A Primer on Annuities
As the baby boomer generation reaches retirement, many individuals will be presented with the opportunity to purchase an annuity. We
often hear from our clients wondering whether an annuity is an appropriate investment for them. Annuities are complex financial
instruments that are sold as an income-generating option by financial advisors. The goal of this article is to introduce you to the
basics of annuities, the drawbacks to investing in them, and when an annuity might be a suitable investment.
What is an Annuity?
An annuity is a contract between an individual and an insurance company. The contract is purchased with either a single payment or a
series of payments. In exchange for these payments, the insurance company agrees to pay you an income for a specified period of time.
There are two basic types of annuities: immediate and deferred.
In an immediate annuity, you purchase the annuity with a lump sum payment on the date
that the annuity is purchased. The resulting income from an immediate annuity can be either fixed or variable.
- Fixed - pays a fixed rate of income over the life of the contract. Fixed annuities are not securities and, therefore, are not regulated by the SEC.
- Variable - invests the money in mutual fund-like investments called subaccounts. The value of your investment as a variable annuity owner will vary, depending on the performance of the investments you choose.
In the second type of annuity, known as a deferred annuity, your purchase is with
either a single payment or a series of payments, with the income to be received at a later date. Deferred annuities can be fixed,
variable or equity-indexed.
- Fixed – see explanation above.
- Variable – see explanation above.
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Equity-indexed – An equity-indexed annuity has the features of a fixed annuity, but it allows you to participate in the gains of the stock
market. The insurance company credits you with a rate of return based on changes in a particular stock index, such as the S&P 500. The
insurance company guarantees a minimum return in the event that the index declines beyond the pre-defined level.
While this no-loss guarantee sounds great, please read the fine print, as there is often a cap on any gains and a limitation on the
participation rate. For example, if the chosen market index increases 20% and the contract has an 8% cap, the increase credited to your
account will only be 8% and not the full 20% the market index appreciated. The participation rate is the percentage of the index return that
will be credited to your account. For example, if the index goes up 12% and your participation rate is 90% then the gain that would
be credited to your account would only be 10.8% (12% * .9) and not the full 12% that the market appreciated.
Equity-indexed annuities can also limit your returns through the definition of market returns. The insurance company may define market
returns as market price changes only and not include the payment of dividends, which historically have made up 40% of the S&P 500
returns. If we were to go back to the same 12% example above, assumed that 60% of the return was market price changes and the same 90%
participation rate, your return would only be 6.48%.
Pros and Cons of Annuities
There are several drawbacks to investing in annuities:
- They are relatively expensive investments
- They can lack liquidity
- They can be tax disadvantageous relative to other investments
What makes an annuity expensive?
Annuities contain two layers of fees: a management fee and a mortality and expense charge. A management fee is assessed to pay for the
investment advisor who selects the investments for the subaccounts. The management fee can run as high as 1% of your invested amount.
This fee would not be considered expensive relative to the mix of mutual funds held in a taxable brokerage account, but annuities also
charge a mortality and expense charge. A mortality and expense charge is a charge that the insurance company assesses to pay for the
risk that the purchaser may live longer than expected. The mortality and expense charge can run as high as 2%. If you combine the
management fee with the mortality and expense charge, fees can run as high as 3%. By comparison, the average mutual fund has an expense
ratio of around 1.5%.
Annuities lack the liquidity you may want
Annuities lack liquidity because they require a holding period on the investment before you can withdraw your funds penalty free. If
you do withdraw your funds early, you will likely be assessed a surrender charge. Holding periods can run anywhere from one to 16 years,
and these surrender charges can run as high as 20%. The average surrender charge is 7% in the first year of the contract and declines
by 1% every year thereafter until it reaches zero. This fee is mean to discourage short- term investing.
There are tax concerns to consider; as well
Annuities can be tax disadvantageous for estate planning purposes. Unlike some other investments, annuities do not receive a step up in
tax basis at the date of death. For example, if you were to invest $10,000 in a mutual fund that appreciates to $50,000, your
beneficiary would receive $50,000 with no income tax in the event you pass. If your beneficiary receives a qualified annuity of
$50,000, the entire amount would be taxed as ordinary income.
While annuities do have several drawbacks, there are situations where an annuity is a suitable investment. If you are looking for an
investment that gives you guaranteed income for life, then an annuity may work for you. An annuity is tax deferred, so it can be a
suitable investment if you are in a 35% or higher marginal tax bracket, have contributed the maximum to all of your qualified
retirement plans, plan on investing for the long term, and do not need the money until after age 59 ½.
Questions and More Information
You may want to review the following questions taken from the SEC’s website before purchasing an annuity (For more information on
variable annuities, and for the full list of questions, go to: http://www.sec.gov/investor/pubs/varannty.htm).
- Will you use the annuity primarily to save for retirement or a similar long-term goal?
- Are you investing in the variable annuity through a retirement plan or IRA (which would mean that you are not receiving any additional tax-deferral benefit from the variable annuity)?
- Do you understand all the fees and expenses that the annuity charges?
- Do you understand the features of the annuity?
- Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges if you have to withdraw money?
- Have you consulted a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?
Please Note: Annuity contract details on caps, returns, and the lock-in period can vary widely – it would be to your benefit to get
some help from a trusted expert in reviewing the fine print of any annuity you are considering.
If you have any questions regarding annuities or any other investment products, please feel free to contact us by email at
info@smart401k.com or by phone at 877.627.8401.