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Understanding Annuity Contracts

The first thing to understand about an annuity is that it is, indeed, a contract, a formal, written agreement between an individual and a life insurance company that obligates both to a long term commitment. In return for a commitment by the annuity owner to keep a lump sum of money on deposit for a minimum period of time, the insurer is obligated to secure the deposit, credit it with a rate of interest, guarantee its return at the death of the individual, and then guarantee an income over the life of the annuitant or for a specified period of time.

The idea of a “contract” may scare some people, but, with the depth of obligation skewed toward the life insurer, it tends to work more in favor of the annuity contract holder which is why life insurers continue to experience record inflows to their annuity products. To understand how an annuity contract works is to understand just how much the life insurer is obligated to the annuity contract holder and how they provide such unique benefits. Essentially, an annuity contract is comprised of two phases, an accumulation phase and a distribution phase.

Accumulation Phase

For investors with a longer retirement time horizon, and no need for current investment income, a fixed or deferred annuity can be used to accumulate funds until they are needed. The contract includes an accumulation account to which the insurer assigns a fixed rate of interest. The contract spells out the details of the accumulation phase and all of the requirements and restrictions for the annuity owner.

Contract Ownership:

This establishes how the annuity is to be titled as an asset. In the event of the death of the annuity owner it will also dictate how and to whom the annuity contract is to be transferred .

Premium Payment:

Each contract specifies a minimum deposit amount that is accepted. Some annuities allow for additional periodic payments.

Interest Rate:

The terms for crediting interest are outlined including the length of time a rate is guaranteed and how future rates are determined. Annuity rates are usually based on the investment performance of the insurer’s portfolio and credited annually.

Minimum Rate Guarantee:

Specifies the minimum rate of interest that will be credited to the accumulation account. While insurers strive to credit account with competitive rates, a declining interest rate environment could push yields down severely, however, the insurer cannot credit a rate below the minimum guarantee.

Surrender Provisions:

These provisions allow for withdrawals to be made from the annuity at any time, however, if done so within a prescribed timeframe known as the Surrender Period, any amount withdrawn in excess of 10% of the value of the accumulation account will be charged a surrender fee. At the end of the surrender period, typically 7 to 10 years, there are no longer any surrender fees.

Taxation:

Aside from the fact that contributions to annuities are made with after-tax dollars, they are treated in the IRC much in the same way as qualified retirement plans. All interest earnings within the accumulation account are allowed to grow without current taxation and will be taxed as ordinary income when they are withdrawn. Also, any withdrawals made prior to the age of 59 ½ are subject to a 10% penalty by the IRS.

Death Benefit:

The contract includes a death benefit payable to a designated beneficiary. The benefit amount is, at a minimum, equal to the annuity owner’s principal investment.

Distribution Phase

This part of the contract details the process by which the insurer annuitizes the accumulation account and the requirements and options for the annuity owner. Once a contract is annuitized, the accumulation balance is irrevocably committed to the insurer.

Income Ownership:

An income option is selected as single life or joint life. If a joint life option is selected, the surviving annuitant will continue to receive payments based on the selected payment terms and payout rate.

Income Period:

This is the length of time, as specified by the annuity owner, that the insurer is obligated to make income payments. It could be for the lifetime of the annuitant or for a specific period of time.

Income Payout:

This is the formula that determines the amount of income that will be generated each month and it is based on several factors including the age of the annuitant, the life expectancy of the annuitant (which determines the number of payments), and a minimum rate of interest.

Refund Options:

In the event the annuitant dies before life expectancy, a selected refund option will determine the method and the amount of refund of the annuity owners balance will be paid to the beneficiary. Options no refund, cash refund, installment refund, or period certain refund.

Perhaps the most important element of the annuity contract is the financial ability of the insurer to fulfill its contract obligations. Simply put, an annuity contract is only as solid as the financial strength and integrity of the insurer. While an annuity owner has yet to lose any money from an annuity contract, which, in the 150 year history of annuities in this country, is a testament to their safety, companies with the highest ratings have the strongest balance sheets and reserves should be considered before others.

