A riddle wrapped in a mystery inside an enigma.” That’s Winston Churchill describing Russia in 1939. It is also how many would describe retirement annuities today. Here are the keys to understanding them.  

Generally, annuities come in various forms and can be defined as broadly as “a sum of money payable yearly or at other regular intervals,” according to Merriam-Webster’s Dictionary. Others more narrowly define annuities as, “investment income with lifetime payments.” Most of the time annuities consist of periodic payments, whether monthly, quarterly or yearly, of a fixed amount of money. Outside of the insurance and retirement planning world, annuities may be used for real estate transactions, pension payments, estate settlements, social security income and structured settlements of a lawsuit. Annuities apparently got their start in ancient Rome, where they were utilized as payments for military service.  

Today, pre-retirees and retirees are living longer than ever and are experiencing increased costs.  Many are seeking ways to sustain retirement income for themselves and their loved ones for as long as possible, with minimal effort and protections. Beyond traditional investment portfolios, pension plans, social security, and income properties, many turn to annuities to replace or supplement their assets and income producing holdings. For example, it has been my experience that pre-retirees grow tired of managing certain aspects of their working lives and look to simplify by receiving direct payments to their checking accounts from an annuity or other investment. Naturally, pre-retirees want to retire (or are forced to) and grow tired of managing properties as well as the risk of non-insured investments, in light of the 24-hour news cycle. As such, much of the assets invested in annuities are from lump-sum payments sourced from all or a portion of a retirement account, such as an IRA or company-sponsored plan, or sourced from savings, the sale of a home, or an even an inheritance. According to the Insured Retirement Institute, during 2020 in the United States alone, there were trillions of dollars held in annuities.  

In my practice, annuities are used as a tool to complement a comprehensive approach to creating financial stability. Many of my clients gain added peace of mind, and income, knowing that a portion of their current or future retirement income is being provided with insurance company assurances and those assurances can lead to a more predictable and less worrisome retirement.

Plus, as mentioned, many retirees are uncomfortable maintaining most or all of their investment assets in a traditional investment portfolio as the memories of the financial crisis are still fresh. Despite the benefits of annuities and uses, many of my clients, as well as other retirees and pre-retirees, are mystified by their complexities. Let’s move along and unwrap some of the mystery surrounding annuities that insurance companies offer as part of a comprehensive retirement strategy.  

In essence, annuities are a form of insurance. Insurance is the transfer of risk in exchange for a fee, known as a premium. Annuities from insurance companies are somewhat similar to your more familiar forms of insurance, such as life insurance (transfer financial risk of death), auto insurance (transfer financial risk of an accident) and home insurance (transfer risk of fire or other costly damage).
With annuities, which are basically contracts with an insurance company, investors transfer the risk of loss of a current or future stream of income to an insurance company and pay the insurance company a premium to take that risk. Think of these contracts and agreements to provide a privately owned pension. They can also be used as a tax shelter and/or for liability protection (but more on those benefits later).

Let’s look at some categories of annuities:

• Immediate Annuity
• Deferred Annuity
• Fixed Annuity
• Variable Annuity

IMMEDIATE VS. DEFERRED ANNUITIES

Starting simply, an immediate annuity is one that begins paying out income from the annuity to the income recipient (usually the owner) right away. This payment can include interest from the annuity or interest and part of the amount originally invested (principal.) On the other hand, a deferred annuity’s payments commence at some point in the future. Deferred annuities accumulate their interest earnings on a tax-deferred basis and can build up a return within the annuity for an increased income at a later date. When income payments commence, it is usually called “annuitizing” the policy. Various forms of annuitized payouts exist, depending on the annuity and the contract. For example, annuitization can be spread out over the life of the annuity owner. The annuity can also be paid out over a certain minimum fixed period of time, such as 10 or 20 years, even extending beyond the annuity owner’s death. At that point, payments would be paid to a named beneficiary. In addition, certain annuities can be made to provide income for two lives, such as spouses, and the payouts are usually based on the age of the younger spouse.

