First, you must understand that all annuities are contracts between you and an issuer (i.e. the insurance company) in which you pay principal (or premiums) to the issuer in exchange for fixed or variable payments over time.
Second, there are TWO primary types of annuities – variable and fixed. Variable annuities enable you to invest in a selection of sub-accounts, such as securities portfolios, fixed interest accounts and money market securities. The performance of variable annuities is tied directly to market performance, though they may offer features which somewhat mitigate market risk. Think of it this way: with variable annuities, your principal may vary with financial market movements; with fixed annuities, your principal will never vary with financial market movements, though interest credited to your account may vary should you select a stock market index crediting method. Interest credited may vary with variable or fixed annuities (should you select an index interest crediting method rather than a fixed interest method), but principal may only vary with variable annuities.
Given that variable annuities may possess principal volatility which reflects that contained in the general financial markets, I do not recommend variable securities to those planning retirement. Because I don’t consider variable annuities to be in the same “safe money” category as fixed annuities, I do not review them, do not discuss them and consider variable annuities outside my area of interest and focus.
Thus, The Annuity Foundation, AnnuitySpeak, Annuity TV and any affiliates will discuss fixed annuities only, which I consider to be the “safest place” for retirees to protect and grow their savings today. So, let’s move on to “safe retirement money” or fixed annuities – the focus of AnnuitySpeak.
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Under the umbrella of fixed annuities, we have three primary types: (1) fixed indexed annuities (FIAs); (2) immediate annuities; or (3) multi-year guaranteed annuities (or MYGAs). Remember, with all annuities, under the umbrella of fixed annuities, you can never lose premium payments (or principal) due to losses in the stock market. Thus, I won’t repeat that point for each product highlighted below. Please remember that the following highlights are intended as an overview and do not cover every nuance and minute detail of each annuity type. (To do so would take thousands of words and put most readers to sleep.) If/when you arrive at a point where you are seriously considering purchasing an annuity, you should then “drill down” with an annuity specialist, attorney and, perhaps, a CPA or other advisors to ensure that you understand all of its many specific financial and legal details.
1. FIXED INDEXED ANNUTIES, or “FIAs,” are my favorite annuity product because they provide the greatest upside potential and the most options and flexibility to the annuitant. Let’s look at their features.
Highlights
A. Annual account interest credits options may be linked to growth in your choice of a stock market index, typically the following: S&P 500; Nasdaq 100; FTSE 100; or, a blended index of the Dow Jones Industrial Average, Barclays Aggregate Bond, FTSE 100, and Russell 2000. Contrarily, an annuitant may elect to choose a simple fixed interest rate offered by the carrier at contract issuance. Rates and index caps may be adjusted by the carrier annually, typically follow movements in the markets, but, historically, such annual adjustments are relatively small.
B. Caps (or ceiling) and spreads applied to index growth will limit your interest upside, but remember that your downside is always zero. (Typical annual caps range from 6% to 9%, but there are other ways of computing caps as you’ll see below.)
C. Bonuses are paid by many insurance carriers who sell FIAs, usually range from 10% to 20% of premiums paid, and generally require the annuitant to hold the annuity for ten years in order to earn or retain the full bonus and its benefits.
D. Penalty free withdrawals amounting to ten percent (10%) of premiums paid are generally allowed on an annual basis.
E. Fixed Interest crediting can be selected in which the carrier guarantees a fixed interest credit to the annuitant.
F. Various index interest crediting methodologies can be selected, generally the following: annual point-to-point, monthly sum or monthly averaging. This is where it gets a bit tricky.
Annual Point-to-Point Crediting: Growth in the selected index interest is determined annually by computing its twelve month increase from the anniversary date of the annuity contract, subject to the caps in place (typically in the 6 to 9% range). If the selected index has decreased over the past twelve months, your account value remains unchanged.
Monthly Sum Crediting: Growth in the selected index interest is determined by computing its percentage change in value each month for twelve months from the anniversary date of the annuity contract, subject to a monthly growth cap (currently in the 2%- range), then totaling the twelve months of percentage changes. While the monthly percentage increase is capped, there is no floor on monthly decreases (which is why I don’t love this crediting method). If the previous computation yields a negative percentage change, your account value remains unchanged.
Monthly Average Crediting: Growth in the selected index interest is determined by taking the index value at the end of the month for twelve months from the anniversary date of the annuity contract and adding them togther, then dividing that total by twelve. Next, the beginning index value is subtracted from the average index computed and the difference is divided into the beginning index value. The spread (currently in the 2% range) is subtracted from the percentage change previously calculated to determine the index interest credited. Again, if the previous computation yields a negative percentage change, your account value remains unchanged.
