Annuities are definitely a source of confusion among consumers. For people familiar with pension plans, use of the term “annuity” contributes to the confusion over annuity products. Pension income and the term “annuity” are synonymous. However, in the financial world, annuities are much more than just a stream of income.
The General Information. Annuities are developed and offered by insurance companies. However, they can be sold by insurance companies, banks, credit unions, investment firms, on-line brokerages, financial advisors, or anyone with a license to sell investments or insurance products.
Insurance companies are not insured by the federal government; so no FDIC. The principal and rate guarantees are backed by the insurance companies themselves. The financial rating of the insurance firm is your assurance of safety. Look to do business with a solid insurance firm earning top financial ratings and with a great reputation.
They can be bought in several different varieties to accomplish different savings objectives. Contributing to the confusion over annuities is that every insurance firm adds their own bells and whistles making comparisons difficult even between similar products.
Annuities can be either savings or investment accounts—“savings” pay interest and “investments” are tied to the stock and bond markets. You can find “saving” annuities that pay better interest rates than other interest bearing accounts like money markets, CDs or short-term bonds. It’s these guaranteed higher interest rate annuities that get attention during low interest rate economies.
Annuities have similarities with “qualified retirement accounts” in that money deposited in the annuity cannot be withdrawn until the owner turns 59½ years old. Owners face taxes and tax penalties for early withdrawal. While all annuities have options that allow them to provide a stream of income, most annuities aren’t used that way.
Ask about the “surrender fees.” A surrender fee is a percentage of the value of a withdrawal that you are penalized for pulling your money out of the plan too early. The surrender fee is on top of the taxes and the tax penalty for withdrawal prior to age 59½. A surrender fee applies regardless of age. A surrender fee is a penalty and must be carefully understood. The penalty amount can run into the double-digit percentages and last for 10 years. It is similar to cashing out of a CD too early but the amount is much greater.
It might be easier to describe the types of annuities by using other more familiar types of savings and investment accounts as examples. Generally there are 3 types of annuities. They are (these are just descriptive labels not the real names):
- the types like a Non-deductible Traditional Individual Retirement Account (IRA),
- the types like CDs, and,
- the types like a pension with a stream of income.
In this article, I will not be describing annuities specifically designated as “qualified retirement accounts.” Qualified retirement accounts are offered as employee retirement plans at work or annuities designated as literal IRAs. This article is about annuities you can buy outside of qualified retirement accounts.
The Non-deductible Traditional IRA-type annuity. Think of this type of annuity as a third level for retirement savings; 401k first, IRA second, annuity third. These are called ‘deferred’ annuities because the potential income stream is deferred to a later date or not at all since producing an income stream is not a requirement. They come in versions called ‘variable’ for the investment version and ‘fixed’ for the interest rate version.
Their official name typically describes what they are as in “Flexible premium, Deferred, Variable” or “Flexible Premium, Deferred, Fixed” annuity. Because it is an insurance product, the deposits are usually called premiums. However, how much you deposit and when you deposit is completely up to you. There are no set payment amounts or schedules.
Variable annuities have many fees and additional options can be purchased for additional cost. Fixed annuities don’t have fees as the annuities costs are factored into the plan and reflected in the interest rate provided. You can shop around for rates as you do for CDs in the fixed annuities. Surrender fees also apply.
These deferred annuities can even pay a form of matching contribution, similar to a 401k match, on top of each deposit if you find one with a “bonus” feature. There is also a ‘fixed’ version known as an ‘equity indexed’ annuity that pays an interest rate that floats with the direction of the stock market. Equity Indexed annuities are “fixed” and pay an interest rate so the principal amount is not at risk (doesn’t decrease) and a minimum return is guaranteed. Equity-Indexed annuities are complicated so be careful when you shop for one of these—it might not be what you think.
There is no tax deduction for money deposited. There is no annual deposit limits as there is with an IRA. The value grows tax-deferred and the gain, not the principal, is taxed upon withdrawal as ordinary income.
Got extra money you want to sock away for retirement? Already over age 59½ and want an account that defers taxes until withdrawal? A flexible premium, deferred annuity may be for you.
The CD-like annuities. These annuities pay interest and you lock up your money like a CD. They are known as “Single-premium” annuities. A single-premium annuity is a single lump-sum deposit up-front, and that’s it. They are “Deferred” annuities meaning there is no immediate income stream upon deposit. However, an income stream is an option should you choose to use it that way in the future.
There are surrender fees as mentioned earlier in the article. You still have the age 59½ withdrawal limitation as with the Flexible Premium, Deferred, Variable/Fixed annuities above. Because the annuity is tax-deferred, taxes are not paid on the interest payments until money is withdrawn from the account.
Remember the interest rate and your principal is guaranteed by the insurance firm because annuities are not FDIC insured. Select your insurance company based on a high financial rating and a great reputation.
These pay an interest rate that can be locked in for a period of years. Once the lock-in period expires, unlike a CD where you cash out or roll into another CD, the annuity just continues along and the interest rate changes to whatever the rate is at that time. Or you can roll the annuity to another annuity.
Got money you want to protect and want to earn some decent interest? Willing or able to lock-up the money for a period time? Check out a fixed annuity as you shop for CDs or short-term bonds.
Pension-like annuities. This is the simplest of all the annuities. All annuities have the option to eventually turn their account value into a stream of income. However, these are called “Immediate” annuities and they create a stream of income immediately. The stream of income is guaranteed for as long as you choose it to last.
Typically, a single, lump-sum deposit is made and income starts. Factors that determine the amount of income include these considerations and options you select:
- Age at deposit.
- Lifetime income.
- Guaranteed income for a set period of time regardless of the beneficiary’s length of life.
- A refund of the deposit at death if the principal amount is un-used.
- A survivor option.
- An inflation adjustment option.
If you are looking to add guaranteed regular income to your financial plan, this is your option. If you opted out of a survivor benefit program upon retirement, an immediate annuity could act as your survivor benefit plan.
The Wrap Up. Explaining annuities in a short article is tough because annuities are so complex. This article does not explain everything. As in buying a car, all cars are cars but there are so many types and so many options, it’s not simply a matter of buying “a car.” Annuities are the same in that they come in so many models and have so many options and features you have to know what you need. If you go shopping without a clue, you risk being sold something you don’t want and paying out the whazoo.