FIXED ANNUITIES

A fixed annuity, whether it is immediate or deferred, generally has a set annual rate of return which can be contracted for a certain number of years. Fixed annuities are usually more predictable in terms of income or deferral and typically offer lower rates of return than other investments, but usually have slightly higher rates than bank CDs. That said, insurance companies offering annuities are plentiful and it is a competitive landscape, so even the simpler fixed annuities can have varying nuances to entice investors.

For example, some fixed annuities offer a purchase bonus made up of credits the insurance company provides beyond the amount one initially invests into the annuity. The bonus is usually a certain percentage added to the annuity. Insurance companies use bonuses to provide investors immediate returns on the investment into their annuity versus those of another insurance company, or the bonuses may be used to offset penalties (known as surrender charges) from annuity funds leaving one insurance company for another, as part of an annuity exchange. (Annuities are not necessarily stuck at one insurance company and can be exchanged for differing contracts, and even different types of insurance.  That is, if it is appropriate to make an exchange, and if it creates a justifiable advantage to the owner.)

In addition, most types of annuities may provide a beneficiary with additional assets beyond the value of the annuity at the time of the owner’s passing. Some annuities even provide added payout rates if the owner ends up in a nursing home. These types of added benefits are usually categorized into “living benefits” and “death benefits.”

Functionally, fixed annuity contracts sit on the general account of insurance companies, and the principal and interest earnings (and payments) of the annuity are dependent on the insurance company’s ability to meet its obligations. Thus, annuity investors must consider the strength and integrity of the insurance company as a key consideration when purchasing an annuity. These are just a few of the mysteries that annuity investors must navigate.  

VARIABLE ANNUITIES

Variable annuities can have three or more dimensions, and this is where things tend to get confusing. First, contributions to a variable annuity are invested in a separate account for the owner, which usually consists of a portfolio of professionally managed investments. The idea with the investments is to both increase the value of the assets of the annuity for a higher payout at some point, and to maintain the value of the annuity for longer after income payments commence, thus making the assets more sustainable for the long-term in light of investment returns, taxes, and inflation. The separate investment account of a variable annuity is maintained off of the general books of the insurance company, but is managed within the annuity company’s framework. Variable annuity investors usually have more flexibility with the balance of the assets as compared to fixed annuities. Second, Variable Annuities have an insurance component that is dependent on the amount of contributions into the separate account and the insurance component can have triggers based on the returns or losses of the separate investments account. In other words, there are some moving parts here. To be clear, the insurance component can consist of benefits, such as lifetime income for a client and a spouse (living benefits), as well as death benefits and nursing home benefits. Variable annuities are usually used as part of a comprehensive financial plan to complement a more traditional investment portfolio, as well as other income-producing assets, to potentially sustain income and assets for a longer time than other forms of investments.

Variable annuity investment returns and income can be substantially higher than fixed annuity returns, but that is not always the case. The returns can be, as the name implies, variable. Sometimes the returns are hamstrung by strategies of the insurance company used to mitigate investment losses, as well as their own risk, by building in certain forms of protections against loss in the separate investment account. Such insurance protections may act as a floor to the amount of income one can garner from the annuity, and can also be in the form of an automatic shifting of assets to preserve investments during times of market volatility.  

Moreover, there can be guarantees provided by the insurance company as to the amount of minimum retirement income the owner and/or their spouse will receive regardless of the value of the separate investment account. As mentioned above, the insurance company can provide additional benefits during the life of the owner(s) such as nursing home benefits and increases in the amount of payout income available from the annuity at certain ages. Death benefits may also be included to help provide an additional legacy for the owner. Regarding death benefits, under normal circumstances, if a variable annuity owner passes away during the contractual term of the annuity and still has a balance of the investment assets in the annuity, the insurance company does not simply keep the balance of assets for themselves. Rather, the assets would pass to the beneficiary(ies), who would have withdrawal options as allowed by the contract and applicable law. The ability for an annuity to “live on” past the owner’s passing is a commonly misunderstood aspect of annuities. Many retirees or near-retirees seem to believe that the insurance company would simply retain the remainder of an annuity, even if the owner passes away soon after its acquisition, but that is seldom the case these days as many annuities usually provide some level of assurances post-death.  

