By Boyce F. Lowery, CLU®, ChFC®
Last month we discussed some of the misconceptions floating around about annuities. Today I want to dispel the myths and clear the air.
First, let’s talk about the different kinds of annuities available. While we frequently hear the word “annuity,” that one simple word actually represents a myriad of different product approaches with a variety of features and uses. What the variety of annuities has in common is that they are all issued by a life insurance company and have inherent tax benefits. Here is an overview of the different types of annuities.
Deferred (Accumulation) Annuities
Deferred annuities are ones that don’t pay income immediately. You purchase the annuity with a lump sum or with ongoing payments in order to receive income at a later date or simply to accumulate funds for later use without turning on the income (annuitization) feature. For example, a 50-year-old may purchase an annuity that is tax deferred so that he can begin receiving guaranteed payments at retirement time. Conversely, the same 50-year-old might use the deferred annuity to defer taxes on growth and later choose to pay taxes and redirect the funds. In any event, there are a number of different kinds of deferred annuities from which to choose.
A multi-year guarantee annuity, also sometimes referred to as a CD annuity, works much like a bank Certificate of Deposit (CD) but with tax deferral on the interest earned. The annuity owner pays the premium to the insurance company and in return, the insurance company guarantees a fixed interest rate for a specific amount of time, usually ranging from 3-10 years. For instance, as of March 1, 2019, you could find a 5-year rate guarantee ranging from 3.30% to 4.00% depending on the insurance company chosen. Once the interest rate is set at the time the multi-year guarantee annuity is purchased, that interest rate is guaranteed for the term of the annuity. At the end of the guaranteed rate period, the annuity owner can elect to renew at a new rate that would be guaranteed for another identical term of years as initially guaranteed, exchange the annuity for a different annuity altogether, determine to take guaranteed income over some time frame or simply take the money and pay income taxes on the accumulated interest earned to date.
With a fixed indexed annuity, the annual interest rate credit is tied to changes in an index, such as the S&P 500 Index or numerous others, instead of having a fixed interest rate. The premiums are not actually invested in the index, but the interest rate ultimately credited to the annuity is based on the index’s performance, typically measured monthly or annually.
Fixed indexed annuities have a guaranteed minimum interest rate (a floor), rate caps (a ceiling on maximum crediting rates), and participation rates (specified percentage of any positive change in the relevant index) tied to the relevant index. For instance, an indexed annuity might have a guaranteed minimum interest rate (floor) of 0% and a cap (ceiling) of 6.00% interest in a given year. Conversely, another fixed indexed annuity might have a guaranteed floor of 0% and have no upside cap on interest earnings. Such annuities would then offer a participation rate which would be a percentage of any upside increase in the chosen index. Today, that participation rate might be between 45%-60% depending on a number of factors. Like a multi-year guarantee annuity, a fixed indexed annuity can be exchanged for another annuity or the annuity owner can elect guaranteed income over some time frame.
Fixed Indexed with Income Rider
This type of annuity is purchased by an owner who believes the funds going into the annuity will ultimately be used to provide guaranteed income. Further, the owner wants to know at the outset what the guaranteed minimum income will be at some future date. The actual income could be higher but never any lower than the amount guaranteed at the time of purchase. The income rider can be set up to provide guaranteed lifetime income for a single individual or for the longest living of two individuals. Because there is a fee associated with the income rider that will limit growth, this type of annuity is only appropriate where the need for future guaranteed income is known in advance. Typically, the “income base” of the annuity is guaranteed to grow at a set rate (say 7%) for a period of time (10 years is common).
Variable annuities do not offer a minimum guaranteed rate of return like fixed and multi-year guarantee annuities do. Rather, you get to choose from a selection of investments (sub accounts) inside the variable annuity, and the growth of your money is determined based on the performance of those investments. Variable annuities offer more growth potential than fixed rate or fixed indexed annuities, but they also carry the risk of loss. Further, many fixed rate and fixed indexed annuities carry no fees. Variable annuities do have fees associated with them. Like other deferred annuities, no tax is due on growth until funds are withdrawn or otherwise paid.