What are SPIA Annuities?

Single premium immediate annuities (SPIA) have been around in various forms for centuries. In their simplest form, they were a promise made to Roman citizens by the government to pay them an annual stipend for life in return for a deposit made to the government for its use. Similar arrangements were used by governments throughout the centuries and the deposits helped to finance wars as well as major construction projects. The SPIA of today is not very different in terms of its basic functions; however, the contract that is issued by a life insurer is a bit more complex than the simple arrangement of yesteryear.

SPIAA Essentials

SPIAA annuities are essentially used for the same purpose today that is to create a stream of income that lasts for a lifetime. Life insurers obligate themselves to that promise in return for a lump sum of money that they then invest in their own portfolio to generate a return that can be credited to the annuity balance as well as a profit for the insurer.

How do SPIA annuities work?

Upon receiving a lump sum deposit, which is an irrevocable investment on the part of the annuity owner, the insurer then makes a calculation to determine how much income can be paid out. The income period could be for a specific time frame, or for the life expectancy of the annuitant. Either way, the number of periods for which the income is to be paid is established. Then the insurer makes an assumption about the rate of interest the annuity balance will earn over that period of time. Using these two factors, a payout rate is established and fixed for the life of the contract.

When the income payments commence, typically within 30 days of the deposit, the amount paid includes interest earned on the account balance as well as a portion of the principal. The amount of principal that is returned in each payment is dependent on the number of pay periods. The objective is to pay out the entire principal by the end of the income period. The annuitant is only taxed on the interest portion of the payment.

At the end of the income period, the principal is exhausted and the income payments stop, except in the event that an annuitant lives beyond his or her life expectancy. Even though the insurer calculated the amount of payments based on an assumed number of years in which the annuitant would live, the insurer is obligated to continue to make the full payment for as long as the annuitant lives. This is the “insurance” aspect of annuities and the primary reason why people buy them.

How SPIA Annuities are Structured

A straightforward SPIAA would be structured as a single life annuity in which the income is paid to the annuitant, and if he or she should die before the end of the income period, the annuity balance is retained by the life insurer. In many cases, the annuitant is married and would want to ensure that the spouse was able to continue receiving income payments, so the SPIAA could be structured as a joint-life annuity. The income payments from a joint-life SPIAA would be slightly less than those from single-life because of the extra cost of insuring both lives.

Also, it’s not uncommon for an annuitant to want his or her heirs to receive some or all of the remaining annuity balance in the event that both spouses die prematurely. So, SPIAs can be structured to provide a refund of the balance, typically in installments. Some arrangements allow for a refund for a period certain after which a refund would not be available. These arrangements also add to the cost of the annuity which is recovered by reducing the income payment some more.

Additional Toppings

One complaint about SPIAs is that the fixed income it generates won’t help the annuitant over time when the cost-of-living increases. Most SPIA contracts allow for an inflation hedge option that, for an additional cost, will index the income payments to inflation.

What to Expect from an SPIA

SPIA annuities stand apart from other types of retirement income vehicles, and while they are not for everyone, they are unmatched in the benefits they can provide the right investor.

Security:

The principal balance and income payments are guaranteed by contracts issued by the strongest financial institutions in the country. Life insurers have a solid history of paying their obligations and those that receive the highest ratings (AAA from S & P and A++ from A.M. Best) are as rock solid as it gets.

Guaranteed lifetime income:

No other investment vehicle can do this.

Tax Advantages:

The interest earned on the annuity account balance is tax deferred. And, the income, as it is received, is only taxed on the interest portion.

Peace-of-mind:

SPIAs are also known as “sleep insurance” for those who might otherwise lie awake at night fearing that they might outlive their income source.

Are SPIA Annuities Right for You?

SPIAs are only suitable for anyone who has an immediate need for a guaranteed income stream. If you are retired and you want to build in an income safety net then an SPIA may be an appropriate investment. It is important to have available other liquid assets that can be used to cover short term needs or emergency expenses.

SPIAs are best used as part of an asset allocation strategy that includes short term liquid assets, some conservative growth investment, and other income investment. In that context an SPIA provides the stability that every retirement portfolio needs.

