FA Playbook

Lifetime income? Tax deferral? What investors should know about annuities

Key Points
  • Generally, annuities give investors access to a stream of payments, plus potential tax-deferred growth, in exchange for an upfront sum of cash.
  • All-in, the average so-called B-share variable annuity contract with a living benefit feature costs close to 3.35%, according to Morningstar.
  • Advisors and investors should be aware of the fees, the surrender schedule and whether the insurance companies can alter the annuity contract or its terms after the fact.
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Whether it's lifetime income, tax deferral or the prospect of protection from falling markets, an annuity can sound like a good idea for many investors.

But clients ought to bring plenty of questions and some skepticism to the table before they commit.

"We know that there are people in this industry who have annuities in their bag, and if you have a hammer, everything looks like a nail," said Skip Schweiss, managing director of retirement plan solutions and advisor advocacy at TD Ameritrade Institutional.

Generally, annuities are insurance contracts that provide investors with a stream of income in exchange for a cash lump sum up front.

From there, it gets complicated: There are different flavors of annuities, with some offering market exposure and others crediting interest.

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Investors can also opt for extra features, if they're willing to pay. Living benefits, for instance, may give consumers additional income in the future.

There are plenty of catches, including contract expenses and surrender schedules — a set period of time in which consumers pay a fee if they withdraw their investment too soon.

"You have to look at the whole lifetime in which you'd have the annuity," said Scott J. Witt, founder of Witt Actuarial Services in New Berlin, Wisconsin.

"It's not just the accumulation in the contract that matters, but also how will you get the money out of it?"

Annuity flavors

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Primarily, there are three types of annuities.

Variable annuities allow consumers to invest in the equity markets via subaccounts, which are similar to mutual funds, and defer taxes on appreciation. Investors experience both the upside and downside of the market, so their account balance may fluctuate.

The types of subaccounts available for investors to select will differ from one insurance company to the next.

Be cognizant of fees. In 2018, so-called B-share variable annuities charged an average all-in of 2.366%, plus 0.991% for a cost of a living benefit rider, according to Morningstar.

Fixed annuities encompass a broad array of annuities.

Fixed-rate annuities credit a stated rate of interest to the amount of money invested in the contract for a specified period of time. Taxes are deferred on the growth.

Income annuities are also a type of fixed annuity: They offer customers a stream of income payments in the present (what's known as an immediate annuity) or in the future (what's known as a deferred income annuity).

Indexed annuities grant customers a rate of interest, which is based on the gains of a market index.

Contract holders aren't directly invested in the index, so they aren't fully exposed to market activity. Insurance companies use derivatives to keep the account value from declining when the index falls.

The amount of interest an insurance company will credit an indexed annuity is subject to limitations imposed by the insurer. These are known as "rate caps," "participation rates" and "spreads."

You have to look at the whole lifetime in which you'd have the annuity. It's not just the accumulation in the contract that matters, but also how will you get the money out of it?
Scott J. Witt
founder of Witt Actuarial Services

With these restrictions, the index tied to a customer's account might go up by 10%, yet the client might only capture 5% of that increase.

Financial advisors have been using indexed annuities as a way to counter equity exposure, said Scott Stolz, president of Raymond James Insurance Group.

"It's being used as a fixed income alternative," he said.

Fees charged on fixed and indexed annuities aren't explicit, the way they are with variable annuities.

Instead, insurers charge an implicit fee through rate caps, participation rates and spreads. That way, they can adjust the amount of interest customers receive.

Tax implications

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Growth in all annuity contracts is tax-deferred, but be aware that when the time comes to withdraw the money — or if you, the investor, surrender the contract early — you will be subject to income taxes on the growth.

Further, withdrawals prior to age 59½ may be subject to a 10% penalty.

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Finally, many annuity contracts are subject to a "surrender period," or a stated period of time in which a client loses a chunk of principal if he takes his money out prematurely.

This "surrender period" can last six to eight years. Some contracts have surrender periods that run for 10 years to 15 years.

Kicking the tires

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Both the advisor and the client should be ready to kick the tires on any annuity before making it part of a financial plan.

"You must at least go into it with a healthy amount of skepticism," said Witt at Witt Actuarial Services.

Keep the following questions in mind when it comes to annuity recommendations:

• What role does this annuity play in the portfolio?

The more features you add, the more it will cost. Higher expenses dampen your returns.

Further, an annuity might not always be the answer.

For instance, investors who want a credited rate of interest over a specified period of time might also want to consider laddering certificates of deposit.

Whether a CD ladder or a fixed-rate annuity is the right answer will depend on a number of criteria, including an investor's tax situation and time horizon.

• What are the commissions? Commissions paid to advisors will vary based on the product they're recommending. These payments are negotiated between the insurance company and the broker-dealer or insurance agent with whom the advisor is affiliated.

Commissions aren't always up front; "trailing" commissions spread advisor payments out over a number of years.

Clients should not shy away from asking how their advisor is being paid for the annuity recommendation.

• Can the terms of this contract change? Insurance companies can adjust the fees of the living benefit riders they offer, as well as adjust the investment options available in the annuity, said Stolz.

Some insurance companies restrict the types of funds customers can select in their variable annuities, which can affect the growth of an investor's account.

• What happens when the investor draws down on the account? Tax-deferred growth is attractive in the present, but advisors and clients should plan ahead for what happens when the investor receives income.

If the client funded the annuity with after-tax dollars and then later chooses to receive a steady series of payments for the remainder of his life, then he has "annuitized" the contract.

That means a portion of each payment is considered earnings and is subject to income tax, while the rest of the payment is considered a return of principal and is tax-free.

This is different from taking a lump sum withdrawal from the annuity. In that case, your first withdrawals are all earnings and subject to ordinary income tax rates, said Witt.

"It's a less efficient way to pull the money out," he said.