In sum, variable annuities are touted as providing potential for additional growth versus fixed annuities and can possibly help investors maximize their investments and income over the long term. As you would imagine, various bells and whistles that are added to an annuity to make it better for an investors’ retirement income, or legacy, can come at a cost.  Usually this cost is made up of a fee charged quarterly taken as a percentage of the assets in the variable annuity separate investment account. As with many things, investors can usually get what they are willing to pay for, but more on fees later.

INDEX ANNUITIES  

Index annuities are a form of fixed annuity that includes contractual returns based on the value of an index of stocks or investments. Think of an index as a tracking mechanism linked to the value of a group of investment holdings, for example, the S&P 500 Index is a basket of 500 US stocks.  With an index annuity, investors have the potential to earn increased returns over that of a normal fixed annuity, depending on the performance of the index to which the annuity is tied. (There is no such thing as a direct investment in an index.) The index is merely the instrument used to measure the gain or loss, and that measurement is used to calculate the rate of return for the annuity, with the annuity company usually providing some floor or minimum rate of return in case the index does not perform well. Interestingly, there is usually a significant limit to the potential gains of an index annuity. One way in which insurance companies can limit gains is to put a cap on growth. If the cap is 10 percent and the index increases 20 percent, the investor only gets 10 percent of the gain. Insurance companies may also offer only a percentage share of the index performance. For example, if the insurance company sets the rate at 50 percent of index performance, and a particular index rises 10 percent, the annuity would earn 5 percent. Finally, the insurance company can implement margins or spreads. If your margin is set at 4 percent and the market rises 10 percent, your annuity would rise only 6 percent. How and when interest is credited is an essential consideration as well. Some companies calculate return by comparing your account value at the beginning of the year to its value at year-end and credit the return at that time; others wait until the end of the annuity contract altogether, which could be many years. Index annuities have been gaining steam lately due to its strong downside protections and new and competitive benefit offerings in the form of both living and death benefits.

MUDDYING THE WATERS

Confusion surrounding annuities arises because annuity contracts themselves are confusing and they can use highly complicated language and actuarial formulas. In addition, life itself is not simple. Consider for a moment a few of the various “what if” situations that the annuity contracts must cover: What if the annuity owner’s beneficiary dies before them? What if the owner dies early? What if the investments drop significantly in value? What if the insurance company goes out of business? What if the index drops? What if an investor needs more money out of the annuity than the income component can provide? What if I end up not needing the money at all? You get the point.

In addition, annuities are enigmatic because they sit at the nexus of multiple and varying regulatory bodies. It is possible that as many as 10 different entities have their hands in oversight and compliance of annuities, depending on the situation, and amazingly, different types of annuities require varying licenses and varying standards of practice for insurance agents to offer them to investors.  

A basic insurance license can give an insurance agent the ability to sell fixed annuities, including many index annuities. In other words, the barrier to entry to begin the sale of a few types of annuities to the public by insurance agents is low. While fixed and index annuities require only a minimal license, variable annuities usually require an insurance license plus a securities license coupled with a broker/dealer registration, and/or a Registered Investment Advisory firm affiliation, which are more difficult to obtain and are more costly, but usually require higher standards in conducting business with clients versus a mere insurance license. Many insurance agents who promote only fixed and index annuities usually do not have the licenses or registrations to conduct business with their clients comprehensively, which include the potential use of other classes of annuities. So, minimally licensed providers may tout only a particular type of annuity as if it’s an antidote to everyone’s retirement planning problems, however, it may be that the particular type of annuity touted is the only type the insurance agent is permitted to discuss, thus causing confusion to the public by gatekeeping information about what else could be available to the investor. Gatekeeping of information coupled with minimally licensed agents marketing themselves as comprehensive financial advisors or retirement planners leads investors to believe they are working with a comprehensive planner, when they are not. Basically, many annuity “experts” are limited and structurally unable to explore entire classes of annuities, as well as other investments, which can cause confusion to the public who are unaware of certain limitations.  

