Common Annuity Shopper Questions

For many investors, shopping for an annuity is about as enjoyable as shopping for a new car. Everyone enjoys driving off in a new car, but the experience leading up to that point is usually laden with information overload, confusion, frustration and endless sales pitches. The more informed you are about your automotive needs and the cars that are best suited for your priorities and preferences, the quicker and easier the shopping process becomes. Shopping for annuities is no different. The more questions you can have answered before you are confronted with the buying decision, the better your experience will be.
Here are some more commonly asked questions by annuity shoppers:

Is an annuity right for me?

This is probably the most important question, so it deserves an in depth answer. The problem is that it can only be answered after you have done a serious assessment of your own financial situation. Annuities can meet a variety of financial needs, but generally, they are best suited for investors who have a long term time horizon who are seeking growth, stability and tax advantages on their assets. You should only consider annuities if you have maximized your savings in your qualified retirement accounts.

What exactly is an annuity?

Annuities are investment products issued by life insurance companies which offer investors a way to save for retirement on a tax deferred basis. Most annuities guarantee a minimum rate of growth, a return of principal, and a guaranteed income at retirement.

What’s the difference between an annuity and an IRA?

While annuities do provide tax deferral on earnings in their accounts, they are not issued as “qualified” retirement plans as defined in the U.S. tax code. The tax deferred earnings from annuities are treated similarly to qualified plans in that they are taxed as ordinary income upon withdrawal, and withdrawals made prior to age 59 ½ may be subject to a 10% penalty. Qualified retirement plans, such as IRAs qualify for additional tax benefits such as tax deductible contributions (traditional IRAs) or tax free withdrawals (Roth IRAs).

Are annuities guaranteed like Bank CDs

Annuities offer several layers of protection that bank CDs don’t. While CD deposits are covered by FDIC insurance, the coverage is limited to $250,000 per account, per bank. Also, few people realize that the FDIC is only fractionally funded, and it is technically not backed by the U.S. government. Banks are only required to maintain a very small fraction of reserves compared to outstanding obligations. Conversely, life insurers are required to maintain a level of liquid reserves, up to 95% of outstanding obligations. Additionally, each state maintains a guaranty association that covers policyholders up to $500,000 (coverage varies by state).

Are annuity rates guaranteed?

Yes. With most fixed annuity rates, there are actually two rate guarantees. The first one is a guarantee on the initial rate which can be fixed for a period of time (one to 10 years). The second guarantee is for a minimum rate that is paid after the initial rate guarantee expires. After the initial rate guarantee expires, the contract calls for resetting the rate based on a formula or based on prevailing interest rates. The minimum rate guarantee ensures that the adjusted rate cannot fall below the guaranteed rate.

Is my principal guaranteed?

All annuities guarantee that the principal will be paid in full at the death of the annuity owner. During the accumulation phase, the principal is fully backed by the assets of the issuing life insurance company. As indicated above, life insurers must maintain an adequate reserve that could meet the obligations of all of its annuity owners. These reserve levels are strictly monitored by state regulators to ensure complete solvency. In the 200 year history of life insurance issued annuities, no annuity owner has ever lost a penny of principal.

Do I really need the tax deferral of annuities?

If you pay income taxes at a high rate, 40% or above (state and federal combined), you could benefit from tax deferred earnings. Essentially, for every dollar earned and not taxed you are receiving an instant boost on your return. So, when left to compound, your earnings will grow faster. They will eventually be taxed at your ordinary income tax rate when they are withdrawn, however, many investors assume that they will be in lower tax rate when they retire.

Are there any minimum withdrawal requirements?

No. Unlike IRAs and other qualified retirement plans, annuities are not subject to Required Minimum Distributions, so your funds can be left to accumulate, tax deferred.

How liquid are annuities?

Annuities should not be considered as an investment unless you are able to commit to a long term time horizon. That’s the way to ensure you receive the maximum benefit from tax deferred earnings. But, things do happen, and annuity contracts do allow for access to your funds. One withdrawal per year is permitted, and, as long as it doesn’t exceed 10% of your annuity value, it can be made without any surrender charge. After the surrender period expires, from seven to 12 years, you can withdraw as much as you’d like without a fee.

What are the expenses associated with annuities?

Annuities have certain costs associated with them that you might not find in other investments, such as mortality and administrative expenses. The life insurer needs to cover its costs for insuring your life (guaranteed death benefit) and for administering the contract. These fees range from .5 to .8 percent of your annuity value and are deducted annually. Variable annuities charge for the professional management of the separate accounts, similar to mutual funds investment fees. These fees vary depending on the type of investment (stocks, bonds, real estate trusts, fixed yield) and how actively they are managed. They range from .5 to 1.5%.

