What Types Of Annuities Are Available?

Here is a truth about annuities that is neither self-evident nor widely understood – not all annuities are created equal.  In fact, I sometimes wish there was another word for this financial instrument because it so misunderstood by so many.

Originally, an annuity simply meant an annual payment.  The Latin word for year is Annus, from which we get such words as annual and per annum.  In ancient Rome, soldiers were given an annuity, or an annual salary, when they retired from the military.  British businessmen developed life expectancy tables in the sixteenth century and came up with contracts that would allow private individuals to create their own annuities, or lifetime yearly payments.  Pay a premium to an insurance company now in return for a yearly stipend later on in life. Since then the basic idea of annuities have metamorphosed into financial instruments that perform all manner of functions along that basic theme.

So why is it that, when most people hear the word “annuity” they find two pieces of wood and make the sign of the cross, you know…like they did in those old black and white vampire movies?  Mainly it’s because they don’t understand what they are and how they work, and therefore tend to lump all annuities into the same basket.  The fact is that there are more types of annuities than Baskin-Robbins has flavors of ice cream.  In this post we will consider the five basic kinds of annuities:

  • Variable
  • Immediate
  • Fixed
  • Indexed
  • Hybrid

Variable Annuities

When people come after you with a deadly weapon when they hear you say the word “annuity,” it’s probably because they are thinking of variable annuities.  Why? Because variable annuities can lose value.  Variable annuities are essentially stock market investments in an insurance wrapper.  They go up in value when the stocks go up. When those stocks fall, your account value falls.  With variable annuities, for example, you can start out with $100,000, and a month later, have only $80,000 in your account… or less, depending on how your stocks perform. During the stock market crash of 2008, many who had variable annuities learned this lesson the hard way.  Because variable annuities are encased in an annuity shell, they contain provisions that only an insurance company can offer.  Death benefits, for example.  You can protect your investment for your heirs by tacking on a death benefit rider.  This means that if your variable annuity lost, say, half of its value because either you or your advisor picked the wrong stocks, the death benefit would ensure that the heirs got the original principle.  But just so we are clear, let’s assume that you have a variable annuity that was once worth $100,000 but is now worth $80,000, but has a $100,000 death benefit.  How much can you withdraw from it?  $80,000. Can you pull out the $100,000 death benefit?  No. You have to die, and then it doesn’t go to you; it goes to your heirs.  One of the misconceptions people have about variable annuities is that if they have a death benefit, their annuity is immune from the vagaries of the stock market.  Not true.

As with any other annuity, gains accrued are tax-deferred.  Taxes will eventually be paid, however, when those gains are withdrawn.

Because variable annuities have sub accounts similar to mutual funds, they also come with fees and expenses that fixed annuities do not have.  These charges include administration fees, mortality fees, expense risk fees, income rider fees, extra charges for the optional death benefit.  When it’s all said and done most variable annuities are going to cost between 4% and 8% per year in fees. There may be cases where a variable annuity fits that one person out of 20, who needs that one special rider.  But as a general rule I find it difficult to endorse them, and most of my colleagues who can see the entire financial planning playing field feel the same way.

Immediate Annuities

Here’s what happens with an immediate annuity. You put, say, $100,000 into this financial instrument and it starts paying out right away – thus the term, immediate annuity, as opposed to one you pay into over a period of time.  The immediate annuity payout can continue for a certain length of time, which is known as “period certain,” or it can pay out for the rest of your life.  The amount paid out will be determined by the insurance company using life expectancy tables.  The payout can be set up so that it comes to you every month, or every year.  Using the figure $100,000 for easy math, a 67-year-old male, for example, can expect to be paid $577 per month for the rest of his life.  If he lives to be 102, the payments continue.  If he dies a year later, however, the insurance company keeps the balance and heirs get nothing. However immediate annuities also have a guaranteed payout option. You can have an immediate annuity with a five-year payout to the beneficiary; you have an immediate annuity with a 10 year-payout to the beneficiary; 15 years, or 20 years. You can even have a refund immediate annuity. You get the highest payout if you take a lifetime immediate annuity, which is the one that pays you a certain sum of money and if you die it’s finished.

