An annuity is a contractual relationship between an investor and an insurance company that is designed to meet retirement or other long-range cash flow goals. As insurance products, annuities are defined by a contract between the investor and the issuing insurance company. In this contract, the insurance company usually agrees to make either a lump-sum payment or series of payments beginning at a specified time. Though there is a valid use for annuity products in financial planning, it is important for investors to understand the benefits and limitations of an annuity contract. With temptingly high commission returns to the sales representatives, these contracts can be inappropriately pushed to clients who would be better served with other types of investments. With certain exceptions, an annuity product is an insurance investment product governed by a different set of regulations than traditional equities and bonds.
When purchasing an annuity, there are two investment steps to keep in mind. First you must examine the credit worthiness of the issuing insurance company. Second, you must decide on the type of underlying investments which the annuity contract will be invested in. These investments must fit within the investor’s risk profile and objectives. Once the investment is made in an annuity contract, unlike purchasing a traditional equity or bond investment, an annuity contract is generally not easy to unwind.
The financial strength of the issuing insurance company should be examined on any potential annuity investment. Should the company fail, the contract is subject to the limits set by state law which may be substantially less than the equivalent FDIC or SPIC limits. During past economic downturns, insurance companies have successfully had their contracts rewritten with annuity investors at much less favorable terms to annuity investors than originally agreed upon.*
Among the tax advantages of an annuity is that the investment returns accumulate tax free until the investor makes withdrawals from the account much the same way as an IRA account where the returns accumulate tax free until withdrawn. Unlike an IRA account, an annuity does not have maximum annual contribution limit. In addition, in some cases, since annuity contributions can be after tax contributions, the investor pays taxes on the investment gains of the annuity not the return of principal.
An annuity contract is treated similarly to a life insurance product with a named beneficiary and can pass outside the estate directly to the beneficiary upon death of the investor. The investor should be sure that the beneficiary listed in the annuity matches what is desired since the distribution of the proceeds are not necessarily dependent upon the directions of the will.
Types of Annuity Investments
There are 3 basic types of annuities offered to the general public: Fixed, Indexed and Variable annuities. These descriptions relate to the underlying investments that are made on behalf of the investor by the insurance company offering the annuity. Many of these products are complex and an investor must do their homework before settling on a specific annuity. Truly knowledgeable independent advice can be very helpful in making an annuity investment.
Fixed – Fixed annuities are products with a specified rate of return. Periodic payments are usually made in a specified amount for a defined period (e.g. 20 years) or an indefinite time period (e.g. your or your spouse’s lifetime). Since they are not securities, fixed annuities are not regulated by the SEC.
Indexed – Returns are based on the return of a specific index (e.g. S&P 500) and often include a specified minimal return despite the return of the index. However, even if coupled by an issuer’s promise of no loss of principle, there is generally a potential for losses due to management fees charged as part of the investment. Generally indexed annuities are not registered with the SEC, although an indexed annuity may or may not be legally deemed a security.
In a variable annuity, investments can be chosen amongst a number of different investment options, usually mutual funds. The selection of investment options is often similar to many retirement products such as 401(k) s. Rates of return will depend on the performance of the underlying investments chosen. Variable annuities are regulated by the SEC.
Annuity Withdrawals
Before purchasing an annuity, the investor needs to have a general idea of when the investor is planning to withdraw funds from the account. With most annuities, withdrawals are either immediate or deferred. Keep in mind that annuities are contracts which are difficult to rewrite if life circumstances change. The cost of switching contracts can be considerable. In many contracts, the decision of when to withdraw funds (or annuitize) can occur at a later date and do not have to be locked in when the investment is made.
An immediate annuity is a product where the investor trades a lump sum of money for a stream of income from an insurance company. With an immediate annuity, payments begin soon after the initial annuity purchase. Immediate annuities are often purchased when nearing retirement age or when the investment return is matched to an ongoing expense.
In a deferred annuity, funds are invested for a period of time until the decision to begin to withdraw funds from the account much like and IRA account.
Commissions and Fees
For most annuity products the benefits presented to the customer are upfront but the fee structure can be both complex and opaque. Different types of annuities charge different types of fees. Generally, variable annuities charge explicit fees while fixed annuities tend to embed their costs. Fees that may be associated with annuities include sales commissions, management fees, underwriting fees, rider charges and surrender charges. Some fees can reduce the initial principle investment and all fees reduce the total return annuity value.
Like other life insurance products, commission fees are sales charges paid when setting up the annuity. These fees are usually paid by the issuer and are therefore hidden from the annuity holder. The WSJ reports that commissions may range from 5% to 7% and that some issuers pay agents 8% or more. In addition, some insurance companies offer a trailing commission structure which pays the agent a portion of the investment over the life of the product in exchange for a lower up front commission. This cost is reflected in the initial principle or in a reduced rate of return. However, a higher commission fee may mean lower surrender fees if funds are withdrawn early. Due to high commission fees, total returns can be much lower than other investment vehicles. When shopping, make sure to ask the salesperson to disclose the commission fee and how it is charged before making a decision.
Ongoing management fees are often charged with fees up to 3% of current assets. Management fees are most often associated with variable annuities.
Many annuity providers charge underwriting fees which reflect the insurance premium associated with the death benefit for the annuity holder and beneficiary.
Annuities are often designed to discourage the early withdrawal of funds, particularly within the first 5 to 8 years of purchase. In order to discourage early withdrawal, fees known as surrender charges can be assessed on the amount withdrawn. These charges can be as high as 10% or even more.