How does an annuity guarantee a lifetime income?

Great question, because this was the original purpose behind annuities when they were offered centuries ago. Essentially, a life insurer guarantees a stream of payments calculating how much income can be generated from your account value by dividing it by the number of payment periods and factoring in earned interest. The payments consist of both earned interest and a return of principal. Should you live beyond your life expectancy, the life insure is obligated to continue your monthly payments for as long as you live. This “insurance” against living to long, is paid for with the mortality expenses deducted from your account value.

Does it matter where I buy my annuity?

There are dozens of insurance companies offering hundreds of different annuity products, and, as with any type of product, some are of higher quality than others. Annuities are serious commitments involving serious money, so it would important to deal with the most established and reputable providers. You can quickly narrow down your choices by limiting your search to those life insurers who rate the highest by the independent rating companies. Companies that are rated ‘A’ or better (AAA+ is the highest rating), are considered to be financially strong and able to meet their obligations in the worst of economic climates.

Are Variable Annuities Good or Bad

Variable annuities are a mainstay among savvy investors because they can provide an ample amount of freedom and empowerment for the investor. Like other annuities, variable annuities are investment vehicles that deliver payments periodically for a predetermined period of time and are bought from an insurance company. Income streams that are created can last ten or twenty years, or for the rest of the investor’s life. Annuities in general, allow the investor to have a predictable stream of income for a specific period of time.

With variable annuities, there are several important elements that should be taken into consideration: The ability to diversify an annuity, institute a beneficiary designee, and defer taxes for a later date. Variable annuities are one of three general annuities offerings for investors. For example, fixed and indexed annuities also exist and provide certain features to investors. All three types are contracts purchased for the promise of a future payment and are usually backed by insurance companies. Each type of annuity has its own positive characteristics and features that may or may not appeal to an investor. Variable annuities offer a unique feature from the others, which allow the investor to choose a beneficiary for their account in the unfortunate possibility that they may die before the collection any benefits.

In addition, variable annuities allow the investor a greater spectrum of freedom to invest in several types of mutual funds based on his aversion to risk. The variety of mutual funds can be vested in stocks, fixed insurance accounts, and or bond funds. Still, as with other annuities, variable annuities are beneficial because they are able to defer taxes in your account. Essentially, this means that the investor does not have to pay any taxes on the income gained on the interest growth, until the investor makes the first withdrawal. To avoid paying the 10% penalty fee investors need to keep their funds in the annuity account until he or she is at least 59.5 years of age.

In addition, with variable annuities, the investor is able to choose the funds they want based on the risk they want to take. Let’s take for example, an older man in his early 70’s. His aversion to riskier accounts will certainly be less tolerable to a woman in her late 20s, and would choose to more fixed level of growth. Considering whether an investment is good or bad should be based on the several factors that are entirely based on the investor’s needs. An investor needs to consider several factors with every investment including the liquidity of the investment; the growth rate, the fees involved, and the risk of the investment.

Annuities in general are not backed up by the FDIC. Like the investment in all annuities, the investor assumes a greater possibility of financial loss if the company issuing the promise of repayment becomes unable to pay. Extremely rare that a company would become in danger, many states have created organizations and groups that offer a certain degree of investor protection. As with any investment, the investor’s risk management should include a full assessment of the issuing insurance company and regularly read the prospectus and quarterly reports. Nevertheless, annuities have earned a solid reputation among seasoned investors in delivering solid benefits, including predictable income streams, tax deferred investments, and control.

Understanding Variable Annuities

Variable annuities often draw comparisons with mutual funds, which has often led to criticisms over their higher expenses and lack of flexibility. While they are similar to mutual funds, variable annuities provide investors with a number of guarantees that long term investors who have endured volatile stock market swings can appreciate. And, when they are really understood, it becomes clear that variable annuities do offer investors enough flexibility to prevent that “locked in” feeling. Understanding variable annuities would be important for investors who have their sights set on a secure retirement.

Additionally, since their inception and subsequent rise in popularity, variable annuity products have undergone some major changes which has resulted in enhanced features, greater security and more guarantees, all at less cost than past versions of the product. So, even for those who have dismissed them in the past, variable annuities today certainly warrant a second look.