I like the annual point-to-point methodology best, both because it is simple to understand and compute and because, in my opinion, it most often generates the best interest credit rates. Of course, any of the three index crediting methodologies may provide the best performance in a given year, but it is my opinion that the annual point-to-point is most often the best performer.
With all fixed index annuity interest rate crediting methodologies (including fixed interest) the insurance carrier may adjust rates, caps, spreads, etc. on an annual basis. However, I hasten to add that the insurance industry is very conservative, has a vested interest in long-term customers and relationships, and, historical, makes relatively small annual adjustments to these variables.
Purposes
Long-term savings growth vehicles (10 years or so): Because FIAs perform best when untouched for ten or more years, they are ideally designed as long-term savings vehicles which provide the annuitant with safety and growth potential. FIAs eliminate market dips and accompanying losses of principal, participate in index growth, and money is only taxed when withdrawals are made. When putting away funds unneeded for ten years or so, FIAs would be my first choice.
2. IMMEDIATE ANNUTIES are those in which you may a single lump sum of money, then begin to draw immediate income. You have the option to choose a specific annual withdrawal, in which case the insurance carrier then determines how may years it can pay out your requested amount. You also have the option to specific the number of years you desire payments, in event the insurance carrier determines how much it can pay out for your specified number of years. Finally, you have the option of choosing a lifetime payout, in which event (based upon your age, gender and other factors) the insurance carrier determines the amount of money it will pay you each year for the rest of your life.
Insurance carriers don’t publish the interest rates on these products. Because of age, gender, and other factors impacting expected lifespan, insurance carriers don’t specify interest credit rates implicit in these products.
Purposes
Good Source of Immediate and Predictable Long-Term Income Required by Annuitant: Immediate annuities are probably the simplest of all annuities to understand. The annuitant pays a lump sum of money and is guaranteed a certain amount of money for a specified number of years, or perhaps life. When holding substantial value in liquid assets, yet desiring immediate and long-term, or life-time, income predictability - immediate annuities are the way to go.
3. MULTI-YEAR GUARANTEED ANNUTIES (“MYGAs) are sometimes called CD annuities, but they out-perform CDs in many respects. MYGA’s can provide long-term guaranteed annual interest rates (from one up to ten years). For example, as I write in November of 2009, some carriers are offering a guaranteed MYGA interest rate of 3.5% or so for ten years. Unlike CDs, the interest credited in MYGA’s is tax-deferred until withdrawn. Additionally, the annuitant may withdraw up to 10% of premiums paid without penalty on an annual basis.
Purposes
For Conservative Financial Planning Purposes, MYGAs Offer A Precise Means to Forecast Savings Growth: For those who are extremely conservative and desire to protect from any market losses, while also knowing precisely what their annual gains will be – MYGA’s are a perfect solution. Also, if an annuitant expects years of down markets (and, thus, little to no market index growth) in addition to low inflation and interest rates, the MYGA product may be perceived as both safe and the best bet for superior long-term performance.
EMERGENCY WITHDRAWALS FOR HEALTHCARE EMERGENCIES
Generally, fixed annuities provide a “Nursing Home Benefit Option” (or something similar) which allows you to take accelerated distributions of your accumulation value if you are admitted into a nursing home, long-term care facility or hospital for an extended period of time. Be sure that you examine an individual annuity carefully to be certain you understand its terms and provisions for early distributions, without penalty, in the event of health emergencies.
TAX ISSUES WITH ALL ANNUITIES
Certain tax issues are common to all fixed annuities and must be understood. First, any earnings on an annuity contract are subject to ordinary income taxes. Second, of course, all earnings are tax deferred such that taxes are never due until the annuitant withdraws the earnings. Third, for tax purposes, earnings are considered to be withdrawn first from your annuity contract. Withdrawals of principal (i.e. the premium you paid into the contract) may or may not be taxable, depending upon whether you funded the annuity with Qualified or Non-Qualified money. In other words, if you have already paid taxes on monies used to fund an annuity (Qualified funds) you would not owe taxes on distributions of premiums. If you have not paid taxes on monies used to fund an annuity (Non-Qualified funds), you would owe taxes on premium distributions additionally. Whether now or later, Uncle Sam always gets its share of your earnings. Fourth, any death benefits paid under the contract are taxable as ordinary income to the Annuitant. Estate taxes may also apply.
Finally, if you are under 59 ½ years old at the time of any withdrawal, the portion of such withdrawal subject to ordinary income tax may also be subject to a 10% federal tax penalty. However, there are several exceptions allowed through IRC Section 72(q) and 72(t) in which such penalty can be avoided. One such exception makes it possible to access retirement assets IRS penalty-free, at any age, by receiving income as a series of substantially equal periodic payments. Please consult your tax advisor or attorney to confirm how and whether you might qualify for an exception to the early penalty provision and for to discuss all annuity tax issues.
