Annuity
Insurance
Subject:
Insurance - Annuities
An annuity is an investment vehicle sold
primarily by insurance companies.
Several types of annuities exist. Every
annuity has two basic properties:
whether the payout is immediate or
deferred, and whether the returns are
fixed (guaranteed) or variable. An
annuity with immediate payout begins
payments to the investor immediately
after it is purchased, while deferred
payout means that the investor will
receive payments at some later date. An
annuity with a fixed return offers a
guaranteed return by investing in
low-risk securities like government
bonds, and is commonly known as a fixed
annuity. An annuity with a variable
return offers results that vary with the
performance of the funds (called
sub-accounts) where the money is
invested, for example stocks. This
article discusses fixed and variable
annuities, and gives a list of sources
for additional information about
annuities.
Fixed Annuities
The basic premise of a fixed annuity is
that you give a sum of money to an
insurance company, and in exchange they
promise to pay you a fixed monthly
amount for a certain period of time. In
the case of a single premium immediate
annuity (SPIA), the payments begin
immediately. In the case of a single
premium deferred annuity (SPDA), the
payments begin at a date of your choice,
for example at your retirement. So these
vehicles can be used as tax-deferred
investments, or can be seen as a way to
convert a lump sum into an income
stream.
Once annuity payments begin, they do not
change, even to account for inflation. A
fixed-annuity investor has two choices
for the term of the payment stream:
You can specify a fixed period, for
example 10 years, meaning that payments
will be made for 10 years to you (or
your heirs). These payments generally
are a combination of principal and
interest. If instead of immediate payout
you choose deferred payout, the
investment grows with taxes deferred on
that growth, and of course the payments
begin at the chosen date.
You can annuitize. To annuitize means
you are telling the annuity company that
you want to receive payments until death
(i.e., specify the period to be your
time on earth). And after that time is
done, your heirs do not receive anything
back. It doesn't matter if the payments
are made for 1 month or 40 years, they
stay the same provided the company stays
in business, and they stop at the
investor's death. Annuitization is
optional but arguably the most important
angle to these investments, and explains
why these investments are sold by
companies with experience in figuring
out how long the investor (sometimes
called the annuitant) will live.
A fixed annuity may have various
surrender provisions that prevent you
from withdrawing money for a period of
5, 10, or more years. However, depending
on the company, fixed annuities may
allow you some access to your
investment; commonly the investor can
withdraw annually the interest and up to
10% of the principal. An annuity may
also have various hardship clauses that
allow you to withdraw the investment
with no surrender charge in certain
situations, so be sure to read the fine
print.
When considering a fixed annuity,
compare it with a ladder of high-grade
bonds that allow you to keep your
principal with minimal restrictions on
accessing your money. But this is not
the only factor to consider.
Annuitization (choosing an income stream
for life) can work well for a long-lived
retiree. In fact, a fixed annuity can be
thought of as a kind of reverse
life-insurance policy. Where a life
insurance contract offers protection
against premature death, the annuity
contract offers protection against
premature poverty; i.e., it addresses
the risk of someone out-living a lump
sum that they have accumulated. So when
considering annuities, you might want to
remember one of the original needs that
annuitities were created to address,
namely to offer protection against
longevity.
Another situation in which a fixed
annuity might have advantages is if you
wish to generate monthly income and are
extremely worried about loss of your
capital (or somone else's risk of losing
their money), for example in a lawsuit.
If this is the case, for whatever
reason, then giving the capital to an
insurance company for management might
be attractive. Of course a decent trust
and trustee could probably do as well.
Variable Annuities
A variable annuity is essentially an
insurance contract joined at the hip
with an investment product. Annuities
function as tax-deferred savings
vehicles with insurance-like properties;
they use an insurance policy to provide
the tax deferral. The insurance contract
and investment product combine to offer
the following features:
Tax deferral on earnings.
Ability to name beneficiaries to receive
the balance remaining in the account on
death.
"Annuitization"--that is, the ability to
receive payments for life based on your
life expectancy.
The guarantees provided in the insurance
component.
A variable annuity invests in stocks or
bonds, has no predetermined rate of
return, and offers a possibly higher
rate of return when compared to a fixed
annuity. The remainder of this article
focuses on variable annuites.
A variable annuity is an investment
vehicle designed for retirement savings.
You may think of it as a wrapper around
an underlying investment, typically in a
very restricted set of mutual funds. The
main selling point of a variable annuity
is that the underlying investments grow
tax-deferred, as in an IRA. This means
that any gains (appreciation, interest,
etc.) from the annuity are not taxed
until money is withdrawn. The other main
selling point is that when you retire,
you can choose to have the annuity pay
you an income ("annuitization"), based
on how well the underlying investment
performed, for as long as you live. The
insurance portion of the annuity also
may provide certain investment
guarantees, such as guaranteeing that
the full principal (amount originally
contributed to the account) will be paid
out on the death of the account holder,
even if the market value was low at that
time.