Rider charges are optional guarantees often obtained to protect annuities principal and income in the event of extreme market gyrations. Riders are typically used on variable annuities and carry additional costs to protect against downside market risk.
Taxes
Annuities purchased with pre-tax funds (much like an IRA or 401k) are deferred. However, any withdrawals deemed investment returns are usually fully taxable. Withdrawals on annuities purchased with after-tax funds are generally taxed on the gains only. Gains in this type of account are taxed as ordinary income and not capital gains. There may be tax penalties assessed upon early withdraw however. The IRS generally assumes that the earnings portion of funds withdrawn is taken first which makes early withdraw costly.
Another tax implication is the loss of a step-up in cost basis to heirs. Capital assets that were purchased at a low cost, like stocks and bonds, are afforded a step-up in their cost basis upon the original investor’s death. If the original investor sold those assets during their lifetime, the investor would pay capital gains. If the investor chose to give those same assets to their children (for example) while the investor was still alive, the children would inherit the original cost basis. On the other hand, if the assets were to pass to the heirs at the time of the original investor’s death, the heirs will receive a step-up in their cost basis to the value of the asset at the time of death of the investor. In effect, the gains could pass tax free to the heirs based on the value at the time of death.
Annuities with significant appreciation, receive no step-up in cost basis at the time of death of the original investor. This means that the heirs generally inherit the original cost basis and are taxed on taxable annuity proceeds at an ordinary income rate.
Benefits of Annuities
One of the most attractive benefits of annuities is that the amount at which an individual is able to invest tax-deferred is nearly limitless as opposed to other tax deferred retirement products such as 401k and IRA’s whose contributions are capped at any given year. Also, since annuities can be fixed contracts, the holder knows what to expect throughout the term of the annuity.
The pre-determined clarity of an annuity contract may be appropriate for some who have beneficiaries who may need funds in the future and whose assets may be limited. One example would be a life insurance policy providing the assets to fund the cash flow needs of a Special Needs Trust. This investment could be appropriate for a parent with limited assets who needs to provide regular income to a beneficiary upon the parent’s death. The cost of the life insurance premiums would be substantially less than the assets required to generate a regular income stream to the beneficiary. Upon death of the investor, the life insurance policy would pay a lump sum into the Special Needs Trust and the Trust would then purchase an immediate annuity and begin paying out an income stream to the beneficiary. An appointed Trustee could still administer the distribution of the immediate annuity cash flow in accordance with the legal requirement of the Special Needs Trust but the cash required to fund the Trust (in the form of life insurance premiums) should be substantially less by using the life insurance product to fund the trust than depositing a large amount of funds with the Trust before the investor’s death to create a similar income stream.
Negatives of Annuities
Annuities are not for everyone. Individuals with limited funds for retirement investing should first take full advantage of other tax deferred accounts such as 401-k’s and IRA’s. In addition, the lower an investor’s tax rate, the lower the tax deferred benefit of an annuity.
Annuity Buyers Beware- look carefully at the company offering the annuity product. Beware of insurance companies offering substantially better than market return rates in their annuity products. It is extremely important to look at the financial strength of the insurance company offering the product. These investment vehicles are only as good as the companies that underwrite the products. In the event of a failure of the insurance company, the contract is subject to the limits set by each state individually which may be substantially different than the FDIC or SPIC limits. In addition insurance companies have had success in rewriting their obligations to investors in economically tough times especially with guaranteed return contracts in falling interest rate environments.
Beware of complicated annuity products. Annuity contracts are often complex and disclosure is poor with the upside highlighted up front and the negatives buried deep within the documents. Since annuities are long term contracts, if life circumstances change, the contract is difficult to modify without significant costs.
The life insurance component of an annuity contract, unless a specific death benefit is listed in the contract, can be misleading. If the annuity is not yet annuitized, the death benefit may be limited to the principle invested.
Variable annuities are essentially bundled mutual funds often allowing funds to be moved from one fund to another much as you would shift your IRA account or 401 K account. Movement from one fund to another in an annuity contract is generally allowed only within a small offering of managers or funds to which the issuing insurance company has a relationship. In addition, movement from one fund to another may be restricted as to time and frequency.
The broader the offering of investment alternatives, the more diversified and generally the less the risk for contract investment underperformance. Since many annuities are tied to a specific financial institution, investment options can be severely limited. Costs may be higher than similar offerings from other providers. There are only a handful of companies offering a very wide variety of investment options of outside fund managers to manage the portfolios of underlying annuity contracts. Companies offering an extremely broad array of investment options exist but are very few and far between.
Conclusion and Close
Investors should remember that annuities are essentially insurance contracts and as with any contract the terms should be well understood by investors. Because commissions generated to salespeople for the placement of annuity contracts with investors are among the highest in the financial services industry, it is important to consult with an advisor who has a fiduciary obligation to the client to insure that the investment is appropriate.
*Executive Life Insurance- the largest life insurance company in California at the time went bankrupt in 1991. After offering above market guaranteed rates of returns in its annuity products, the firm went under and its annuity contracts the terms of which were substantially rewritten to the detriment of investors. Some investors had to wait over 10 years for settlement.
Sources
http://www.sec.gov/answers/annuity.htm
http://www.sec.gov/investor/pubs/varannty.htm
http://www.schwab.com/public/schwab/investing/accounts_products/investment/annuities
http://money.cnn.com/retirement/guide/annuities_basics.moneymag/index10.htm?iid=EL
http://www.investopedia.com/articles/retirement/07/annuity-benefits-fine-print.asp