3 Different Types of Annuities and How They Can Be of Benefit

12 minutes

 

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Did you know that Charles Dickens refers to annuities in his novels often because they were the favored investment of the upper class in 18th century Europe?

Or did you know that Babe Ruth didn’t lose his money during the Great Depression because his money was safely invested in annuities?

One last one for you. Did you know that Wheel of Fortune often gives away annuities as prizes?

Annuities are a product that most of us have heard of, but what do we really know about them? What are they really? How do they work and when should I use them?

These are some of the questions we will answer as well as looking at the different types of annuities, and there are many.

What are Annuities?

Annuities were invented by Babylonian landlords in approximately 1700 BC. They used the income from a certain piece of farmland to provide lifetime rewards for soldiers loyal assistants.

In more recent times, annuities were first offered to the American public in 1912 by the Pennsylvania Company for Insurance on Lives and Granting Annuities.

According to Investopedia, an “annuity is a contractual financial product sold by financial institutions that are designed to accept and grow funds from an individual and then, upon annualization, pay out a stream of payments to the individual at a later point in time. The period of time when an annuity is being funded and before payments begin is referred to as the accumulation phase. Once payments begin, the contract is the annuitization phase.”

Annuities were designed to be a reliable source of steady cash flows for an individual in their retirement years. Or alleviate risk or the fear of outliving your money. A very real fear.

Annuities can also be created to turn a large lump sum of cash into a steady cash flow. This is great for winners of large sums of cash such as lottery winners or a winning a lawsuit.

Defined benefit pensions or Social Security are two examples of lifetime guaranteed annuities that pay retirees a steady cash flow until they pass.

You remember those J.G. Wentworth commercials? Well, those are the perfect example of a lifetime guaranteed annuity. You give them your lump sum of cash and they give you a lifetime cash flow for that exchange.

How do Annuities Work?

An annuity is a cross between an insurance product and an investment product. They come in many different shapes and sizes, but the basic theme is that you give your money to a financial institution, like an insurance company and they promise you a certain rate of return, usually for the rest of your life.

The annuity will make payments to you on either a future date or series of dates determined by you. The income you receive from an annuity can be paid out monthly, annually, or even a lump sum payment.

Typically the size of your payments is determined by the length of your payment period, among many other factors. You can either opt for a set number of payments for a set number of years or opt for payments for the rest of your life.

A big question asked often, are there tax benefits to an annuity?

In a word, yes. Money that is invested in an annuity grows tax-deferred. When you eventually start to take distributions that original investment is not a tax, but any gains will be taxed at the regular tax rate. This is very much like a Roth IRA in that respect.

Do you use annuities in an IRA? No, no, no, must I say it again! No.

Putting your money in an annuity is already tax-advantaged, which is one of the main benefits of any IRA, so that would be like trying to fly that airplane you are on by flapping your arms. Silly.

What are the different types of Annuities?

There are two different types of annuities: deferred and immediate.

1. Immediate Annuity-this is usually the easiest annuity for most people to understand. In its most basic form, it has very easy provisions. A typical fixed immediate annuity involves you making a lump-sum payment to an insurance company upfront. This is done with the understanding that you will receive payments on a regular basis from the insurer on an immediate basis. These would begin right away.

You can structure an immediate annuity to pay for the rest of your life, for a fixed period of time, or for as long as you live and you designate someone as a beneficiary and they will continue to receive your benefits for as long as they live.

Payments for most immediate annuities are sensitive to interest rates, so when rates are low, like today, historically low if you weren’t aware. And when I say historically, I mean as in the history of mankind! This means that the amount of future income you can receive from an immediate annuity will be small.

Something else to keep in mind. If you purchase an immediate annuity based solely on your life and you pass away shortly after purchasing the annuity, the money spent on the premium can be lost if you don’t choose a specific insurance rider for your contract.

As a way to ensure a steady stream of income during your lifetime, an immediate annuity can be of some benefit.

2. Deferred Income Annuities-Unlike immediate annuities, deferred income annuities don’t start making payments right away.

They are very similar in many ways to the immediate annuity. You pay a lump sum upfront to your insurance provider and the agree to make payments in a predetermined amount to you at a later date determined by your contract.

Many people use deferred income annuities as a hedge against longevity risks, with payments that are scheduled to kick in when you are 80 to 85. These can provide supplemental income when you need it most.

Theses annuities are somewhat sensitive to interest rates as well. But the payments can be much higher than with immediate annuities because of the delay to receive payments and the chance that you will pass away without reaching the specified age.