First, while variable annuities are similar to mutual funds to the extent that they are investments in professionally managed portfolios of stocks and bonds, the similarities end there. Variable annuities have three very distinctive features that set them apart from any other investment:

Distinct Variable Annuity Features

Tax Deferral

The earnings from the investment accounts are not currently taxed until they are withdrawn. Plus, funds may be transferred between investment accounts without incurring any taxes. If held for a period of time, the benefits of tax deferral will not only offset any of the costs associated with variable annuities, they will enable you to accumulate more money than if the earnings had been taxed each year. When the earnings are finally withdraw, they are taxed as ordinary income.

Guaranteed Death Benefit

All variable annuities have a death benefit, much like a life insurance policy. The difference is that the life insurer guarantees a payment to your beneficiary equal to your original principle, no matter how the investments performed. Some variable annuity contracts offer options, for an additional cost, that will guarantee the account value as payment if it is higher than your principle at the time of your death. Death benefit payments will reflect any reduction in the account value due to withdrawals.

Guaranteed Period Payments

When a variable annuity is converted to income, the life insurer will guarantee that you or your spouse cannot outlive it.

How Variable Annuities Work

Variable annuities were designed as an accumulation vehicle that could later be converted into an income distribution vehicle, so they are comprised of two distinct parts: an accumulation stage and a distribution stage.

Accumulation Stage

In the accumulation stage, your funds are deposited into a choice of separate investment accounts. In essence, these are mutual funds wrapped inside of an annuity contract, and there are typically a half dozen or more investment options from which to choose. There are usually enough options for an investor to develop a well diversified and balanced portfolio of stocks, bonds, cash, and even real estate, with variations of each to create an allocation for any investment objective or risk tolerance. Most variable annuities include a fixed account which, like a fixed annuity, offers a fixed yield with a minimum guarantee.
As your investment objectives or risk tolerance changes, you are able to adjust your allocation as needed. Most variable annuity allow for a certain number to transfer each year without a transfer fee. So, it is important to periodically review your investment allocation to ensure it continues to match your investment objectives and preferences.
Variable annuity contracts due allow for withdrawals, once per year, of 10% of your account value without charges. Withdrawals in excess of 10% are charged a surrender fee on the excess. The fees usually start off high, in the range of 7% to 12%, but diminish over the length of the surrender period (7 to 12 years) until the surrender fee disappears. Any withdrawal made prior to the age of 59 ½ may be assessed a penalty of 10% by the IRS. In certain hardship or disability cases the penalty could be waived.

Distribution Phase

When you are ready to begin receiving income from your annuity, the life insurer will take your account value and calculate a payout rate based on your age and your life expectancy (or a specified period of time). Once your income begins, payments are received a regular intervals, usually monthly. Since you funds are still invested in separate investment accounts, your income will vary depending on the performance of the accounts. In rising markets, your income will increase, and in declining markets it will decrease. Generally, variable annuity income payments are considered to be a good hedge against rising costs over your lifetime.

Some contracts offer an option to lock in a payout based on a fixed rate as opposed to a variable rate. Or, if you would prefer to receive the variable rate payout, you could purchase an option that will guarantee a minimum payment even if your account values decline.

Variable Annuity Expenses

Another difference between variable annuities and mutual funds that critics like to point out is that variable annuity expenses are higher. In addition to paying an investment management fee which is similar to that charged in a mutual fund, you will also incur a mortality expense which the insurer charges to cover the risk it assumes for the death benefit. These charges, typically in the 1.25% range, are deducted from your account values each year.

Additionally, you are likely to pay an administrative fee, typically a flat dollar amount around $25 per year, that the insurer uses to defray record keeping and other administrative costs.
Also, for most of the additional guarantees and options that have been discusses here, such as the minimum income guarantee, there are additional charges. Many of these options serve to enhance the guarantees and provide more security, so the additional charges can be considered as “insurance premium”.

While the variable annuity expenses are higher than those of mutual funds, the question that risk adverse investors might ask is how much would they be willing to pay to be able earn market-like returns, without paying current taxes, and the peace-of-mind that, no matter how the market performance, they are assured of getting at least a minimum return.

To better understand how any one variable annuity product works, it is important to ready and study the prospectus which includes detailed information on the investment accounts, the various charges and any minimum guarantee options.

A variable annuity purchased with a minimum rate guarantee

How to Find the Best Variable Annuities

Variable annuities have been making a comeback in recent years. This is due, in part, to the improved performance of the markets, but much of the resurgence can also be attributed to the renewed spotlight on some of the guarantee features that many shell-shocked investors desperately seek. Couple that with the fact that the variable annuity space has become much more competitive driving down expenses and fees while their benefits have been greatly enhanced. For investors, it is good news all around, so it may be good to time to explore how to find the best variable annuities.

