Understanding Deferred Annuities

Editor's Notes

• #3: Characteristics of Deferred Annuities There are many challenges in long-term investment planning. The key to reaching financial goals depends greatly upon how and where individuals invest their money. Providing for a secure retirement does not just happen overnight, but is the result of careful planning. Deferred annuities are an investment savings vehicle typically sold by insurance agents and financial advisors that may help meet the challenges of retirement investing with these key features: Building retirement assets With few limitations on contributions, no mandatory distribution requirements, and the power of compounding, principal and potential earnings can work together to help reach an investor’s retirement goals. The tax-deferred status of annuities also allows principal and interest to grow uninhibited by the burden of taxes each year. There are a couple of other choices that need to be made when investing in a deferred annuity. The annuity contract can be purchased to allow for either single or flexible payments. A single payment annuity means that only a lump-sum investment can be made. If investors want to contribute more, they would need to purchase another annuity. Flexible payment annuities allow investors to contribute to the annuity as they want. The biggest decision is perhaps choosing between the two primary types of annuities: fixed and variable. There are a number of differences between them, but most notable is that a fixed annuity provides a guaranteed fixed rate of return on the investment, whereas a variable annuity’s return is not guaranteed and will fluctuate with the market. Choice on how to withdraw money The decision to take out money in a lump sum, as needed, or annuitized is the investor’s choice. “Annuitization” requires an investor to exchange his or her portfolio balance for a stream of income payments for life, a predetermined number of years, or some combination of the two. This allows for customized payout options that best suit individual needs.
• #4: Benefits of Deferring Taxes While it is impossible for individuals to avoid taxes with most investments, it is often possible to defer taxes. Deferring taxes over long periods of time can result in substantial gains. When holding investments subject to taxation, it is possible to defer taxes by delaying the sale of the investment (not realizing the gain). However, taxes on income, such as coupons or dividends, must be paid annually. The impact of taxes on an investment portfolio can be significantly reduced through the use of tax-deferred investment vehicles. Examples include individual retirement accounts (IRAs), company-sponsored 401(k) plans, 403(b) plans, Keogh plans, and tax-deferred annuities. Talk to a professional investment advisor to learn more about the differences between these tax-deferred investment vehicles and to your employer to learn about plans sponsored by them. Tax-deferred plans work by allowing interest, dividends, and capital gains to accumulate without incurring taxes. Taxes are due only when the investment is sold (once withdrawals from the plan begin). This image illustrates how deferring taxes can increase the value of an investment over time. A hypothetical value of $10,000 is invested in both a taxable and a tax-deferred account. The difference is fairly modest after 20 years. After several more years, however, the difference is more substantial. Allowing the investment to grow tax-deferred for 30 years would have provided approximately $11,745 more than the taxable account. After 45 years, the difference is even more dramatic. Returns and principal invested in stocks are not guaranteed. Withdrawals of tax-deferred accumulations are subject to ordinary income taxes. A 10% federal tax penalty may apply to withdrawals made before age 59½. About the data This hypothetical example is for an investor in the 28% bracket using the 2009 tax code (estimated to become the 31% tax bracket in 2011). $10,000 is invested in stocks at the beginning of year 1 (2010). Assumes an 8% annual total return (6% price return and 2% income return) and a 15% tax rate on capital gains and dividends in year 1 (2010), after which the rates revert to 20% and the investor’s marginal tax rate, respectively. The investment is taxed at a 28% marginal tax rate in year 1 (2010), and then reverts to 31%. Taxes are assessed yearly on the taxable account but only at the end of the period on the tax-deferred account. Estimates are not guaranteed.
