Annuities - Fixed, Variable & Equity-Indexed
Annuities are insurance contracts that guarantee a fixed or variable payment to the annuitant (the investor) at some future time. Annuities come in different varieties with many different options (called riders) so each annuity works in its own particular way, but there are some general concepts to understand.
Two Phases of Annuities
Generally, Annuities have two phases:
- Accumulation phase
- Distribution phase
In the Accumulation phase, the investor’s contributions are called premiums. The contributions can be made in a lump sum or in installments over a period of time.
The Distribution phase is when the investor can withdraw their money. The distribution can also be done in either a lump sum or in payments over a period of time.
Deferred vs. Immediate
When entering an Annuity, you may set the Distribution phase to begin immediately or have the payments delayed to some point in the future. As such, Annuities can be Deferred Annuities or Immediate Annuities. Whether Deferred or Immediate, earnings in the Accumulation and Distribution phases grow on a tax-deferred basis.
In a Fixed Annuity, the insurance company guarantees a fixed payment to the annuitant (investor) for either the lifetime of the investor or for a specified period of time. If an investor dies before their principal has been fully paid out, they may receive only a portion of the monies invested during the Accumulation phase. Essentially, the insurance company insures two risks in offering the Fixed Annuity: the investment risk and the risk of an investor living beyond the principal and interest earned.
To finance a fixed payment over time, a Fixed Annuity must generate interest on the premiums paid. A Fixed Annuity contract typically specifies two levels of interest: a Current Rate and a Minimum Rate.
The risk of a Fixed Annuity is entirely based on the financial health of the company selling the Fixed Annuity.
Variable Annuities differ in that their rate of return is based on an underlying securities portfolio or other index of performance (called a subaccount). The Variable Annuity contract itself may rise or fall with the stock market. Not only does this affect earnings in the Accumulation phase and payments during the Distribution phase, but also presents the risk that the Variable Annuity loses money.
Variable Annuities are often sold by comparing them to a mutual fund, but focusing on the features that Variable Annuities offer and mutual funds do not. These selling points include:
- Tax-Deferred Earnings — While market gains in the subaccount are not taxed until the Distribution phase, other types of investment accounts offer the same tax advantage. A Traditional or Rollover IRA also holds securities (e.g. mutual funds, stocks, bonds) and defers taxes until distributions are made.
- Death Benefit — Similar to insurance products, most Variable Annuities include a death benefit, which allows a designated beneficiary to receive a certain amount upon the annuitant’s death. That amount is often the greater of either: all the money in the account, or some guaranteed minimum (e.g. all premiums paid minus withdrawals taken). Sometimes riders are available to elect a “stepped-up” death benefit. Remember, that any death benefit guarantee is only as good as the insurance company that gives them.
- Payout Options / Guaranteed Income for Life — As its name implies, a Variable Annuity's rate of return is not stable, but varies with the investment options in the subaccount. There is no guarantee that an investor will earn any return on their investment and there is a risk that they will lose money. Because of this risk, variable annuities are securities registered with the Securities and Exchange Commission (SEC).
- Other Riders — Variable Annuities are often sold with a number of add-on options (riders) that provide specific benefits. Be aware that these special features may result in additional charges to the investor in the overall annual fees and expenses of the annuity contract.
Equity-Indexed Annuities are complex financial instruments that combine elements of both Fixed and Variable Annuities. The return on an Equity-Indexed Annuity varies more than a Fixed Annuity, but varies less than a Variable Annuity. So the risk for Equity-Indexed Annuity is somewhere between a Fixed and Variable Annuity.
Equity-Indexed Annuities combine a minimum guaranteed interest rate with another interest rate linked to a market index. The minimum guaranteed interest rate is typically a modest amount and a market index is the combined result of a number of stocks representing a specific segment of the market or the market as a whole. So while the market component of the Equity-Indexed Annuity still creates a risk (and potential losses), the minimum guaranteed interest rate may offset that risk somewhat. However, the minimum guaranteed interest rate may not even cover the costs of the surrender charges, rider expenses, and tax penalties if the investor needed to cash out their Equity-Indexed Annuity.
Regulation of Annuities
Fixed Annuities are not securities and are not regulated by the Utah Division of Securities or the Securities and Exchange Commission (SEC). Fixed Annuities are insurance products regulated by the Utah Department of Insurance.
Variable Annuities are securities regulated by the SEC. The individual sales agents should be licensed both as an insurance agent with the Utah Department of Insurance and as a broker-dealer agent with the Utah Division of Securities.
Equity-Indexed Annuities combine features of traditional insurance products (guaranteed minimum return) and traditional securities (return linked to the stock markets). Currently, Equity-Indexed Annuities are deemed to be a Fixed Annuity in Utah and are regulated by the Utah Department of Insurance, not the Utah Division of Securities. However, the SEC evaluates Equity-Indexed Annuities on a case-by-case basis and may regulate them as securities depending on the mix of features.
Free Look Period
Annuity contracts typically have a “free look” period of ten or more days, during which you can terminate the insurance contract without paying any surrender charges and receive a return of your purchase payments (which may be adjusted to reflect charges and the performance of your investment). You can continue to ask questions in this period to make sure you understand your Annuity before the “free look” period ends.
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Key Questions Before Buying an Annuity
Is the primary goal for the annuity purchase to fund retirement or a similar long-term goal? Annuities are long-term contracts between an investor and an insurance company. They are not suitable for short-term investments largely due to the surrender charges and tax penalties involved in cashing out of an Annuity.
Is the Annuity being purchased through an Individual Retirement Account (IRA) or some other retirement plan? IRAs and retirement plans already grow on a tax-deferred basis. So the purchase of an Annuity in such an account provides no additional tax benefit.
For Variable and Equity-Indexed Annuities, are you willing to take the risk of losing the money invested? There is no guaranteed return in the market. So products that are based on underlying securities portfolios carry that same market risk.
Are there tax consequences of purchasing an Annuity, including the effect of annuity payments on tax status in retirement? Depending on your tax situation in retirement, an Annuity may be advantageous, but you should be aware of the effects. Consult a tax advisor regarding your personal situation.
What are the fees and expenses of an Annuity? Annuities may have a number of “hidden” fees buried in the fine print of the contract. The only way to ensure you understand them all is to read the documents provided, ask questions, and verify with the insurance company. An investor should verify and consider: investment management fees, rider fees, surrender fees, the cost of insurance, and any other fee disclosed in the written materials provided by the insurance company.
What are surrender charges? Most Annuities have surrender charges that apply when an investor seeks to withdraw funds from the Annuities during the first 7 to 11 years of the Annuity contract. If you will need the funds prior to the expiration of these surrender charges, you may want to consider a short-term investment option instead.
Do the benefits of the exchanging one annuity for another outweigh the costs, including any surrender charges? While there are a number of reasons to exchange one Annuity for another (1035 Exchange), make sure you understand all the consequences so you can properly determine whether the advantages outweigh the disadvantages. For example, 1035 Exchanges typically reset the surrender period, lengthening the amount of time an investor has to wait before withdrawing funds without paying surrender charges.
How can I all the features of the Annuity? Annuities can be incredibly complex financial instruments with many different features. The only way to ensure you understand all the features of the Annuity is to read the documents provided, ask questions, and verify with the insurance company.
Are there any features of the Annuity, such as long-term care insurance, that I could purchase separately for less money? Annuities may include a number of benefits, but some benefits may cost you more than if you purchased separate policies through the same or another insurance company.
Contact the Division with questions or concerns - 801-530-6600