Variable Annuity Comparative Features

When comparing variable annuities, it is important to remember that they are a multifaceted investment vehicle wrapped inside of a contract which actually becomes an obligation of a life insurance company. Unlike a fixed annuity, in which your funds are comingled with the general investment account of the life insurer, a variable annuity has separate sub-accounts consisting of various investment portfolios that enable you to determine how your funds will be invested. You can allocate your funds among a family of professionally managed stock, bond, fixed yield, or real estate funds, much like you can with a family of mutual funds.

That’s where the direct comparison with mutual funds stops. One of the primary differentiators of variable annuities is their favorable tax treatment that allows all of the earnings inside the sub-accounts to grow tax deferred. Although they ultimately are taxed as ordinary income upon their withdrawal, they will be left unencumbered by taxes for many years which means faster accumulation. Additionally, variable annuities include a death benefit which, in effect, guarantees that your beneficiary will receive no less than your original investment (less any withdrawals).

As variable annuities evolved, so did their features, benefits and guarantees. Newer contracts include features or options that beef up the guarantees that, effectively, minimizes the risks associated with investing in the financial markets. While some of these additional guarantees come at an additional cost, the premium investors pay for these protections may very well be worth the peace-of-mind that they bring.

Comparing Investment Sub-Accounts

As with mutual funds, comparing the historical performance of the sub-accounts is one way to separate the best variable annuities from the rest. Investment pros will caution you, however, that past performance is no indication of future performance, and so simply comparing past returns is not likely to give you the complete picture you need.

A stronger indicator of good professional management is its consistency in outperforming the major indexes. Managers who do a good job, year-end and year-out beating the market indexes, even if by a small margin, may be better in the long run, than managers who get big returns for a couple of years, but then underperform the market in bad years. The better managers find a way beat the market indexes in down years as well.

All of the information on historical performance, fund managers and fund objectives can be found in the prospectus that must accompany any discussion of the product with a financial professional.

Comparing Fees and Expenses

Next to fund performance, the fees and expenses of variable annuities garner the most attention. This is due to the fact that, over the years, variable annuity expenses have been criticized as being too high, at least as compared to mutual funds. It’s somewhat of an apples and oranges comparison because of the additional features and benefits offered through variable annuities.

They both share an expense known as a management fee which covers the cost of professional investment management of the funds. For most investors, the lower the management fee, the better, however, some well-managed funds may warrant a higher fee if it has demonstrated consistent returns over the years. These fees can range from .25% to 1.25% depending on the type of fund. Aggressive stock funds are more actively managed, so their fees tend to be higher (but so are their potential returns).

Variable annuities charge an additional fee to cover mortality costs which provides the death benefit guarantee. Most variable annuities also include an administrative fee to cover the costs of record keeping and other administrative functions. These fees can vary widely as well; however, mortality costs tend to fall into the 1% range.

Account Access

With variable annuities you do have access to your account values, but with some limitations. The contract includes a surrender period, during which you may withdraw up to 10% of your account value without a surrender charge. Any excess funds withdrawn are charge a surrender fee which can be as high as 12% in the first year. The fee is reduced by one percentage point each year of the surrender period until it vanishes, which, essentially ends the surrender period.

Both the surrender period and the surrender fee are also competitive features that should be compared. For the most part, the shorter the surrender period is, and the lower the fee, then the better the product, perhaps. It would be important to make sure that a variable annuity with a highly attractive surrender feature isn’t offsetting that with higher expenses elsewhere.

Minimum Guarantees

Although an investment in variable annuity sub-accounts involves risk due to fluctuating market prices, variable annuity contracts come with some guarantees that can reduce or even eliminate the risk. For instance, the death benefit guarantee ensures that your beneficiary will receive at least the principle investment at your death. Some contracts have a step-up valuation, as an option, which continuously ratchets up the death benefit amount to include the gains in the sub-accounts.

Additionally, some variable annuities offer an option that will ensure that you receive a minimum return on your account value even if they decline due to a decline in the markets. The minimum rate guarantee is an option with a charge, but it may a good risk reduction premium to pay. More variable annuity contracts are offering this as standard feature. For any options, it is important to weigh their costs against the potential benefits.

To Find the Best, Look to the Top

All of the guarantees and protections provided in variable annuities are backed by the issuing life insurance company, so it is important to consider only those companies in the best financial condition. Life insurers are rated for their financial strength and ability to pay all of their obligations. For the greatest peace of mind, it may be best to look for the best variable annuities among the top rated companies.

