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How Does an Annuity Work?

On the surface, annuities may appear to be straightforward, long-term products to help fund your retirement. You give an insurance company a sum of money, called a premium, either in a lump sum or periodic payments. In return, you will receive a steady stream of payments over time.

But if you’ve ever bought an annuity or seen the typically lengthy contracts, you may already realize that they can be very complicated insurance vehicles. The cardinal rule of finance is to never invest in something you don’t fully understand – but when it comes to annuities, even insurance agents may not always know the finer points in the contracts they are selling! Protecting yourself is crucial, especially with products like annuities where the large sales commissions can potentially create a conflict of interest for the agents or advisers that sell them.

It takes some effort, but learning the basics can help you better understand annuities—whether you already own one or are considering a purchase.

To get you started, we’ve outlined annuity fundamentals in the sections below. If you get confused, we suggest you refer to the following resources:

And if you’re still stuck, you can click here to speak with an AnnuityAssist advisor. We will gladly bring you up to speed.

 

Six Attributes Every Annuity Investor Should Consider Carefully

There are some major factors to be aware of when it comes to annuities. Are they safe? How are they taxed? What are the rates of return? We address these and other concerns in the section below:

1. Annuity Riders

Optional annuity benefits, called riders, are frequently the main selling point of variable annuities. Riders fall into two basic categories: death benefits and living benefits. For a fee, these benefits offer to enhance the contract’s income-generating ability or death benefit payout. However, a 2012 study found that despite being very popular when purchasing a product, income features may rarely be used.1

 

2. Annuity Fees

Variable annuities have many annual fees ranging from basic insurance administration and expenses to optional feature add-on expenses. Although it may be a difficult task, these fees can be compared from contract to contract, with some annuity companies offering very low annual expense options. Most variable annuity expenses are charged annually. These fees will impact any investment returns and can result in significant sums paid to the insurer over time.

 

3. Annuity Returns

Many annuity contracts are sold with guarantees that provide some principal protection or base-level return. These guarantees usually come with high fees relative to other investment options. Or they may systematically limit upside potential through performance caps and participation rates.

For instance, variable annuities have several layers of fees that pay for the underlying insurance features and investment funds, so they are unlikely to keep up with equity indexes in the long run. Fixed-indexed annuities guarantee a minimum return and offer a variable interest rate based on an equity index, but contract features such as a cap, spread, or participation rate limit overall returns to a sustainable level for the insurance company.

 

4. Annuity Liquidity

Most deferred annuities, such as variable and fixed-indexed, have high surrender fees for the first few years. While the majority of the cash value will always be available, it may come at a high cost that can deplete any gains made. It may even result in a substantial loss.

Immediate income annuities (also known as Single Premium Immediate Annuities) are typically impossible to liquidate once purchased. Access to the original principal is forfeited in exchange for regular income payments over a set period of time -- often as long as the life of the annuitant(s).

 

5. Annuity Taxes

Annuities can be purchased in a taxable or tax-deferred account, but the Financial Industry Regulatory Authority (FINRA) has noted that a deferred annuity within a traditional IRA provides no additional tax advantage and “may not be a good idea.”2

Taxable annuities do have an appealing tax-deferral status that allows for the tax-free growth of funds within the annuity. Depending on an investor’s income level and tax status, this can be a positive or a negative – but it could take many years for tax deferrals to yield a significant benefit.

It is also worth noting that these gains are taxed as ordinary income – not capital gains -- upon withdrawal. With the federal income tax maximum rate of 39.6% and the capital gains tax top rate of 20%, annuities can be a costly investment without the right planning.

We highly recommend discussing any investment with a tax-advisor. Given their complexity, this is especially true with annuities.

 

6. Insurer Financial Strength

The insurance company’s financial strength will be a major factor in its ability to pay benefits over time. Investors are unlikely to lose principal in the event of an insurer default. But any add-on benefits or contractual guarantees could be lost.

If you found any part of that confusing, you’re not alone. We at AnnuityAssist want to help. Click here to contact one of our team of investment professionals with your questions.

 

 

1 Ruark Consulting LLC 2012 Variable Annuity Policyholder Behavior Studies – GMIB Annuitization, Surrender and Partial Withdrawal
2 Financial Industry Regulatory Authority, Inc. Variable Annuities: Beyond the Hard Sell (FINRA, 8/31/2009)

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