Investing For Your Future
Monthly IFYF Investment Message
July 2006
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Compared to mutual funds and common stock, annuities are more of a mystery to most investors. One reason is that there are many different types of annuities: fixed, equity indexed, and variable as the major categories and immediate and tax-deferred as the primary annuity funding methods. There are also numerous annuity distribution options such as payments for a specific length of time or for the lives of an individual and/or married couple.
An annuity is a contract between an investor (annuitant) and a life insurance company. Annuities are sold by insurance agents, stock brokers, and other financial advisors. The annuitant, who is usually the owner of the annuity (but not always), pledges to pay a lump sum amount or make deposits over a period of time while the insurance company promises immediate payments or payments at a future date. Below are some other facts about annuities that investors need to know:
- Regardless of who sells them, annuities are a life insurance company product. Look for an issuer that is highly rated by at least two insurance company rating firms such as A.M. Best, Duff and Phelps, and Standard and Poor's.
- Of the three types of annuities, fixed annuities are the most widely used. They are like CDs, only tax-deferred, and guarantee a certain interest rate for a specified time period. Afterwards, an investor can select another guaranteed period or earn whatever interest rate the issuer is offering based on market conditions.
- An equity-indexed annuity is a type of fixed annuity that ties a portion of its return to a stock market index such as the Standard and Poor's 500. A variety of methods are used to do this and contracts need to be read carefully. Many equity-indexed annuities cap the potential return investors can earn, regardless of how the market performs. The annuity's "participation rate" determines how much of an index's increased value can be applied to an annuitant's account.
- Variable annuities are like mutual funds, only tax-deferred. Variable annuity owners select underlying mutual funds, called subaccounts, and their annuity's performance is based upon that selection. The value of these subaccounts is called their accumulated unit value (AUV). Like the net asset value of mutual funds, AUV is calculated by adding up the value of all the variable annuity subaccount investments and dividing by the number of outstanding shares.
- Immediate annuities begin payment within a year of purchase. They are often purchased with money from settlements and lump sum pension plan distributions. Deferred annuities make payments at a future date and allow annuitants time to make periodic deposits.
- Annuities are generally not appropriate for qualified retirement plans such as 401(k)s or IRAs. They are already tax-deferred and investors gain no benefit by placing them in a tax-deferred plan. In addition, many annuities have high expenses, making them a less attractive alternative to low-cost investments such as index funds.
- Earnings on annuities are tax-deferred until annuitants make a withdrawal, generally at retirement. Most annuities have no limit on the amount of after-tax income that can be contributed, compared to annual IRS limits for IRAs ($4,000 in 2006 and $5,000 if age 50+) and tax-deferred employer plans ($15,000 in 2006 and $20,000 if age 50+). A 10% IRS penalty is charged for distributions from annuities prior to age 59 ½.
- A variety of annuity payout options exist, including income for one person's lifetime (single annuity), more than one person's lifetime (joint and survivor annuity), and lifetime payouts with guaranteed payments for a certain number of years (e.g., 5, 10, 15, or 20). Generally, the simpler the payout method, the higher the annuity payment.
- A unique feature of annuities is the death benefit (a.k.a., mortality charge). This is a guarantee, which investors pay for, of a return of premiums invested regardless of stock market performance. In other words, you won't get back less than the amount of money invested. The death benefit is often highly touted as a selling point for variable annuities, where there is a possibility of losing money during market downturns.
- Investors need to carefully consider the cost of the annuity death benefit and other expenses which can run as high as 2%. This means that, on a $100,000 account, the life insurance company would deduct $2,000 a year or about $166 per month. Consider investing, instead, with low cost annuity providers such as Vanguard, TIAA-CREF, and T. Rowe Price.
- Annuities are a long-term investment. They must generally be held 15 to 20 years before the "drag" of their high expenses is offset by their tax-deferral feature. This analysis assumes a comparison to alternatives such as stock index funds placed in a taxable account.
- Investors are generally advised to fully fund tax-deferred employer retirement accounts (e.g., 401(k) and 403(b) plans), especially with employer matching, and individual retirement accounts (IRAs) up to their maximum annual limit first and then purchase annuities if they still have after-tax dollars available to invest tax-deferred.