Let’s say you were to put $500,000 in the same type of annuity, and you are still a male, age 67, then that payout would be $34,608 per year, every single year, for as long as you live, or $2,884 per month.  The same $500,000 for female age 65 would yield an annual payout of $30,348 per year for the rest of her life, or $2,529 per month.  Why is it lower?  Because, generally speaking, females live longer than males.  So when calculating a lifetime payout, the insurance company takes into consideration your age, sex, how much you deposit and the payout option.

Fixed Annuities

A fixed annuity is just what it sounds like. It’s kind of like a CD, or certificate of deposit, only with an insurance company instead of a bank. You put in $100,000, and five years from now, if you’re earning, say 3% interest, you will have $115,927.40. There is one significant difference between a fixed annuity and a CD.  You pay taxes as you go with a CD…even if you don’t withdraw the money, whereas a fixed annuity is tax-deferred.  Usually, you will get a higher rate of return with a fixed annuity than you will with a CD. Like CDs, you will pay a penalty for early withdrawal.  With fixed annuities this is called a “surrender charge.”  Surrender charge periods are usually between three and seven years.  Once the annuity is past the surrender charge, you can withdraw your principle and any gains penalty free.  You will pay taxes at that time on the gains.  You may roll it over into another annuity, leave it in the same one.  As with any annuity, the owner may “annuitize,” or exchange the balance of the contract for a payout that can either last for a certain number of years, or guaranteed for the life of the annuitant.  A more popular option in the last ten years is to opt for an income rider instead of annuitizing.  Why?  Because when you annuitize, and die early, the insurance company keeps the balance of the account.  With an income rider, the annuitant still gets a lifetime payout and, should he or she die early, the balance of the accumulation account is passed on to heirs.

Indexed Annuities

Indexed annuities are sometimes called fixed indexed annuities (FIAs), or equity indexed annuities.  Whatever the name, they all work the same.  The indexed annuity is a type of fixed annuity that provides a minimum rate of interest, just like the traditional fixed annuity.  Call it a “floor.” But that’s not the end of the story. With these annuities, the rate of return over that floor is predicated on the performance of a stock market index usually the Standard and Poor’s 500 (S&P 500) index – thus the name, indexed annuities.  The insurance company sets a cap ranging between 4% and 8% on this feature, which means that you get a portion of the positive returns of the market, but do not participate on any of the downsides.  In other words, if the S&P jumps up 20% in one year, your growth will hit that cap and stop.  The caps are a tradeoff for having guarantee of principle.  If the index loses 20%, the value of the indexed annuity is not negatively affected.  In that year you get a zero rate of return.  Zero is your hero, however, because eliminating the negatives enhances overall growth.  Different companies have different rules, percentages and structures.  Some have participation rates, some do not.  These annuities are relatively new, having appeared on the scene in the early 2000s.  They have become increasingly popular with baby boomers approaching retirement because of the growth potential combined with safety.  The moving parts of this annuity have been described as a “ratchet/reset.”  At the contract’s anniversary date, the growth is locked in, and becomes the new high-water mark of the annuity.  It is that amount that becomes the new balance and represents the new amount that cannot be lost due to market fluctuation.  These annuities grow tax-deferred and can be annuitized, or converted into income streams of various lengths or a lifetime income stream.  The addition of income riders has made annuitizing obsolete, however, for all practical purposes.

Depending on the insurance company offering it, indexed annuities can come with a bonus feature, which simply means that the insurance company will add a bonus to the amount that you deposit.  If the insurance company offers, say, a 7% bonus, then if you deposit $100,000, your account value is immediately $107,000.  Insurance companies compete with brokerage houses, banks and other insurance companies for your money and bonuses are offered to attract customers.

