ANNUITIES EXPLAINED

 

What is an annuity?
An annuity is an investment contract or policy between you and a life insurance company. Annuities can be a useful tool for retirement planning:
  • Save tax-free
    Annuities enable you to save money on a tax-deferred basis. You will not pay taxes until you begin to withdraw your money. Unlike a 401(k) or IRA, there are no limits on the amount you can put into an annuity.
  • Offers retirement income
    You can purchase a contract that provides lifelong income or one that pays you for a specific time. Payments can be monthly, quarterly, semiannually or annually at a designated time.
  • Provides benefits to your heirs
    Some annuities include an insurance component. If you die before you start to collect on the annuity, it pays your heirs the amount you invested plus interest or the market value of the funds in your account, whichever is more.
  • Offers an array of investment options
    You determine how much you want to invest in an annuity and the amount of investment risk you are willing to take. If you put your money into a variable annuity, your premiums can be invested in stock or bond funds. There are no tax consequences if market conditions prompt you to change how your balances are invested. You can also change from one fund to another without tax consequences. If you don't want to deal with the ups and downs of the stock market, you can invest your money in a fixed annuity, which would offer you a specific rate of return.
Why should I consider purchasing an annuity?
You may need to protect yourself against outliving your assets, even if you have diligently saved for your retirement. Consider the following:
  • Retirement plans limit contributions
    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 are limited.
  • Social security and pensions may not be enough
    Your social security and pension may provide less than you need to retire. In 2002, the average Social Security check was $876 per month, according to the Social Security Administration and the value of fixed pensions is eroded by inflation.
  • Inflation and taxes can eat away at savings
    Over time, inflation will make everything you purchase more expensive, so your investment earnings need to keep pace to maintain your current standard of living. Many sources of income may also be taxable such as Social Security, IRA payments, interest earned on CDs and savings accounts. You may end up with a lot less after-tax income that you had been expecting.
How much should I invest in an annuity?
The amount of money you should consider putting into an annuity depends on your:
  • Current savings and investment portfolio
  • Immediate economic needs
  • Long-term financial goals
You may need to build retirement savings with a tax-deferred annuity or supplement your retirement savings with an immediate annuity.
Unlike a 401(k) or an IRA, there are no limits on the amount that you can invest in an annuity.
How are annuities different from life insurance?
Both annuities and life insurance should be considered in your long-term financial plan. While both include death benefits, you buy life insurance in the event you die too soon and an annuity if you live too long.

Essentially life insurance provides economic protection to your loved ones if you die before your financial obligations to them are met, while annuities guard against outliving your assets.

Annuities are a retirement planning tool. You can invest in a:
  • Deferred annuity: A long-term investment contract that builds savings on a tax-deferred basis.
  • Immediate annuity: A type of personal pension plan that is purchased at or near retirement. It offers something that no other investment can guarantee – regular income payments for the rest of your life – no matter how long you live.


Life insurance provides financial protection to your loved ones when you die by providing:

  • Income replacement
    If you have dependents, then you need to consider what would happen to them if they no longer have your income to rely on.
  • Payment of outstanding debts and long-term obligations such as burial costs, credit card debts and medical expenses not covered by health insurance. In addition, life insurance can be used to pay off the mortgage, supplement retirement savings and help pay college tuition.
  • Estate planning
    The proceeds of a life insurance policy can be structured to pay estate taxes so that your heirs will not have to liquidate other assets.
  • Charitable contributions
    You can designate some of the proceeds from your life insurance to go to your favorite charity.

While both life insurance and annuities have death benefits, they are not the same. The purpose of life insurance is to provide death benefits to your loved ones, while the primary goal of an annuity is to supplement retirement savings.

Most annuities (deferred in particular) include a death benefit. Generally, the death benefit is determined by the amount in your account balance when you die. You can guard against declines in the market, by purchasing an enhanced death benefit, which locks in the account balance periodically.

Some immediate annuities, such as a Life Income Only Policy with No Guarantee, don’t continue payments to a beneficiary after your death. Payments to a beneficiary are waived in exchange for providing a larger income stream while you are still alive.
What are surrender fees?
If you take money out of an annuity, there may be a penalty called a surrender fee or a withdrawal charge. This fee is higher if you withdraw funds within the first years of an annuity contract. The penalty, however, drops gradually each year. Since immediate annuities are purchased to provide income, they usually can’t be “surrendered” and will therefore not be subjected to a fee.

