In recent months, I have received several calls from clients and questions during review appointments about annuities. As a licensed insurance agent in California and other states I receive an abundance of mail, sales literature, etc. for both fixed and variable annuity sales promotions. Since I have been insurance licensed in 1987, I have witnessed interest rates in fixed annuities dropping from as high as 16% to the current low of about 3%. The trend toward lower rates has been accompanied by the rise in popularity of variable annuities which offer the opportunity for higher investment returns. I thought I would clarify how I view annuities in the context of their use in an overall long term financial plan. I will limit this to generalized descriptions to convey basic decision making rather than address the myriad of annuity concepts being marketed today.
Annuity is a contractual arrangement with an insurance company. The contracts, whether fixed or variable, are generally designed to accomplish one of two basic functions:
Function #1: To purchase a limited term or lifetime of income in exchange for a lump-sum and/or periodic deposits contributed to the annuity account. This income is only partially taxable since the payout is a combination of return of principal (already taxed) and the earnings (taxable).
Actual Example: Recently, a single client, 74 years old, was contemplating retiring from her part time job. She said she would really like to use her saved up money to “replace” that income and know that she could count on it coming in on a monthly basis for the rest of her life. After some discussion, it was concluded that she needed about $500 per month. We requested a “quote” from a list of insurance companies and were offered $510.63 a month in exchange for a lump sum deposit of $80,000. This income was guaranteed to be paid to her for her lifetime. If she were to die prior to the end of a 10 year guarantee period, the income would be paid to her beneficiaries for the balance of the 10 year guarantee period. While receiving $510.63 each month, only $67.40 was TAXABLE due to the favorable tax treatment of “annuitization” payments. Note that a year’s worth of cash paid to her was 12 x $510.63, or $6,127.
a. She chose a 10 year guarantee period to “protect”, to some degree, against the risk that if she died too soon she would not leave any of the $80,000 behind for her beneficiaries.
b. Neither of her children were concerned about her using her money to guarantee her income (not that common I might add, in my experience) and not leaving anything behind for them.
c. Her payments would have been a little bit higher had she not wanted the 10 year income guarantee.
d. CAUTION!...$6,127 per year of income is about 7.6% of the $80,000. I often hear radio advertisements that, I believe, unethically refer to this as a “7.6% return on her money.” If she lives exactly 10 years she would have been paid $61,270 and there would be NO remaining funds for her beneficiaries. If she lives 20 years, she will have received $122,540 and “won” her bet with the insurance company.
Conclusion: This was an appropriate transaction for her because she did not want to expose herself to market risk, she liked the guarantee of the income, she liked the favorable tax treatment of the income, and she did not have children who were looking to protect HER money for themselves. Unfortunately, with current interest rates so low, it took a bigger deposit to guarantee her monthly income.
Function #2: To defer the earnings on a lump-sum or periodic deposits until a future date without taking current income. Current interest rates in fixed annuities are about 3%. When I started in the financial planning business in 1985, they had been 11%-16%. So why use the annuity instead of other lower risk money alternatives (CDs, money market funds, tax-free bonds, etc.)? If you are paying too much in taxes, the annuity provides for NO taxes on the earnings until those earnings are WITHDRAWN from the annuity policy. So annuity earnings do NOT show up on your tax return. Nor do they factor into calculating the taxes paid on Social Security benefits. They also do not count in the calculation of your Medicare premium.
Note that up to 85% of Social Security benefits are taxed if you have too much other income from wages, both taxable and tax free dividends, interest earned on CDs, capital gains on investments, etc. I see this very often on client tax returns I review.
A client may choose to use the annuity as a savings instrument, deferring the decision to take income until some later date such as when they retire. Most fixed annuities offer a wide range of payout options (annuitization options) that can be “matched” to the client’s goals. (The government has even promoted the creation of special annuity products that, if turned on for long-term care needs, will receive favorable tax treatment.) To receive the favorable tax treatment of systematic payments as in the above client example, the payments must be done under a contractual payment plan. If instead, random withdrawals were taken from an annuity, the first money withdrawn is considered to be the untaxed earnings, and therefore fully taxable until all the earnings have been withdrawn.
a. For people with a sizable amount of funds in CDs, bonds, etc, annuities may offer a way to get “income” off the tax return.
b. Even with historically low interest rates in the annuities, they do provide a higher than CD return currently.
c. Annuities do have named beneficiaries and avoid probate when remaining in an estate upon death of the owner. However, the beneficiaries will still have to pay the tax on the earnings when withdrawn.
Regarding the types of annuities:
Fixed Annuity is an annuity in which the insurance company establishes a fixed interest rate for a certain period of time. The rate MAY change after a certain number of years, or annually as noted in the contract.
A variation of “fixed annuity” is a product called an Index Annuity. Rather than paying a fixed interest rate, the earnings are based on the earnings or growth in value of an “index” of financial assets, such as the S&P500. Terminology such as “cap rate”, “participation rate”, “resets”, etc. along with the multitude of product designs tends to make the selection of these products a bit intimidating due to the sheer quantity of available options in this area.
Variable Annuity is an annuity in which the owner selects from a list of investment options for the deposit of funds. These are referred to as “sub-accounts” and often designed to mimic the investment strategy of publically available mutual funds. Rather than owning “shares” in a variable annuity contract, you own “units”. The unit value grows due to dividends and goes up and down due to the fluctuations in the value of the investments of the sub-account.
Variable annuities can be turned on for either guaranteed fixed income or variable income that rises or falls dependent on how the units are growing or shrinking in value. The owner of the annuity does generally have the option to make investment changes within the contract during both the time before income begins as well as while income is being paid out.
Variable annuities generally offer “riders” that provide for death benefits, income guarantees, long-term care payout options, and other features. It may be some of these riders that would cause an investor to consider a variable annuity along with the opportunity to earn more than the fixed interest rates offered in fixed annuities. If someone feels comfortable taking investment risk, they may want the prospects of rising income over time vs the level income offered in fixed annuities.
These usually optional riders all add to the “expenses” charged in the policy which, in turn, can limit the investment returns. Besides the “expense” of the sub-accounts, adding a full suite of riders to a variable annuity contract can add typically 2-3.5% of additional annual expenses (or reduced investment return).
Just a little discussion on surrender charges. Surrender charges act as a penalty for early withdrawal. Fixed annuities and index annuities can be sold by insurance agents that are not necessarily licensed in securities and they receive a commission from the insurance company for the sale. Since the company has paid out the commission, they need to encourage you to leave your money in the policy so they have time to recover the commission expense, hence the surrender charge.
Variable annuities are sold through the broker-dealer industry by representatives with securities licenses that allow variable annuity sales.
Most annuities have surrender charges if you withdraw more than a certain amount in any year until the surrender charge period (typically 3 to 24 years) expires. While not always true, longer surrender charge periods tend to go along with higher interest rates paid in fixed annuities. In variable annuities, longer surrender periods usually apply to policies with lower ongoing management fees. In fact, in many cases, a NO surrender charge annuity often has the highest ongoing management fee. The annuity company’s cost of getting the annuity started is harder to recover if they cannot count on the money being held for the longer term.
State and Federal regulators have developed “rules” by which annuities can be sold. States such as California often have special rules for annuity sales practices to the elderly, which include restrictions on selling “in the home”, special disclosures of annuity costs, etc. The securities regulators have guidelines for annuity turnover, exchanges between annuity companies, surrender charge disclosures, concentration of client funds in annuities, etc.
Written by Thomas J. Wolf, Registered Principal of TCFG