Variable with Income Rider
Like a fixed indexed annuity with an income rider, you can purchase a variable annuity with an income rider that guarantees growth of the “income base” at a set rate, regardless of the performance of the actual investments inside the annuity wrapper. The income rider guarantees that there will be a guaranteed minimum amount of money available from which to take guaranteed income payments that will last for a lifetime, regardless of age.
The dollar amount of the income base is NOT available for the annuity owner if they cash out the annuity. Rather, the actual cash paid at surrender would be the value of the investment accounts less any applicable surrender charge. Variable annuities with an income rider have significant fees which are a drag on actual cash accumulation. Therefore, the purchase of a variable annuity with an income rider is best suited to one who knows in advance they intend to use the annuity to provide guaranteed income at some point in the future.
Immediate (Income) Annuities
Immediate annuities typically begin making payments to the annuity owner 30 days from the date of purchase. Instead of allowing the money in the annuity to grow, as with a deferred annuity, the funds are used to purchase a guaranteed stream of payments commencing right away.
A life-only annuity pays guaranteed income during the entire lifetime of the annuitant, who might be someone other than the annuity owner. It doesn’t matter if the annuitant dies a short time after the payments begin or lives to be age 110, the payments will end upon the annuitant’s death. This type of income annuity is best used when the owner wishes to maximize lifetime income and doesn’t need the income to continue upon the death of the annuitant.
Life with Period Certain
You can combine a life-only annuity with a time-specific payment guarantee, called life with period certain. With a life only with period certain option, if the annuitant lives to a very old age, the period certain will have been exceeded but the payments will continue so long as the annuitant lives. However, if the annuitant dies prematurely, his or her beneficiaries will continue to receive the annuity payments for the guaranteed amount of time from commencement of the annuity payments, usually 10 or 20 years.
Life with Cash Refund
Another way to protect against losing premium payments through early death of the annuitant with lifetime income guaranteed is to include a cash refund rider. With cash refund, if the annuitant passes away before they have received benefits equal to the premiums paid, the insurance company will refund the difference to the annuitant’s beneficiary.
Life with Installment Refund
A life with installment refund annuity is much like a life annuity with cash refund except that the refund is not paid out in a lump sum at the death of the annuitant. Instead, the refund of premiums is paid over a period of time through continuation of the annuity payments until the amount paid for the annuity has been paid in total.
Joint Life Only with 100% to Survivor
A joint life annuity continues paying until both the annuitant and spouse/partner pass away. It doesn’t matter which annuitant dies first, the payments will continue until they are both deceased. 100% to survivor means that the annuity payment will not change when the first annuitant passes away. Some other options would reduce the payment by ⅓ to ½, but with 100% to survivor, the payment does not change. The annuity option is chosen by the annuity owner prior to annuity payments commencing.
Qualified Longevity Annuity Contract (QLAC)
For those individuals who will be faced with taxable Required Minimum Distributions (RMDs) from an IRA or qualified retirement plan(s) at age 70 ½, a qualified longevity annuity contract (QLAC) is an option to consider to lower the RMD amount otherwise applicable (to reduce taxable income). This vehicle allows a portion of IRA funds or qualified retirement accounts to be exempt from the Required Minimum Distribution calculations.
A QLAC is a special kind of deferred annuity that ultimately will provide lifetime income to the owner. Like a life annuity, it provides guaranteed monthly payments until death once income payments commence. Current IRS rules allow the lesser of $130,000 or 25% of an individual’s retirement savings account to be used to purchase a QLAC. QLAC payments can be deferred to as old as age 85. Payments can be higher than would otherwise be the case because of mortality credits gained from those who don’t live to receive the payments from their QLAC.
The Bottom Line
Annuities are insurance company products that offer unique provisions not available elsewhere.
For those that want safety of principal, returns similar to other fixed-income instruments, tax advantages and/or lifetime guaranteed income, then an annuity should be taken into consideration. Because there is such a variety of annuity products available, you should work with the assistance of an independent knowledgeable advisor. At Suncrest Advisors, we are intimately familiar with the annuity landscape and can help you find the right options for you. Call us at 888-827-0146 for a complimentary consultation.
It is important to remember that all financial vehicles have pros and cons. Come back next month as we discuss the pros and cons of annuities.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.