The kicker with this type of annuity is that you could get nothing if you pass away before your specified age of your contract. This kind of annuity is often referred to as the longevity insurance. There are very few insurers that offer this type, those being New York Life, Symetra Financial, and Northwestern Mutual. These companies are willing to hedge against the possibility of you living a longer life.

One difference with this type of annuity from the immediate is that you don’t have to offer up as big of a lump sum in exchange for future payments per your contract.

Let’s say you are 55, you buy a $100,000 immediate annuity that will start paying you $5800 a year for the rest of your life, with the payments beginning right now. Or you could buy a deferred income annuity that will pay you $68,000 a year starting at 85 and continuing for the rest of your life.

This longevity insurance can reduce the risks of living a long life but it can be a risk that you won’t live that long and not be able to collect on that money.

3. Fixed Annuities-A fixed annuity is an annuity whose value increases based on the returns improving during the life of the contract. The money that is invested in the annuity is guaranteed to earn a fixed rate of return during the accumulation phase of the annuity. During the annuitization phase, the money less the payouts will continue to grow at the fixed rate.

Typically fixed annuities don’t have payments begin right away and can be considered deferred annuities. But the difference being that unlike a deferred annuity you get to pick and choose when your payments can begin during the contract.

Interest rates can be higher on fixed annuities than bank CDs and other popular income investments, and another bonus. They are tax-deferred.

You do have to be careful about how you access the money and the ease of getting it. There may be taxes and penalties involved in accessing the funds when you may need them. Surrender charges can make it extremely expensive to access the money in the first few years after you open an annuity. You will be able to find any specific provisions in your fixed annuity that will allow you to access the funds.

Among fixed annuities there are two main types:

  1. Life Annuities-there are several different kinds of life annuities, they differ by the insurance components they offer. Certain types of life annuities may alter the future payment structure of the annuitant in the case of something negative happening, such as illness or sudden death. The more insurance components that are added, the longer the payments may last over time and consequently, the more components the lower the payments will be over time. The also depend on the life expectancy of the annuitant, the shorter the expectancy the higher the payments and the longer the smaller the payments.

        In addition, the more insurance components added to the annuity

        The more expensive it will become. With life annuities, you can designate a beneficiary who will receive a lump sum payment upon the passing of the annuitant.

  • Straight Life Annuities-these are the simplest form of life annuities. The insurance component is based on nothing but providing income until death. Once the annuitization phase begins, the annuity will pay a set amount until death. Because of the simpleness of the insurance component, it is the lowest cost annuity. Also, straight life annuities do not offer any form of beneficiary payments after the annuitant’s death.
  • Substandard Health Annuity-it is a straight life annuity that may be purchased by someone with a serious health problem. These annuities are priced according to the chances annuitant’s chances of passing away in the near term. The lower the life expectancy, the more expensive the annuity because there is a reduced chance of the insurance company making a return on the money invested in the annuity. Because of this, the annuitant will receive a lower percentage of their original investment in the annuity. In addition, because the life expectancy is shorter the payments will be substantially larger.
  • Joint Life with Last Survivor Annuity-This annuity continues payments to the annuitant’s wife after their death. The payments continue no matter what, there is no term limit that must be passed. These annuities also allow additional beneficiaries to be added in the unforeseen early death of the significant other. In addition, the annuitant may designate lower payments for the beneficiaries. This type of annuity gives the spouse peace of mind of continued payments after the annuitant’s passing. And because the payments are individual payments, this eliminates a tax liability as they would have with a lump sum payment. One downside is the added insurance components which makes this annuity very costly.

2. Term Certain Annuities-these annuities are very different from the life annuities. Term certain annuities pay a given amount per period up to a specified date, no matter what happens to the annuitant during the term of the contract. One downside, if the annuitant dies before the end of the contract then the insurance company gets to keep the remainder of the annuity’s value. There are vastly fewer insurance components to this type of annuity which makes it substantially cheaper than other annuities. Another downside is that once the contract is fulfilled there are no more payments, so the income stream ends.

For all fixed annuities the growth of the money invested is tax-deferred. But annuities can be purchased with pre-tax funds and be tax-deferred. Or they can be purchased with after-tax funds. The type of income, pre-tax or post-tax, with which an annuity is purchased determines whether it can be qualified for tax-deferred status.

Qualifying annuities are purchased at retirement with funds that have been invested in a qualified retirement plan and have grown tax-free. Qualifying annuities can be purchased during your working life with monies that have not already been taxed.

Annuities that are purchased with funds that have already been taxed are not considered tax-deferred.

The advantage of a qualified annuity is the growth of the funds tax-free and then are only taxed upon disbursement. The advantage of a nonqualified annuity is tax-deferred growth on the income made from taxed money invested in the annuity.