A typical surrender fee schedule could be:
  • 7 percent if you withdraw funds in the first year,
  • 6 percent in the second year,
  • 5 percent in the third year,
  • 4 percent in the fourth year,
  • 3 percent in the fifth year,
  • 2 percent in the sixth year,
  • 1 percent in the seventh year,
  • and zero in the eighth year and beyond.

The purpose of the fee is to allow the insurer enough time to recover its expenses, largely commissions, in setting up the annuity contract. It also serves to discourage annuity buyers from using deferred annuities as short-term investments for quick cash.
Some contracts may annually permit you to pull out a portion of the funds, usually up to 10% without a surrender charge. If this option is important to you, ask your insurance agent or company representative about this before deciding to invest your money in a specific annuity. Also, ask if there may be any other fees or charges.
What are the different types of annuities?
There are many types of annuities for a variety of different needs and budgets. Your age and risk tolerance should weigh heavily in your decision regarding the type of annuity in which to invest.

When considering an annuity, you will have to decide when you want to receive the money. If you invest in an immediate annuity, you would receive the income now, while a deferred annuity would be a savings vehicle for the future.
  • Immediate annuity: You pay the insurer a lump sum of money in exchange for receiving income for a set period of time or for as long as you live. You usually start receiving payments immediately after transferring funds into an annuity.
  • Deferred annuity: This is a long-term retirement savings vehicle, which builds savings on a tax-deferred basis.
You will also need to select how your money will be invested. You can invest your money so that you get a stable rate of return or you can pick an annuity where your money is invested in the stock market. You can pick one or a combination of the following:
  • Fixed annuity: This provides a stable, guaranteed rate of return.
  • Variable annuity: The annuity is invested in the stock or bond market. As a result, you assume some financial risk in return for a potentially higher economic reward.
Life insurance companies offer many combinations of the above, with a number of special features.
What is the difference between a fixed and variable annuity?
Fixed annuities pay a “fixed” rate of return. When you receive payments, the monthly payout is a set amount and is guaranteed. Fixed annuities may be a good choice for:
  • Conservative investors who value safety and stability.
  • Those nearing retirement who want to shelter their assets from the volatility of the stock or bond market.
With variable annuities, you can invest in a variety of securities including stock and bond funds. Stock market performance determines the annuity's value and the return you will get from the money you invest. The amount of risk you are willing to assume should influence the kind of funds you select.

You may want to consider a variable annuity if you are:
  • Comfortable with fluctuations in the stock market and want your investments to keep pace with inflation over a long period of time.
  • Young and want to prepare financially for retirement by reaping the gains in the stock or bond market over the long term.
What are deferred and immediate annuities?
Deferred Annuity

This type of annuity is good for long-term retirement planning for the following reasons:
  • Payments on income taxes are deferred until you withdraw the money.
  • Unlike a 401(k) or an IRA, there are no limits on your annual annuity contributions.
  • There is a death benefit. If you die before collecting on the annuity, your heirs get the amount you contributed, plus investment earnings, minus whatever cash withdrawals you made.
Immediate Annuity

This allows you to convert a lump sum of money into an annuity so that you can immediately receive income. Payments generally start about a month after you purchase the annuity. This type of annuity offers financial security in the form of income payments for the rest of your life. In other words, you cannot outlive it.

Immediate annuities allow you to:
  • Supplement your current income. If you are nearing retirement, you may consider transferring another savings or investment account into an immediate annuity. You can also move the proceeds from a deferred annuity into an immediate annuity.
  • Pay taxes only on the portion of your immediate annuity payments that is considered earnings. You are not taxed on the portion that is principal. The principal is the initial deposit made with funds that have already been taxed.
Like deferred annuities, immediate annuities can be fixed or variable. Fixed immediate annuity income payments are pegged to the amount you contribute, your age and the interest rate at the time of purchase. Those payments to you will not go up or down. Variable immediate annuity payments vary with the investments you chose.
What is a lifetime annuity?
You can think of a lifetime annuity as investment vehicle that functions as a personal pension plan. Sometimes referred to as “single life,” “straight life,” or “non-refund,” these are a form of immediate annuity that provides income for your entire life. The payments can be increased to cover a second person. This is called a “Joint and Survivor” annuity. While most provide income for life, some may offer the option of payments for a fixed number of years.