Hybrid Annuity

A hybrid annuity is merely an indexed annuity with an income rider attached.  They are sometimes called “income annuities.”   What does it mean?  It means if you put $500,000 into this annuity, and let’s say the company gives you a bonus of 8%, that means you’re starting off with $540,000. That is the actual account value.  That same $540,000 is also going to be what is referred to as an ”income base.”  In essence, with a hybrid annuity, you have two accounts running simultaneously. The historical average rate of return for an indexed annuity over time is somewhere in the neighborhood of 6%.  But let’s assume worst case scenario and attribute just the 1.25% that is guaranteed.  After 10 years you would have an account balance of at least $611,426.

Simultaneously, as the actual accumulation account is growing, the $540,000 income base grows as well, rolling up at, say 7% per year.  Again, this varies from company to company, but the idea is the same. If you had $540,000 to work with, that income base rolls up at 7% per year. So at the end of 10 years, in the income base account, your 500,000 is now $1,062,262.  If, at that point, you want to turn on that income rider, you may do so.  What do you receive in the way of income?  Based on the age of 75, and a single lifetime payout of 6.5%, or $69,047 per year, every single year, no matter how long you live, for the rest of your life.  So let’s extrapolate that.  If you get $69,047 per year for 20 years, you would’ve collected $1,380,940.  But you only put in $500,000. And what if you die sooner? Let’s say a tragic accident occurs and both you and your spouse are killed after having collected only three payments from your lifetime income, you would have collected a total of $207,141.  However, your real account value, not your income base value, at that time, having grown at only the 1.25% guaranteed rate, would be $634,642. So when you subtract what you have taken, from the real account value, there’s $427,501 left for the heirs.  Why is that important?  Because in an immediate annuity, if you put the money in, and you got a payout for your life, but once you die it’s done, your heirs didn’t get any money.  With the income rider, however, you get the best of both worlds.  You get a guaranteed income that you can’t outlive and if you pass away, your heirs get the difference between the actual account value and the amount of income you took.  This is why I believe that a hybrid annuity is the best annuity for you if you’re looking for income you cannot outlive.  By using this as an income source, you are likely able to delay taking your Social Security until age 70, which will make that income as high as possible.  You have an income that will keep up with inflation and be larger than it would have been had you taken it at age 62, and you reduce your taxes.

Fees and Commissions – Contrary to opinions put forth by those who are not able to offer them, fixed annuities and fixed indexed annuities charge no fees.  The only exception to that rule is the nominal fee (usually less than 1% of the annual return) when a hybrid annuity utilizes a lifetime income rider.   Brokers and bankers typically offer variable annuities, which, since they are typically invested in mutual funds, do charge fees called “loads.”  You will pay these fees, as well as the broker or banker’s commissions, with variable annuities even if you lose money.  By contrast, fixed and fixed indexed annuities have no risk, no fees except for the nominal charge for optional riders, and no commissions that come out of your balance.  Any commissions paid to agents are paid by the insurance carriers that produce the product, similar to the way an airline pays a travel agent.  Who does the travel agent work for when he books your trip?  YOU!  Who pays the agent?   The airline that the agent uses pays the agent.  You do not pay the agent.  No self-respecting financial advisor would be influenced by products or by commissions. In fact, the fiduciary relationship that binds most financial advisors prohibits them from allowing even the hint of personal gain to enter into the recommendations made to clients. And that is how it should be.

Compare Companies Carefully

When selecting annuities, you must remember there are many makes and models out there.  As the title of this post suggests, not all annuities are the same.  Even within the different families or types of annuities mentioned here, not all annuities are the same.  Insurance companies are like any other profit-making enterprise.  They provide product offerings that are designed to add value to your financial life.  They plug features into these offerings in order to remain competitive in the marketplace.  For example, Company A may offer you a 10% bonus just for placing your money with them, instead of Company B.  Company B may come back with a 12% bonus next year, but may change some other aspect of the contract to balance out the equation so they can continue to make a profit and stay in business.  One of the reasons why you need to seek the help of a retirement specialist instead of a generalist is that the retirement specialist will keep up with all of these changes and be able to sift out all of the changes and determine for you which company is actually offering the best product, all things considered.  He or she will know which features are “window dressing” and which ones will positively impact your investment.