One potentially big problem for these types of annuities beneficiaries are taxes. When the annuitant passes away the beneficiaries will have a very large tax burden on the investment income. It is very important to do your homework and consult with a tax accountant when setting up an estate plan that will include annuities. You don’t want to burden your loved ones with a big tax burden after you pass.

4. Variable Annuities

Variable annuities are often called “mutual funds with an insurance wrapper”. This all-in-one product that is sold by the insurance company combines the characteristics of a fixed annuity with the benefits of owning mutual funds. When you pay your premium, it goes towards the purchase of accumulation units of those mutual funds.

The Good

Variable annuities get a lot of bad press from misleading sales techniques and inadequate disclosure. But there are some annuity products out there that have some benefits for you.

  • Tax-deferral of investment gains-just like your IRA, your contributions and gains grow tax-deferred until you start to take distributions.
  • Ease of changing investments-because variable annuities have sub-accounts with numerous mutual funds to choose from, there is very little cost, if at all to the investor to make a change.
  • Income for Life-once you select payment from you account, you and your wife, if you should choose that option are guaranteed payments for the rest of your life.
  • Asset protection-in certain states, annuities are shelters from creditors.

The Bad

Although the idea of income for life sounds great, one little point that most annuity salesmen forget to mention is that once you decide to annuitize your contract. Then your contract is frozen, and your decision is final.

Let’s take an example to show you how this can be bad for you. Let’s say you pay an insurance company $264,000 at age 60 and accept the company’s offer to pay you $1000 a month for the rest of your life. You will have to live until 82 just to break even on the contract and if you die before then you will have surrendered the rest of money to the insurance company. If you live past 82 then they will have to continue to pay you. This is the bet you have to make, that you will live longer than the insurance company thinks that you will, that is their hedge. That you will die before you collect all of the money. Nice, huh.

Another downside is that once you sign the contract you cannot touch the funds until you are 59 ½ or you will pay a 10% penalty on the withdrawal. Additionally, when you start to take distributions you will be taxed on the investment gains at your ordinary income tax rate instead of the long-term capital gains rate. For some this could be higher than the capital gains rate.

So you think having your funds frozen once you decide to annuitize? Wrong!

The Ugly

  • Surrender charges-Most insurance companies charge you a surrender charge, usually a diminishing seven to eight-year scale. Starting around 8% the first year and decreasing 1% a year incrementally. So, a $100,000 investment could cost you $7000 in surrender fees if you decide to move your annuity into another company in the second year.
  • Front-end loaded annuities-to this day annuities are primarily commission based products. When your salesperson attempts to sell you the annuity, you must ask about the commission they will make from selling the annuity. In most cases they will make a 5% fee on the sale, your funds will be under a surrender penalty for at least 5 years. In addition to that, the mutual funds will charge your fees too. So check for front-load fees, 12b-1 fees, and others.
  • Annual fees and administrative and mortality and expense charges-This is where investors get burned. All of these charges are buried in the language of the annuity contract and take away from your annual profits. The average annuity will charge around 1.4% for these expenses, and some as high as 2.5%. Keep in mind that if your fund’s performance is less than that you will lose money! They will take the fees regardless of how poorly the mutual fund performs. That is the rip off of mutual funds.

Final Thoughts

Annuities have been around for thousands of years. They go so far back that a Roman named Domitius Ulpianus compiled the first recorded life table for the purpose of computing the estate value of annuities.

So these products are nothing new, but I would argue that they are very misunderstood and misrepresented.

We discussed what an annuity is and how they are set up. We also discussed at great length many of the different kinds of annuities that are out there. And to be honest we only scratched the surface of this product. There is so much information out there about annuities that it was a little overwhelming. I could probably write 10 more posts about annuities and still not cover everything.

My goal with this post was to illustrate how an annuity could be a benefit to you, with the right guidance from a trained professional that you trust.

There are some great annuities out there, you just need to look and ask questions.

Annuities have gotten a bad rap in recent years because of frankly a lot of greed and deception on the part of the agents that sell them. The fees involved in annuities can be extremely prohibitive to your returns and it is absolutely imperative that you ask lots of questions and if you aren’t sure, don’t pull the trigger.

On the good side, they can be a great way to guarantee income in your later years, and potentially at a great rate. They also can help you set up arrangements to make sure that your beneficiaries are taken care of. Which can be a great relief.

That should do it on annuities.

As always, thank you for taking the time to read this post, and if you find it of value and you think it could be of benefit to someone else. Please share it with them.

Take care,

Dave

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