• #5: There Are Many Annuity Features From Which to Choose Deferred annuities offer various features depending on whether a fixed or variable annuity contract is chosen. Fixed annuities Fixed annuities offer a guaranteed interest rate (rate of return) for a set period of time. The interest rate may be reset periodically, but the annuity contract guarantees that the rate will not fall below a minimum level stated in the contract. Variable annuities Variable annuities offer investment flexibility through an array of investment choices ranging from conservative fixed accounts or money market portfolios to aggressive stock portfolios. The investment return and account value in a variable annuity will fluctuate, so that when redeemed it may be worth more or less than the total amount invested. They are very complex because of the number of insurance features available; therefore, investors should make sure they fully understand how the variable annuity contract works and the fees associated with the insurance protection. Furthermore, variable annuities may offer the following services and features that could help make the investment process easier. Dollar-cost averaging is a convenient, systematic way to invest for individuals who are reluctant to deposit large sums of money in the market at one time. It minimizes the effects of market fluctuations, encourages discipline, eliminates the need to decide when to invest, and avoids the temptation to time the market. Dollar-cost averaging does not ensure profit or protect against a loss in a declining market. It also involves continuous investment regardless of fluctuating prices, so an investor should consider his or her financial ability to continue purchases through periods of high price levels. Asset allocation is the process of developing a diversified investment portfolio by combining different assets in varying proportions. Many annuities help make this process easy by providing a number of diverse portfolios from which to choose. Many annuities offer automatic portfolio rebalancing of the percentage of money invested in individual funds. Because funds perform at different levels, investors need to make periodic adjustments to keep their desired investment mix. Moreover, tax-free transfers can be made among the funds a variable annuity offers. Living benefits are intended to protect portfolio assets or income payments from downside risk by guaranteeing a minimum level of account value, withdrawals, or annuity income. A death benefit is an insurance feature that guarantees your beneficiaries will never receive less than, at a minimum, the amount contributed. Living- and death-benefit guarantees are based on the claims-paying ability of the issuing insurance company and are generally reduced by any withdrawals prior to the exercise of the benefit. Keep in mind that there are certain fees and charges associated with variable annuities, which include but are not limited to: mortality and expense charges, sales charges, administrative fees, and surrender charges. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #6: Assets of Deferred Variable Annuities Variable annuities offer a variety of equity and fixed-income investment sub-account options. Deferred annuity assets reached $1,311 billion as of September 30, 2009, with 77% of assets invested in variable accounts and 23% in fixed accounts. While most assets are in variable accounts, some variable annuities offer a fixed-account option that guarantees both principal and interest, similar to a fixed annuity. The idea is to give investors the flexibility of splitting their money between lower risk fixed accounts and higher risk variable accounts, all within the same annuity contract. It is important to remember that investments in variable annuities fluctuate, meaning that returns and principal invested are not guaranteed. Performance depends upon the underlying investment accounts. There are certain fees and charges associated with variable annuities, which include but are not limited to: mortality and expense charges, sales charges, administrative fees, and surrender charges. Any guarantees associated with an investment in variable annuities are subject to the claims-paying ability of the issuer. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract. Source: Fixed and variable account assets—Morningstar Annuity Research Center.
