance – often years earlier – and funds are left to accumulate over time. In the future, depending on how the contract is structured, the insured can opt to “switch on” and annuitize the funds for lifetime income, or exchange, or surrender the annuity for its accumulated cash value. However, once an income option is initiated, annuities cannot be surrendered or exchanged for their underlying values.
Here are at least four major reasons someone might choose to purchase a deferred annuity:
1. Tax-deferred internal growth. The internal cash value of an annuity grows on a tax-deferred basis. That is, the gains aren’t taxed until withdrawn. Withdrawal can take the form of future income payments or liquidation of the annuity.
2. Diversifying before retirement. Someone approaching the decade or so before retirement may wish to set aside a portion of funds slated for the funding of future income. This might mean repositioning dollars from more volatile investments, or through the sale of less liquid assets, such as property. The idea would be to safely pre-stage these funds for eventual annuitization upon retirement.
3. To secure an “ALDA” or advanced life deferred annuity. An ALDA is a deferred annuity intended to be annuitized in late age – such as age 80 or 85. Initial premiums are generally lower, and qualified funds (i.e. IRA-type funds) may be available within certain IRS guidelines to fund an ALDA. Qualified funds used to purchase ALDAs are called “QLACs” or qualified longevity annuity contracts. These were made legal in 2014, as the government noted a need for more widespread access to guaranteed retirement income.
4. For insuring long-term care expenses. A hybrid annuity is a leveraged way to help pay for extended care and (currently) receive preferential tax treatment. Money grows tax-deferred in a hybrid annuity. If qualifying long-term care is needed, it can be paid for with dollars from the policy. If care is not needed, the unused funds in the annuity can be left to beneficiaries. Note that beneficiaries will be taxed on any untaxed gains.
There are basically three types of deferred annuities: fixed, indexed, and variable.
- Fixed annuities. These are annuities that allow for accumulation of capital on a very conservative and tax-deferred basis. Internal funds are credited with a guaranteed fixed rate of return – generally tending to be a bit higher than a bank CD. Fixed annuities are one of the safest financial instruments available.
- Indexed annuities. Indexed annuities – or equity indexed annuities – offer tax-deferred growth and insulation from downswings in the market. Internal funds are credited with an interest rate that is linked to an outside equity index, such as the S&P 500Ⓡ or other equity index. Indexed annuities employ a variety of crediting formulas that split potential gains between the insurer and annuity owner. For example, an indexed annuity contract may stipulate a “spread fee” of 3%. This means if the linked index returns 12% over the crediting period, the amount credited to the annuity would be 9%, with the insurance company keeping 3%. Typically, stock dividends are not included as a part of indexed annuity interest crediting. Though the internal funds of an indexed annuity can benefit from upswings in a linked index, the principal of an indexed annuity is not put at risk. This is accomplished using options strategies. Generally, options are purchased to buy future stock shares in the linked index. If the index’s share values go up, the options are exercised to lock in a gain. But if the index’s share values go down, the options can expire with no loss in the annuity owner’s account balance. Index annuity contracts can be complicated and the fees and commissions much higher than with immediate annuities – so be careful. Make sure you fully understand how the contract works – especially how interest is credited and what any surrender charges would be should you want your money back prior to annuitization – before purchasing an indexed annuity.
- Variable annuities. Variable annuities are a form of annuity that enables the underlying premiums to be invested in various types of securities such as stock-mutual funds. Future payments from variable annuities generally include a guaranteed minimum but are also based on the underlying performance of the funds selected. The difficulty with variable annuities – beyond their fluctuations in income payments and increased level of risk – is that they tend to have high overall fees which drag down their performance. I am hard pressed to find any useful reason for anyone to select a variable annuity, especially given the wide array of more favorably guaranteed, safer, and lower-cost alternatives.
Questions or comments?
I can be reached at this link – contact Ted Stevenot.