Unlike a conventional IRA, the money you
put into an annuity is not deductible
from your taxes. And also unlike an IRA,
you may put as much money into an
annuity as you wish.
A variable annuity is especially
attractive to a person who makes lots of
money and is trying, perhaps late in the
game, to save aggressively for
retirement. Most experts agree that
young people should fully fund IRA plans
and any company 401(k) plans before
turning to variable annuities.
Should you buy an annuity?
The basic question to be answered by
someone considering this investment is
whether the cost of the insurance
coverage is justified for the benefits
that are paid. In general, the answer to
that question is one that only a
specific individual can answer based on
his or her specific circumstances.
Either a 'yes' or 'no' answer is
possible, and there may be much support
for either position. People who oppose
use of annuities will point out that it
is unlikely (less than 50% probability)
that the insurance guarantees will pay
off, so that the guarantees are expected
to reduce the overall return. People who
favor use of annuities tend to suggest
that not buying the guarantees is always
an irresponsible step because the
purchaser increases risk. Both positions
can be supported. But the key issue is
whether the purchaser is making an
informed decision on the matter.
Now it's time for some cautionary words
about the purchase of annuities. Many
experts feel that annuities are a poor
choice for most people when examined in
close detail. The following discussion
compares an annuity to an index fund
(see also the article on index funds
elsewhere in this FAQ).
Variable annuities are extremely
profitable for the companies that sell
them (which accounts for their
popularity among sales people), but are
a terrible choice for most people. Most
people are much better off in an equity
index fund. Index funds are extremely
tax efficient and provide, overall, a
much more favorable tax situation than
an annuity.
The growth of an annuity is fully
taxable as income, both to you and your
heirs. The growth of an index fund is
taxable as capital gains to you (which
is good because capital gains taxes are
always lower than ordinary income) and
subject to zero income tax to your
heirs. This last point is because upon
inheritance the asset gets a "stepped up
basis." In plain English, the IRS treats
the index fund as though your heirs just
bought it at the value it had when you
died. This is a major tax advantage if
you care about leaving your wealth
behind. (By contrast the IRS treats the
annuity as though your heirs just earned
it; they must now pay income tax on it!)
If you remove some money from the index
fund, the cost basis may be the cost of
your most recent purchase (or if the law
is changed as the administration
currently recommends, the average cost
of your index investments). By contrast,
any money you remove from an annuity is
taxed at 100% of its value until you
bring the annuity's value down to the
size of what you put in. (The law is
more favorable for annuities purchased
before 1982, but that's another can of
worms.)
Tax considerations aside, the index fund
is a better investment. Try to find some
annuities that outperformed the S&P 500
index over the past ten or twenty years.
Now, do you think you can pick which
one(s) will outperform the index over
the next twenty years? I don't.
Annuities usually have a sales load,
usually have very high expenses, and
always have a charge for mortality
insurance. The expenses can run to 2% or
more annually, a much higher load than
what an index fund charges (frequently
less than 0.5%). The insurance is
virtually worthless because it only pays
if your investment goes down AND you die
before you "annuitize". (More about that
further on.) Simple term insurance is
cheaper and better if you need life
insurance.
Annuities often invest in funds that are
difficult to analyze because independent
reports such as Morningstar are not
available. However, you may find
insurance companies that use portfolios
for which Morningstar reports are
available, which will help with analysis
of their annuity contracts.
Annuity contracts are very difficult for
the average investor to read and
understand. Personally, I don't believe
anyone should sign a contract they don't
understand.
Annuities offer the choice of a
guaranteed income for life. If you
choose to annuitize your contract
(meaning take the guaranteed income for
life), two things happen. One is that
you sacrifice your principal. When you
die you leave zero to your heirs. If you
want to take cash out for any reason,
you can't. It isn't yours anymore.
In exchange for giving all your money to
the insurance company, they promise to
pay you a certain amount (either fixed
or tied to investment performance) for
as long as you live. The problem is that
the amount they pay you is small. The
very small payoff from annuitizing is
the reason that almost no one actually
does it. If you're considering an
annuity, ask the insurance company what
percentage of customers ever annuitize.
Ask what the payoff is if you annuitize
and you'll see why. Compare their payoff
to keeping your principal and putting it
into a ladder of U.S. Treasuries, or
even tax-free munis. Better yet, compare
the payoff to a mortgage for the
duration of your expected lifespan. If
you expect to live to 85, compare the
payoff at age 70 to a 15-year mortgage
(with you as the lender).
For a fixed payout you would be better
off putting your money into US
Treasuries and collecting the interest
(and keeping the principal).