A lifetime annuity could serve as a retirement income supplement to Social Security checks, 401(k) retirement plans, company pension funds, etc. Lifetime annuities provide income for as long as you live - even after all the money you contributed is exhausted. They can be useful for those who want the certainty and security of establishing a regular and guaranteed income stream. If, however, you die before all the funds in your account have been used up, the payment option to your beneficiaries will be determined by the choice you made when you purchased the annuity. In some cases, no payouts will be made to your dependents or other beneficiaries. Instead, you will be getting an income that you can’t outlive.

A straight life annuity makes sense for someone who needs the most retirement income possible and does not plan to use the money invested for dependents or other beneficiaries.
How are annuities sold?
Annuities can be purchased through insurance agents, financial planners, banks and life insurance carriers. However, only life insurance companies issue policies.

Here is a closer look:

Agents

Agents are insurance professionals who are licensed by your state insurance department. Some agents work exclusively for one insurance company, while others represent several.

If you decide to use an insurance agent, find one who is knowledgeable about annuities and has a reputation for excellent customer service. The agent should be able to advise you and answer all your questions. If you are thinking about buying a variable annuity, the agent should also have a license to sell variable annuity products. Since variable annuities are considered securities, you should receive a prospectus describing the investment alternatives available to you.

Banks and brokerage firms

Products developed by life insurance companies are often marketed through banks and stock brokerage firms. Make sure the person who sells you the annuity is a licensed life insurance agent. In the case of a variable annuity, the agent should also be a licensed securities dealer. If you buy an annuity through a bank or brokerage firm, you should ask about the types of annuities the insurer issues and the financial strength of the insurance company.
How do I select an insurance company?
The annuity business, like the insurance industry itself, is very competitive. There are hundreds of insurers and many different types of products available to you. Before buying an annuity, contact your state insurance department to see whether it offers an annuity buyers guide for your state.

There are four things to consider:
  1. Insurer's financial strength
    You should check the financial stability of the insurance companies you are considering. Several companies provide this information, including:

    A.M. Best Company, Inc.
    Ambest Road
    Oldwick, NJ 08858
    (908) 439-2200
    www.ambest.com

    Moody's Investors Service
    99 Church Street
    New York, New York 10007
    212-553-1658
    www.moodys.com

    Standard & Poor's Insurance Ratings Service
    55 Water Street
    New York, New York 10041
    212-438-7280
    www.standardandpoors.com

    Weiss Research
    4176 Burns Road
    Palm Beach Gardens, Florida 33410
    800-289-9222
    www.weissratings.com
  2. State insurance department license to do business
    Make sure that the insurer you select is licensed to issue annuities in your state. Ask whether the specific type of annuity you are considering is available in your state.
  3. Service
    Expect excellent customer service. Your insurance company representative should answer your questions promptly and provide useful information that addresses your concerns. This way, you can make a well-informed decision on the annuity that best meets your needs and objectives.
  4. Choice of investments and riders
    Some insurers offer annuities with an array of investment choices and a large variety of riders. Compare these options. Some options may increase the price of the annuity. Decide on an annuity that best meets your needs.
How do I pick an insurance agent?
Selecting an insurance agent is an important decision. Like picking a doctor or a lawyer, you need to work with people who you are comfortable with and have considerable knowledge about their profession.

Ask your friends, relatives and business associates for names of insurance agents that have an excellent reputation. But, do not stop there. Find out what life insurance carriers they represent. If you are not interested in the companies they represent, you will need to find another agent.

Make sure that the agent:
  • Devotes the time needed to understand and serve your annuity needs.
  • Demonstrates clear knowledge about the various types of annuities that are available and can plainly explain your choices.
  • Has a proven track record of excellent customer service.
  • Is licensed by your state insurance department.
What is a “free-look” provision?
Most state insurance departments require insurance companies to provide a "free-look" period after you have purchased the policy. It is typically a 10-day span in which you can pull out of the contract and obtain a refund based on contract terms or state law. You should use this time to review the policy, ask your insurance agent or stockbroker any additional questions and make a final decision as to whether the annuity you selected was right for you.

Note: Under no circumstances will Equidigm's provided topics and perspectives intended to persuade, indoctrinate, or enlighten producers on a particular philosophical, political, or public policy position. Nothing in this course is intended to imply that one insurance company's annuity is better or worse than another's. The suitability of any company's annuity can only be determined after examining the needs and circumstances of the potential buyer.