In light of these complications, it is no wonder that retirement annuity options remain enigmatic to so many. If you are considering the purchase of an annuity to help secure your retirement income, it is extremely important to work together with a trusted and highly qualified and licensed investment and insurance professional who can work with you comprehensively to assess the various options available to you. Procuring an annuity is a process, not an event, and should be done while considering your big-picture objectives and overall personal and financial situation.  

FEES (PREMIUMS)

As complex as annuities seem, you may be wondering why insurance companies and licensed insurance producers/agents provide annuities to clients. Beyond helping to secure retirement incomes for clients and applying a fiduciary duty or suitability duty to their clients, depending on the advisor, the motivation is simple: The insurance company usually pays a commission to the insurance agent, and the insurance company can usually earn more money on the funds invested in an annuity, or taken as a premium, than the sum of the benefits they provide to annuity investors. Remember, this is not communist Russia.  

In addition, agents can reduce their business risk and add to their own peace of mind by knowing that clients will potentially have protections in volatile financial markets. So, along with helping to make his or her clientele more secure the agent can also garner a substantial income from annuities. Fees and commission to licensed insurance producers varies greatly by annuity type and can range from less than 1 percent to as much as 8 percent or more of the amount contributed to the annuity, and may even include ongoing fees or (trail) commission to an insurance or financial professional.  

A commission usually does not erode the amount of money an annuity purchaser invests in the annuity, and the commission is paid by the insurance company. So if an investor places $200,000 in an annuity, and the annuity pays a commission of 3 percent, the investor will likely have an annuity with an initial value of $200,000, not $194,000. However, to make up for the commission paid to the agent, if an owner cashes in their annuity early or withdraws too much, the insurance company will likely subject the owner of an annuity to a “surrender schedule,” which includes penalties to the owner for early withdrawals. These penalties help the insurance company recoup the expense of commissions paid to agents as well as its costs of setup and servicing. For investors, they can add insult to injury if liquidating an annuity under a hardship, and these penalties cause significant negative press for annuities because they can seem exorbitant. Surrender periods can last 10 years or more and can be as high as 10 percent of the value of the annuity. Surrender charges are a crucial consideration for purchasers of annuities. That said, although there are certain “surrender-free withdrawal amounts,” usually 10 percent of a policy value, surrender charges mean that investors must maintain sufficient liquidity outside of the annuity to insulate the funds in the annuity in the event that a lump sum of money is needed so as to avoid penalties.

Aside from surrender schedules, annuities come with additional costs, including opportunity costs for investors. The insurance company typically makes money on fixed annuities by paying out a lower rate to the annuity investor than what the insurance company is actually earning on investing the funds themselves. Plus, annuities usually carry an annual contract fee of some nominal amount, which can add up, and the insurance company charges a fee beyond the base annuity contract costs for the living and death benefits on the policy, depending on what is chosen. For example, income for life on two lives (spouses) instead of one life may be an option that an investor desires, and the fee for that two-life contract is usually based on a higher percentage of the assets invested in the separate account on a variable annuity than for one life. The insurance company may also participate in investment company level fees derived from the investment portfolio within the separate account. In following, on a net basis, variable annuity benefits are usually greater than a fixed annuity, or if the money were invested outside on an annuity in a normal investment account, but so are the fees.