An illustration of three companies, all of which offer what appear to be attractive features in their annuity contracts.  Just to make the math easy, we are going to say we have $100,000 to invest.  Let’s see how we would fare using one over the other two.  These are actual companies, by the way.  I have just referred to them here as “Company A,” “Company B,” and “Company C.”  When you look at their product brochures, you will find features such as these included in the explanation of the products, but unless you understand them, and unless you can see the entire picture, you don’t know which is the best.  All three companies offer bonuses.  The smallest is 6% and the largest is 8%.  In other word, “Do business with us and we will boost the amount you start with right away!”  But let’s look a little closer.

Company A offers a 6% bonus.  Right away, you put $106,000 to work, right?  Yes.  The bonus is vested 10% per year until it is fully vested. Company A also offers an income rider with a “roll up,” that is a guaranteed rate of compounded return, of 5% per year for 10 years.  Keep in mind this is an income-based account. The reason why it is called an “income” account, as opposed to the actual “accumulation” account, is because it is actually a calculation base for the eventual lifetime income when you trigger it.  So the income base with Company A will grow to $172,663 in 10 years.

Note that all three companies offer a “payout” rate.  Payout rates are determined by age.  The older you are, the higher your payout is.  So that is one thing to pay attention to.  If I am, say 65, what is my “payout rate” on my income rider?  These may vary with a percentage point or so from company to company.   With Company A, the payout rate for someone 69 years old is 4.5%.  If this annuitant decides to trigger his lifetime income stream at age 69, and his income base has grown to $172,663, then his payout is $7,770 per year.  Note that Company A offers a joint life payout. That is another factor to consider.  If you are doing income planning for a couple, and the annuity doesn’t offer a joint life payout, that is for both you and your spouse, it may not be the appropriate choice.

Other things you will learn about Company A’s offering as you research it is that it is a variable annuity.  There’s nothing particularly wrong with a variable annuity, but you can lose money in a variable annuity if the market loses money.  With a VA, you are invested directly in the stock market.  There exist protections in the form of riders, which can be purchased for fees that will prevent your heirs from losing the account base.  You can purchase the income rider for a fee, as well, which offers similar protections.  But variable annuities can experience loss and can come with exorbitant fees.

Company B blows the doors off the competition with its bonus – a hefty 25%! So, right away, you have $125,000 working for you.  A lot of people may pick Company B because the bonus is so big.  Company B’s income rider rolls up at 5%, just like that of Company A, which means that the income calculation base in 10 years will have grown to $203,612 – More than Company A.

How about the payout?  Company B’s payout is also 4.5% at age 69, which will give you $9,163 per year, guaranteed for life.  But notice that the payout is not joint but single.  Just another factor to consider when doing retirement income planning and a fully trained professional will spot that difference and point it out if it makes a difference to the client.

The product offering of Company B is a Fixed Index Annuity. FIAs are not subject to market losses because the gains are predicated on the performance of a market index without requiring that the funds be actually invested in the market.

Company C also offers an FIA with an 8% bonus.  Right away, you have $108,000 at work.  The income rider with Company C’s product offering rolls up at a hefty 7% compounded for 10 years.  That means that the base from which your lifetime income is calculated starts at $212,452.  The payout with Company C’s annuity is at 5.4%, which means that, once initiated, your lifetime income, for both you and your spouse, will be $11,472.  That’s a 47.64% increase over Company A and a 25.20% increase over Company B.

The point is, annuities vary greatly from one to another.  It is yet another reason to consult a specialist instead of a generalist when working with these financial instruments.  The inside of a watch is complex to the untrained eye, but to a jeweler, it is not.  When examining the features of annuities, you need to account for the bonus, the roll-up, and the payout rates.  You can’t just look at just the bonus, or just the roll-up, or just the payout rate by itself.  One company may have, say, a 14% simple interest  roll-up for 10 years.  That looks quite attractive.  But they don’t have a bonus and the payout is only 2.65%.  If you chose that product you would have significantly less income.  When planning income for life in retirement, the income is, after all, the “bottom line.”

 

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