• #7: Annuity Distributions Can Be Received in a Variety of Ways Investors have a variety of distribution options upon maturity of a variable annuity, but do not have to choose among them until they require a distribution. The simplest distribution alternative is the lump-sum payment, where the entire account balance is withdrawn. From a tax or income management standpoint, this may be least effective. Investors will bear a tax liability for their accumulated earnings, which may also include a federal penalty tax of 10% for withdrawals before age 59½. Systematic withdrawal is ideal for those who require flexibility in their income stream. Money will continue to grow tax-deferred while allowing the investor to draw income. The main drawback to this option is that investors could outlive their money. This type of payment may also be subject to certain charges and taxes. Annuitization is the process of exchanging the contract value of an annuity for the issuing company’s guarantee to make payments to investors for a certain period, their lifetime, or both. Investors can choose whether they want a fixed or variable payout. For fixed annuitization, the income payments are set at a fixed amount and not adjusted for inflation. With variable annuitization, the initial income amount is set based on an assumed interest rate (AIR) selected at the time the contract is annuitized (3%, 4%, or 5% are common). Subsequent annuity payments can be higher or lower depending on whether the performance of the underlying investment options is higher or lower than the chosen AIR. This option offers the potential of rising income that may outpace inflation, but low or negative investment returns can lower the monthly income payment. There are a number of annuitization options from which to choose. With the life-only option, payments will continue for as long as the annuitant lives. For the life-only-with-full-refund option, payments are also received for as long as the annuitant lives. However, if the annuitant dies before receiving payments equal to the original premium, the difference between the premium and the total payments received will be paid in one lump sum to a beneficiary. For the life-only-with-period-certain option, payments are guaranteed for the life of the investor, but for no less than the stated number of years. If death occurs, payments will continue to a beneficiary for the number of years remaining. The joint-life-and-survivor option guarantees payments during the lifetime of two people, typically a husband and wife. After the death of one annuitant, payments continue to the survivor. The amount of the payment can be equal to various percentages of the original payment based on the annuity contract. This option can also include a guarantee of payments for a fixed number of years. With the fixed-period option there is no life contingency; payments continue for the number of years chosen, even in the event of the death of the contract holder, and then cease. These options represent the basic annuitization options available in deferred annuity products. Some of the more recent developments include post-annuitization liquidity options such as commutation rights, which allow the annuitant to receive a discounted lump-sum payment of remaining projected annuity payments, and post-annuitization death benefits. In general, the more flexibility, guarantees, and liquidity built into the payment structure, the lower the income payment. Any guarantees associated with an investment in variable annuities are subject to the claims-paying ability of the issuer. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #8: A Variety of Living-Benefit Options Are Available Living-benefit options are intended to protect downside risk to the portfolio value or income payments. There are three primary types of living benefits, although each insurance company has different variations. A guaranteed minimum accumulation benefit (GMAB) guarantees the initial investment (or some multiple) after a specified number of years. A guaranteed minimum income benefit (GMIB) guarantees a minimum annuity payment based on a guaranteed “benefit base” that is generally calculated using the highest account value on any prior contract anniversary and/or net contributions compounded at a fixed annual rate of interest; 6% is common, so the annuity payment cannot be lower than this floor amount, regardless of investment performance. However, it is important to note that most GMIB annuity payments are calculated using a different payout rate table and/or an “age setback,” which results in lower payments on a GMIB benefit base than would be calculated using the same dollar amount of actual account value. In other words, the GMIB does provide a floor annuity payment, but it is not the equivalent of a 6% return on your investment or the purchase of an immediate annuity with funds that have accrued for 10 years at 6%. A guaranteed minimum withdrawal benefit (GMWB) guarantees a return of principal over time through systematic withdrawals. Examples would include receiving 5% of your initial principal over 20 years or 7% over approximately 14 years. More recent innovations include payments for life, or for two lives through “spousal continuation.” “For life” withdrawals are typically limited to 5% annually. Keep in mind that there are certain fees and charges associated with variable annuities, which include but are not limited to: mortality and expense charges, sales charges, administrative fees, and surrender charges. Additional fees generally apply with living-benefit options and are most often charged against the benefit value rather than the account value, therefore the fee as a percentage of assets can increase substantially in a down market. Investment restrictions may also apply for all living-benefit options. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #9: Living-Benefit Riders Are Becoming More Common With interest in living-benefit riders increasing, many insurance companies have begun offering a number of new features. The image highlights the percent of open variable annuity contracts offering the three most common types of living-benefit riders: guaranteed minimum accumulation benefit (GMAB), guaranteed minimum income benefit (GMIB), and guaranteed minimum withdrawal benefit (GMWB). Currently, GMWB is the most popular living-benefit rider offered on variable annuity contracts, followed by GMIB. The percent of variable annuity contracts offering the various living-benefit riders is calculated by taking the number of open variable annuity contracts available to individual investors that offer each feature, divided by the total number of those contracts as of December 31, 2009. Additional fees do apply for living-benefit options. Investment restrictions may also apply for all living-benefit options. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract. Source: Morningstar Annuity Research Center.
