Understanding Annuities

Annuities – and, indeed, companies offering annuities – are getting a mid-level beat down in the news these days. Seen as worryingly long term investments with high surrender charge schedules, many people are concerned that the company they purchase with may not be around in the next few years to guarantee a return on their deposits. A prime example of this is A.I.G, which is in the midst of government takeover for poor investment practices.

However, there is nothing wrong with annuities per se, in fact they can be of great benefit to the investor, provided that careful attention is paid to exactly what is being purchased. There are several different types of annuities on the market today, some more beneficial than others depending on your needs.

Most annuities have two stages – the growth phase and the income phase (often called the annuitization stage). In the growth phase of an annuity, the investment you have put with your chosen company grows in accordance with what you have invested it in. See below for further clarification. In the income phase of an annuity, you are guaranteed a certain payment based on your investment and its earnings, either for a certain time period or for the rest of your life. The payment amount generally becomes locked in, and can be classified as a dependable income stream – for as long as the company exists.

There are a number of annuity types that can be invested in, including:

Variable Annuities – A type of deferred annuity (this means your interest is tax-deferred until you take a withdrawal) that invests in variable sub accounts of your choosing. The key word here is variable. Variable annuities are not FDIC insured, and fluctuate with the market on a daily basis, depending on what types of sub accounts you invested in. It is entirely possible that you can make a great deal of money with a variable annuity if the stock market increases. It is also very possible to lose large sums of money if the market heads south. Although many companies are sweetening the deal on these types of annuities with enhanced death benefit and income benefit additions which guarantee money available for your heirs or for income purposes, this type of annuity is considered to be risky as it is almost entirely dependent on the performance of your chosen sub accounts on the stock market.

Fixed Annuities – Another type of deferred annuity, where your investment is placed in a guaranteed fixed interest bearing sub account generally guaranteed by the issuing company. Again, these are not FDIC insured, although individual states do offer some protection to fixed annuity holders should a company fold – check with your State Insurance Commissioner. The fixed sub accounts are generally locked in at a certain interest rate for a set period of time – between one and ten years being most common. Interest is generally calculated and credited daily, compounded annually. This is considered a relatively safe type of annuity, as it usually comes with minimum guarantees on interest rate offerings, and is not dependent on the stock market for its performance. As a trade off, however, fixed annuities generally have surrender charges for early withdrawal that last longer than variable annuities.

Equity Index Annuities – A type of deferred annuity that has had a great deal of attention in the news recently, an Equity Index annuity is an investment that is dependent on an index fund, such as the Standards and Poor 500 (S+P 500) for its earnings. Generally calculated on a point-to-point annual basis, if the index goes up over that year, you get interest credited to you. If the index goes down, in most types of these annuities, your investment does not go down, you just don’t get any interest credited to you that year. These are considered semi-safe because the potential for your account to go backward is slim to none, but your potential to earn is almost entirely dependent on the index performance, which is driven by the stock market.
Also, Equity Index annuities come with various sub-investment types which use caps (a limit to the year’s earnings), spreads (a percentage of your earnings that will be taken by the company, leaving you with the remainder) or participation rates (the amount of your funds which will be actively participating in the index that year). Knowing the differences between these is very important in order to maximize potential earnings.

SPIA’s – Single Premium Immediate Annuities are exactly as their name states. You make a single deposit, and are immediately given an income stream based on the amount deposited, and the type of payment you have selected. Types of payment include Period Certain (a set number of years – once the years are up, you’re done) or Life with Period Certain (income for life, but if you die within your chosen certain period, there is still money for your beneficiaries) and even Straight Life (The company will pay you until you die, and if you die fifty years from now that’s wonderful for you, if you die a month from now that’s good for the company because they keep the remaining funds). Payout amounts are generally higher than annuitizing a deferred annuity, because the company is guaranteed you won’t cash out of the policy early and they can invest the money in longer term vehicles.

Caveats: The Perils of Annuities
Whilst there are many benefits to an annuity (long term retirement saving, dependable income streams) there are also things that the potential investor needs to be made aware of. These can include but are not limited to:

Detrimental tax implications – Your deferred annuity is not taxable to you until you take a distribution from the account. This means that interest can continue to be credited to your account, increasing your taxable amount when you do take a withdrawal. It is important to note that the IRS considers an annuity to be a long term retirement investment, and if you withdraw funds before you reach the age of 59.5, the IRS will penalize you an extra 10% federal income tax on any earnings, in addition to any normal taxes.

Surrender Charges – Most deferred annuities, being by nature long term investments, impose stiff surrender charge penalties for those who withdrawal the funds before a certain time. These time periods range between 3-10 years on average (federal law indicates that a variable annuity can have no more than a 9% surrender charge in any given year, however) but some annuities have surrender charges for life, unless you annuitize and get an income stream, thereby keeping the money with the investment company. Pay attention to this when purchasing an annuity – VERY few annuties have zero surrender charges, and the ones that do generally have less investment options available.
That being said, most annuity companies do understand that life events do happen, and make available a certain portion of your annuity that you can withdraw each year without a penalty. Common penalty free types are 10% of the account value, or interest only, or even sometimes a percentage of the premium invested plus earnings.

Annuitization – Annuitization is a guaranteed payment option. This is great if you need a fixed income for a long time period, but not so great if you suddenly find yourself in more dire financial straits. Once a policy is annuitized, and a set income is locked in, most if not all annuity companies do not allow any alteration to the frequency or amount of payments – they are written in stone and unchangeable, no matter whether you desperately need the funds or not. The income stream cannot be changed or stopped, and will continue regardless of your situation. This is contractual.

Additional Deposits – Most deferred annuities allow additional deposits. This increases your potential to earn, of course, but the fine print of your contract must be examined. A number of annuity policies stipulate that each additional premium into an annuity policy starts its own surrender charge schedule. This means that if you put in $10,000 in 2009 and it has a 5 year surrender schedule, your $10,000 will be penalty free by 2014. However, if you put an additional $5000 into the annuity in 2011, that $5000 will not be out of surrender until 2016.

As with all investments, it is vital to discuss with your financial adviser or agent the benefits and pitfalls of investing in an annuity. It is also important that you read each piece of paper put in front of you, as all investment companies are required by law to disclose all penalties and charges and fees on an annuity to you. Many people I have talked to about this were of the “There was a bunch of papers, I just signed them – now, what do I have?” school.

Three words: Think, Examine, Ask.
Think about what you need for your future years, examine everything that is in front of you, regardless of what an agent tells you, and ask questions directly to the company if you are shy or uncomfortable in asking them of the selling agent. Believe me, the annuity company that the annuity is held with is happy to assist in this, as selling agents are independent contractors and their actions affect us all.

I work for an investment company as an annuities representative. I do not sell annuities to anyone, nor do I earn any sort of commission. I take calls from angry or upset clients and explain to them exactly what they have purchased. If this article helps just a few people in purchasing an annuity that is fully disclosed to them and that they actually understand, then it is not a waste of time.