Now let's consider a variable payout,
determined by the performance of your
chosen investments. The problem here is
the Assumed Interest Rate (AIR),
typically three or four percent. In
plain English, the insurance company
skims off the first three to four
percent of the growth of your
investments. They call that the AIR.
Your monthly distribution only grows to
the extent that your investment grows
MORE than the AIR. So if your investment
doesn't grow, your monthly payment
shrinks (by the AIR). If your investment
grows by the AIR, your monthly payment
stays the same. When the market has a
down year, your monthly payment shrinks
by the market loss plus the AIR.
If you do decide to go with an annuity,
buy one from a mutual fund company like
T. Rowe Price or Vanguard. They have far
superior products to the annuities
offered by insurance companies.
Annuities in IRAs?
Occasionally the question comes up about
whether it makes sense to buy a variable
annuity inside a tax-deferred plan like
an IRA. Please refer to the list of four
features provided by annuities that
appears at the top of this article.
The first, income deferral, is utterly
irrelevant if the annuity is held in an
IRA or retirement account. The IRA and
plan already provides for the deferral
and, in fact, distributions are governed
by the provisions of Section 72
applicable to IRA retirement plans, not
the general annuity provisions. I would
go so far as to tell anyone who has
someone trying to sell them one of these
products in a plan based on the tax
benefits to run as fast as possible away
from that adviser. S/he is either very
misinformed or very dishonest.
The second, beneficiary designation, is
also a nonissue for annuities in a
retirement account. IRAs and qualified
plans already provide for beneficiary
designations outside of probate, for
better or worse.
The third, annuitization, is potentially
valid, since that is one method to
convert the IRA or plan balance to an
income stream. Of course, nothing
prevents you from simply purchasing an
annuity at the time you desire the
payout rather than buying a product
today that gives you the option in the
future.
I suppose it is possible that the
options in the product you buy today may
be superior to those that you expect
would be available on the open market at
the time you would decide to "lock it
in" or you may at least feel more
comfortable having some of these
provisions locked in.
Finally, the fourth feature involves the
actual guarantees that are provided in
the annuity contract. To take care of an
obvious point first: the guarantees are
provided by the insurance carrier, so
clearly it's not the level of FDIC
insurance that is backed by the US
Government. But, then again, only
deposits in banks are backed by this
guarantee, and the annuity guarantees
have generally been good when called
upon.
Normally, any guarantee comes at some
cost (well, at least if the insurer
plans to stay in business [grin]) and
the cost should be expected to rise as
the guarantee becomes more likely to be
invoked. Some annuities are structured
to be low cost, and tend to provide a
bare minimum of guarantees. These
products are set up this way to
essentially, provide the insurance
"wrapper" to give the tax deferral.
I would note that if, in fact, the
guarantees are highly unlikely to be
triggered and/or would only be triggered
in cases where the holder doesn't care,
then any cost is likely "excessive" when
the guarantee no longer buys tax
deferral, as would be the case if held
in a qualified plan. Note that the
"doesn't care" case may be true if the
guarantee only comes into play at the
death of the account holder, but the
holder is primarily interested in the
investment to fund consumption during
retirement.
What this means is that you need a) a
full and complete understanding of
exactly what promise has been made to
you by the guarantees in the contract
and b) a full understanding of the costs
and fees involved, so that you can make
a rational decision about whether the
guarantees are worth the amount you are
paying for them.
It's theoretically possible to find a
guarantee that would fit a client's
circumstance at a cost the client would
deem resaonable that would make the
annuity a "good fit" in a retirement
plan. Some problems that arise are when
clients are led to believe that somehow
the annuity in the retirement plan gives
them a "better" tax deferral or somehow
creates a situation where they "avoid
probate" on the plan. A good agent is
going to specifically discuss the
annuitization and investment guarantee
features when considering an annuity in
a plan or IRA and will explicitly note
that the first two (tax deferral and
beneficiary designation) don't apply
because it's in the plan or IRA.
Articles about annuities
Tracy Byrnes discussed annuity fees in
an article that appeared on
TheStreet.com on 29 July 05.
http://www.thestreet.com/funds/investorforum/10235461.html
Scott Burns published an article "Why
variable annuities are no match for
index funds" at MSN Money Central on 15
June 2001.
http://moneycentral.msn.com/articles/invest/extra/7272.asp
Mark Ingebretsen rated annuity
comparison-shopping sites in an article
that appeared on TheStreet.com on 5 May
00. Also look for the links to two
articles by Vern Hayden with arguments
for and against variable annuities.
http://www.thestreet.com/funds/toolsofthetrade/934103.html
An article "Annuities: Just Say No"
appeared in the July/August 1996 issue
of Worth magazine.
A writeup entitled"Five Sad Variable
Annuity Facts Your Salesman Won't Tell
You" was published in the April 5, 1995
Wall Street Journal quarterly review of
mutual funds.
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