• #10: Example of GMAB The purchase of a guaranteed minimum accumulation benefit guarantees that, regardless of the investment performance of the underlying accounts in a variable annuity contract, the investor would receive the initial investment value after the stated contract period. Some companies offer GMABs that guarantee a multiple, such as 110% or 120%, of the initial purchase amount rather than just the initial purchase amount. Others allow for the ability to lock in gains during periods of strong market performance. If the underlying investment accounts perform better than the amount guaranteed, the investor would receive the higher amount. Generally, this type of rider is only available during the saving and investment phase and is often selected in the years immediately preceding retirement, when an investor might be most concerned about preserving the value of their investment. The image illustrates how a GMAB might work in a period of poor investment performance for a hypothetical contract offering the initial investment value of $100,000 after a 10-year contract period. Typically, living-benefit options must be selected when the annuity contract is purchased, although there are some contracts that allow options to be added at specific times, such as certain contract anniversary dates. Since the GMAB feature varies from company to company and contract to contract, things an investor should pay attention to when considering a GMAB include investment options/restrictions, calculation of guaranteed amount, ability to lock in gains periodically, and applicable fees. The information presented herein is a hypothetical example given to explain how a GMAB living benefit might work. It is not representative of any specific annuity. Additional fees do apply for living-benefit options. Investment restrictions may also apply for all living-benefit options. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #11: Example of GMIB The purchase of a guaranteed minimum income benefit guarantees a fixed floor of income after a specified period once the contract is annuitized. The basic GMIB offering protects the annuitization value by offering a guaranteed growth rate on the initial investment amount over a specified period during the saving and investment phase. Some contracts enhance the benefit by providing step-up provisions that allow investors to lock in gains. The image illustrates how a GMIB might work for a hypothetical contract offering 5% compound annual growth on the initial investment value and a highest anniversary value step-up provision. Upon annuitization, the investor would receive the value that would provide the greatest income stream for life. The value that produces the highest income may or may not be the guaranteed “benefit base,” even if the benefit base is higher than the actual account value, depending on the payout factors used for annuitization. If the underlying investment accounts perform better than the benefit base, or the amount assuming a guaranteed growth rate or highest anniversary value, the investor would be able to annuitize that amount. The key to receiving this benefit, however, is that the investor must annuitize his or her contract. There are usually waiting periods (often 10 years) before an investor can opt to annuitize the contract. Typically, living-benefit options must be selected when the annuity contract is purchased, although there are some contracts that allow options to be added at specific times, such as certain contract anniversary dates. Since the GMIB feature varies from company to company and from contract to contract, things an investor should pay attention to when considering a GMIB include investment options/restrictions, guaranteed growth rate, ability to lock in gains periodically, GMIB annuity payout factors, and applicable fees. Furthermore, since many investors do not annuitize, this feature only makes sense for those who plan to do so. The information presented herein is a hypothetical example given to explain how an GMIB living benefit might work. It is not representative of any specific annuity. Additional fees do apply for living-benefit options. Investment restrictions may also apply for all living-benefit options. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #12: Example of GMWB The purchase of a guaranteed minimum withdrawal benefit guarantees a return of principal over time through systematic withdrawals, regardless of market performance. Examples would include receiving 5% of the initial principal over 20 years or 7% over approximately 14 years. Some contracts allow investors to step up the guarantee amount if the market performs well. In addition to step-ups, recent innovations include the guarantee of withdrawals for life, or for two lives through spousal continuation features. “For life” withdrawal guarantees are typically 5% of the guaranteed amount. The image illustrates how a GMWB might work for a hypothetical contract offering a 5% withdrawal benefit. Essentially, the investor would receive 5% of his or her initial principal of $100,000 annually ($5,000 per year) over 20 years. The cumulative amount of withdrawals would add up to the investor’s initial investment amount. This benefit is normally used during retirement, when an investor requires income, although it may also be suitable for investors approaching retirement as a way to limit downside risk and lock in any gains through the step-up feature. Annuitization is not required for this living-benefit rider, but with the exception of “for life” structures, the income payments cease once cumulative withdrawals reach the guaranteed value. Typically, living-benefit options must be selected when the annuity contract is purchased or on contract anniversaries. Since the GMWB feature varies from company to company and from contract to contract, things an investor should pay attention to when considering a GMWB include investment options/restrictions, maximum withdrawal amount, ability to lock in gains periodically, applicable fees, and how the fees are assessed. The information presented herein is a hypothetical example given to explain how a GMWB living benefit might work. It is not representative of any specific annuity. Additional fees do apply for living-benefit options. Investment restrictions may also apply for all living-benefit options. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #13: Variable Annuity Fees Increase with Features The insurance protection offered by many of the living-benefit riders can provide investors with peace of mind, but it comes with added expense. In order to appropriately evaluate the fit of a rider, it is important that investors have a clear understanding of the future benefits provided by such features in relation to their cost. The image compares the average mortality and expense risk, administrative, and distribution charges for variable annuity contracts that offer living-benefit riders with those that do not. It also includes average expense ratios. In both instances, fees for annuity contracts offering living-benefit options run higher. Additional fees do apply for living-benefit options. Investment restrictions may also apply for all living-benefit options. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract. Source: Morningstar Annuity Research Center.