Are Variable Annuities Good or Bad

How many times have you watched a movie that you thought was really bad, only to hear from other people how great it was. You might swear that they saw a completely different movie. In a way they did. Judgments about good and bad are purely subjective based on people’s frame of reference and their preferences. The same can be said about investments. Your financial profile is as unique as your fingerprint. An investment might match your profile, and, at the same time, be totally unsuitable for the person standing next to you. It would be good for you, but bad for the other person.

As an investment, variable annuities contain certain characteristics and features that may or may not match your profile. The only way you could determine if it were to be a good or bad investment for you is to assess your own needs, objectives, preferences, priorities, concerns and risk tolerance. Then, with and honest appraisal of the features and characteristics of a variable annuity you would be in a position to render a judgment.

Variable Annuities are Good if….

You understand and can accept market risk.

Variable annuities are accumulation vehicles that allow investors to choose from among different professionally managed investment accounts to create a diversified portfolio of stocks, bonds real estate and fixed yield investments. As such, the account values are subject to fluctuations as the various markets move through their up and down cycles. For investors who understand that they will have to tolerate these fluctuations in order to achieve good returns, variable annuities can be a good investment.

You are in a high combined federal and state tax bracket.

The ability to achieve higher returns combined with the tax deferred accumulation of the earnings, makes variable annuities an attractive investment alternative for people in higher tax brackets. Being able to defer taxes on gains on which you might have otherwise had to pay at a combined 50% tax rate, is as good as increasing your return by 50%.

You have a long term time horizon.

Variable annuities are designed as long term investment vehicles. The tax code treats them as such, and so, in order to benefit from the tax deferral, it requires that the funds be kept in the account until you have reached age 59 ½ or they will be subject to a 10% penalty.

Additionally, the issuing life insurers, can only provide the guarantees and benefits of the annuity if the funds are committed for the long term. While they do allow access to your funds through an annual withdrawal privilege, they will assess a fee of up to 12% for withdrawals that exceed 10% of your account value. This provision is generally not a concern for investors who have a long term investment outlook and who have access to other liquid investments.

You want to protect your financial legacy. Some people saved their money for a good part of their lives, only to have the 2008 market crash wipe out half. Since then, many have had the opportunity to rebuild their 401k and investment accounts, however, for those who met an untimely demise after the crash, their survivors and heirs bore the brunt of the financial suffering. One of the distinctive features of variable annuities is the guaranteed death benefit which gives your family the assurance that, no matter how poorly the market performs, they will receive no less than your original investment.

You are concerned with outliving your income in retirement.

Variable annuities are thought of as accumulation vehicle, they also include an income component like any other annuity. The most essential premise of annuities is their ability to generate a guaranteed stream of income that cannot be outlived. Once you have accumulated a pot of money inside your annuity, you can then have it converted into an income annuity.

You could choose to keep your account balance invested in variable accounts which could potentially generate a monthly income that grows as the markets grow. You would need to be mindful of the fact that the markets will fluctuate which will cause your income to fluctuate. But if you believe that the markets will continue to trend higher, as they always have, they you could benefit from increasing income over time. Alternatively, you could choose to fix your income payout based on a guaranteed rate of interest. A solution that is suitable for most people is to split your investment between a variable and a fixed income annuity.

Variable Annuities are bad if….

You are intolerant of market risk

You could instead choose to invest in a fixed or indexed annuity.

You are in a lower tax bracket.

You may be better off investing in mutual funds.

Your investment time horizon is short

Unless you can commit your funds to at least a 10 to 15 year timeframe, you should avoid variable annuities.

You have no concern for a financial legacy

Although the guaranteed death benefit is not the only reason to invest in variable annuities, it is a feature that you pay for through mortality charges.

You have yet to maximize your contributions to your qualified plans

You should first take full advantage of your qualified retirement plans for their additional tax advantages.

You don’t have sufficient liquid assets.

If a variable annuity is your only investment asset, it could turn out to be a bad investment if your circumstances change enough to force you to liquidate it in the short term.

You can’t derive all of their benefits.

While variable annuities have several unique and advantageous benefits, there don’t come without additional costs. Variable annuities include fees and charges that could reduce the impact of their benefits if you are not in a position to fully utilize them. It is possible to find variable annuities with reduced expenses and sales loads, but they still need to be weighed against the benefits you should expect to receive.

Summary

Are variable annuities good or bad? The answer lies in the eye of the beholder. Only after you truly understand your own situation can you honestly evaluate variable annuities as a suitable investment alternative for you. It’s also important to know that the universe of variable annuity products is vast, and that their features and expenses vary widely, so it would be difficult to form a judgment based on any one product.