Are Annuities Safer than Mutual Funds?

The short answer to the question, “Are annuities safer than mutual funds?” is yes, in a number of ways. However, rather than just take it at face value, a closer examination of the two different types of investments will reveal how they differ in the amount of safety investors should expect from each.

Mutual funds are an exceptional investment vehicle, as much for their potential to generate solid market returns as for the access to the markets they provide average investors.  They provide diversification and professional management which go a long way to mitigate the risk that would otherwise be too great for the average investor to assume. .  With the wide variety of mutual funds from which to choose, investors can create a complete portfolio that is balanced and diversified to their specific risk tolerance and investment preferences.

But, the reality is that mutual fund investors risk the loss of their investment value.  Except for money market mutual funds, which invest in very short term debt instruments, all mutual funds invest in stock or bond portfolios which are all subject to the price fluctuations of the markets.  Technically, mutual fund investors won’t lose any money unless they sell their shares after they have declined in value, but they must endure the possibility that their investment may not recover its value within the timeframe they require.

Annuities Are Built for Safety

Annuities were designed with built-in protections and guarantees that afford investors the assurance that their principle is not at risk.  The amount of protections and guarantees vary in degree depending on the type of annuity.  All annuities guarantee the return of principle upon the death of the annuity owner and some types are structured to protect the principle during the accumulation phase of the annuity contract.

Fixed Annuities

Fixed annuities are considered the safest of all annuities. With minimum guaranteed rates of return and safety of principle as their primary objective, fixed annuities provide the greatest degree of protection for investors.  In the nearly 200 year history of annuities in this country, not one annuity owner has ever lost money.  Life insurance companies, considered to be the strongest and most stable of all financial institutions fully back the principle with their general account assets which are invested in high quality debt securities.  Life insurers are also required to maintain very strict reserve and surplus ratios which are scrutinized by state regulators.

Variable Annuities

Variable annuities share one primary characteristic with their mutual fund cousins and that is their managed separate accounts consisting of stock and bond portfolios.  As such, these accounts can lose value in declining markets, and, as with a mutual fund, if a variable annuity was surrendered during a period of declining markets; it is possible for an investor to lose money.

Although the accumulation accounts are managed separately from the general account of the life insurer, it is the assets of the general account that back the return of principle death benefit. Many variable annuities include a minimum rate guarantee that can assure investors that their money will grow even in a declining market.

Additionally, variable annuity contracts offer guaranteed benefit options (for an additional charge) that guarantee a minimum death benefit, or a “rolled up” death benefit that includes a growth element.  Contract owners can also purchase options that guarantee a minimum income level or income tied to a certain growth rate.  While many of these guarantees increase the cost of owning a variable annuity, they provide protections not found in mutual funds.

Fixed Index Annuities

Index annuities are unique for their ability to provide investors with a return that is tied to stock market returns, yet have guarantees and protections that are closer to those of fixed annuities.  The yield that is credited to the accumulation account is based on a percent of the actual gain in the stock index to which the annuity is linked.  The insurer caps the upside potential, so an investor will not participate in the full percentage gain of the index, but in return, the insurer guarantees that the account will earn a minimum rate during when the index declines.

The reset feature of fixed index annuities, in which the account values are reset each year to lock in the previous year’s gain, ensures that not only is the principle protected, but that any yearly gain is also protected and forms the new basis of the account.

Find out more by visiting the following page: Annuities Explained.

At What Price Safety?

There really is no question that annuities are safer than mutual funds. With all of the inherent and optional guarantees available in annuity contracts, it is fairly difficult to lose money except in the highly unlikely instance of a life insurer failing to meet its obligations. In the rare instance when a life insurer’s reserves fell below its outstanding obligations, the assets of the insurer were purchased by or merged with another insurer preventing any default to its annuity owners.

All of these protections and guarantees do come at a price. Annuities have fees and expenses associated with them that mutual funds do not.  The question investors, especially those who have taken a beating in the market, have to ask, is, how much is peace-of-mind worth?