• #14: Investors are Concerned about Beneficiary Protection The assurances provided by a guaranteed minimum death benefit (GMDB) can help stem the fear of losing money and encourage you to make more aggressive portfolio choices. Many variable annuities feature a guaranteed death benefit, which means that if an investor dies before they annuitize, beneficiaries will receive, at a minimum, the amount invested into the annuity. With many variable annuity contracts, investment gains are locked in regularly so that your beneficiaries receive more than your principal, even if the value of the annuity has decreased at the time of death. The guaranteed death benefit is designed to provide your heirs with two-way protection: Maximize the value of the benefit if death should occur when your investments are increasing. Lock into a minimum benefit if death should occur at a time when investments have decreased. The graph illustrates an example of an annual step-up death benefit. This option allows your minimum death benefit to lock into the maximum account value established on any contract anniversary. Your death benefit will be dependent upon your investment performance over time. An additional charge may apply to purchasing this benefit. The information presented herein is a hypothetical example given to explain how an annual step-up death benefit might work. It is not representative of any specific annuity, nor does it guarantee an increasing current value. There are certain fees and charges associated with variable annuities, which include but are not limited to: mortality and expense charges, sales charges, administrative fees, and surrender charges. Any guarantees associated with an investment in variable annuities are subject to the claims-paying ability of the issuer. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #15: Optional Death-Benefit Guarantees Are Available In addition to the standard death-benefit option, which provides the maximum contract value or investment amount, most variable annuity contracts also offer optional death benefits. Three optional death-benefit guarantees common to many variable annuity contracts include: 1) maximum anniversary value (MAV), 2) rising floor, and 3) earnings enhanced bonus (EEB). A MAV death benefit offers a "look back" to contract anniversary account values to calculate the minimum death benefit payment. A rising floor death benefit sets a minimum death benefit value by compounding net premiums at a fixed annual rate of return. An EEB death benefit adds a fixed percentage payment to the contract value at death, generally 25% to 40%. Additional fees do apply for optional death-benefit guarantees. Violating the terms and conditions of the annuity contract may void guarantees. Read your prospectus carefully for all the fees and expenses that may apply to your variable annuity contract.
• #16: Evaluating the Suitability of Deferred Annuities Due to their complexity, deferred annuities are often difficult products for investors to understand. Like any investment or insurance product, annuities are not necessarily a suitable choice for every investor. Evaluating the appropriateness of deferred annuities for investors requires time and a clear understanding of several factors. Some of the factors include: Types of annuities Differences among annuities Number of features Living- and death-benefit options Fees associated with purchasing the insurance protection Completely understanding the calculation methodologies of the death and living benefits, including any limitations regarding election or exercise Once investors grasp the basic components of annuities, they should be in a better position to understand whether annuities fit with their time horizon, risk tolerance, and goals.