In my experience, for fee conscious clients (just about everyone) it is difficult for them to conduct a cost/benefit analysis because so much of the benefits of using an annuity for part of a portfolio are grounded in realities of income and spending, which can vary, and also derived from the fear of multiple “what if?” scenarios.

The magnitudes of the risks are not clearly understood, and each person’s tolerance for the uncertainties of life is different, so value in terms of fees paid by an annuity owner is not clearly understood either. Hopefully now you see why annuities can be such an enigma!  

TAX CONSIDERATIONS

Given that non-qualified annuities (annuities not in an already tax-advantaged retirement account, such as an IRA) have special tax treatment and can grow tax deferred, the dual nature of the IRS suggests that when there are benefits, there are also drawbacks. The benefit the IRS provides for annuities, like other forms of insurance, is that assets can be contributed to a non-qualified annuity on an after-tax basis and the annuity can grow without taxes being owed yearly. (Contrast this to a normal CD, where the interest is taxable yearly when outside of an IRA.) For many investors of annuities outside of IRAs and other tax-advantaged retirement plans, the tax benefits of annuities outweigh the drawbacks. Deferred annuities are used as tax shelters to grow and defer assets outside the guise of annual tax liabilities, and higher income earners with large balances of after-tax assets commonly take advantage of the benefits. When income is commenced, a proportionate amount of the annuity income representing the principal amount contributed to the annuity in relation to the growth amount is exempt from income taxes. (If the annuity is in an IRA, the entire amount of distributions is likely taxable income, possibly with penalties, if taken early.) The IRS drawback: Annuity income representing growth may be subject to a 10 percent IRS penalty if funds are withdrawn before the age of 59½. Keep in mind, unlike IRAs, non-qualified annuities are not subject to Required Minimum Distributions at age 72. Please discuss taxes with your tax professional or visit the IRS directly.

LIABILITY PROTECTIONS

Asset protection planning is a world unto itself, and annuities can be a useful tool to shelter assets from certain risks. The bottom line is that an annuity may provide significant protection for assets from lawsuits and bankruptcy. It is essential that you consult with your legal professional about your specific facts, circumstances and intentions. Liability protection inquiries involve an analysis of statutory protections, some of which are included below, as well as an inquiry into the applicable prevailing case law. For federal bankruptcy, please see 11 U.S.C. 522(d)(10)(E) - EXEMPTIONS. In Louisiana, please see La. R.S. 20:33, La. R.S. 13:3881, La. R.S. 11:292 and La. R.S. 22:912. For other states, you may find resources here.  

INSURANCE GUARANTEE ASSOCIATIONS  

Some states provide added protections for individually owned annuity and insurance policies should an insurance company become insolvent. Visit the National Organization of Life and Health Insurance Guaranty Associations for more information. In Louisiana, where I’m based, the Louisiana Life & Health Insurance Guaranty Association provides a backup for certain insurance policies, including annuities, to the tune of $250,000 subject to caveats and restrictions.

IN CLOSING

Annuities can be extremely enigmatic, but when utilized properly, annuities can be prized tools for retirees and pre-retirees to complement a comprehensive approach to creating financial stability. Many of my clients gain added peace of mind, and income, knowing that current or future retirement income is being provided with insurance company assurances, and those assurances can lead to a more predictable and less worrisome retirement.

As you know, all financial matters are subjective and particular and informational articles are not tax, legal, or investment advice. To discuss your specific situation, you should reach out to me or seek other highly qualified financial planners to discuss your specific needs.

Joseph M. Prisco Jr, JD, CFP® is the founder of Advocacy Financial, LLC. He helps clients manage and optimize their financial and estate planning affairs. For more information, or to consult with Mr. Prisco, call 888-787-4590 or write to him at jprisco@advocacyfinancial.com  

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Annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to withdrawal charges. Optional riders have limitations and are available for an additional cost through the purchase of a variable annuity contract. Guarantees are based on the claims paying ability of the issuing company.

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