Annuities are a deep chasm of confusion for many people. For one, they have been misused at times in our industry where the wrong people were sold the wrong annuity at the wrong time in their life. And two, even when used correctly, there are so many varieties of annuities with so many different features that it can be frustrating to sort it all out without the right professional help. My goal in this first installment of a 3-part blog series is to present a primer on annuities that can begin to shed some light on what can be an important option for many people as they approach or enter retirement.
What is an Annuity?
Most people think of an annuity as an insurance product that gives you a monthly payment for life. While this can be true, insurance companies now offer annuities that do much more than that. Most annuities have two phases – an accumulation phase during which the value of the policy grows similar to an investment portfolio (often with some level of protection), and an income phase during which the money starts to be withdrawn to cover retirement expenses. Some annuities are focused more on the accumulation phase (we will use the general term accumulation annuities), while others are focused on the income phase (income annuities). When looking for an annuity, it is most important to keep in mind what purpose you are looking for the annuity to serve in your portfolio. This will narrow down your choices and keep you on track for getting the right solution for you.
Let’s say that you are still working and you don’t need income in retirement for several years. You want your savings to grow for your future retirement but you also want some level of protection against market losses. You might be interested in an accumulation annuity that provides asset growth with some protection. There are 3 major categories of accumulation annuities, each with very different risk/reward trade-offs:
- Fixed annuities – the account value will grow according to a fixed or guaranteed rate.
- Indexed annuities – the account value will grow according to an index (such as the S&P 500), often with a cap on the upside but full protection from any losses.
- Variable annuities – the account value will move up and down according to the underlying investments, sometimes with a rider that provides some level of guarantee.
Accumulation annuities can be either qualified or non-qualified. Qualified annuities are purchased with money already designated as retirement savings such as from an IRA. Non-qualified annuities are purchased with non-retirement funds such as money from a bank account or brokerage account.
Let’s say instead that you are about to retire, and you are looking for some guaranteed lifetime income to supplement Social Security and/or any pensions that you have. You might be a good candidate for an income annuity which could provide the monthly income that you need. There are two major categories of income annuities, depending on when you need the income:
- Single Premium Immediate Annuity (SPIA) – the guaranteed monthly income for life will start immediately in return for a lump sum single premium payment to the insurance carrier.
- Deferred Income Annuity (DIA) – the guaranteed monthly income for life will start at some point in the future in return for a single or multiple premiums paid to the insurance carrier.
And like accumulation annuities, income annuities can be either qualified or non-qualified. For more details about the pros and cons of accumulation and income annuities, check out my next two blogs on this topic.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.
Fixed Indexed Annuities (FIA) are not suitable for all investors. FIAs permit investors to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase. FIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59 ½ may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims-paying ability of the issuing insurance company.
Neil Manning, CFP, AIF, CDFA, FSA
I am a reformed actuary turned financial advisor, helping my clients with everything from investments to retirement projections to LTC insurance since 2014. Unlike most normal people, I love numbers and finance – I’m currently reading a book about game theory which my wife and two teenage daughters think is unbelievably boring (they are wrong). For more details about my background, check out my website below.