Deferred Annuity Guide

In the 19th century, insurance companies began issuing financial contracts accepting premiums from individuals in exchange for regular, lifelong income payments. These contracts originally took their name from the system of regular level payments received by the contract holders, which was called an annuity. The insurance company received payment in one lump sum and the income distributions began soon thereafter.

The Birth of the Deferred Annuity

In the 20th century, insurance companies pioneered a new kind of annuity product for people who lacked sufficient means to finance an annuity in one lump sum. This alternative product allowed for regular payments stretched out over years. The insurance company gathered and accumulated the payments, investing them at interest to grow into the capital sum necessary to finance lifelong payments. This long interval between the start of premiums paid by the contract holder and the beginning of income distributions made by the insurance company gave rise to the term “deferred annuity.”

This contrasted with the original form of annuity contract, which consisted of lump-sum payment followed soon by income distributions. The shortness of the interval between lump-sum premium payment and the onset of income distributions led to the name “immediate annuity.” (This was a slight misnomer, since the distributions might begin as late as one year after the lump-sum payment, depending on the frequency of payments called for by the contract.)

The Mechanics of the Deferred Annuity

The deferred annuity consists of two phases: an accumulation phase and a distribution phase. During the accumulation phase, the annuity holder makes regular payments to the insurance company. These funds are gathered and invested to earn interest. The investment account of the deferred annuity receives credited interest, according to the terms of the contract. Although the contract has a limited amount of liquidity during the accumulation phase (typically up to 10% per year may be withdrawn penalty-free), it should not be viewed as a short-term investment. Withdrawals made prior to age 59 ½ will incur a 10% tax penalty at the hands of the IRS, while surrender charges ranging from 1-10% are levied by the insurance company.

The addition of an accumulation phase for investment purposes has certain advantages to the annuity holder. In addition to allowing for gradual saving for retirement via small, regular payments rather than buying the annuity in one lump sum, the accumulation phase also allows the holder to take advantage of the insurance company’s tax-deferred status to shelter investment gains from taxation until distribution. Tax deferral is a very significant advantage of annuity investment.

At the end of the accumulation phase, the distribution phase begins and the insurance company starts to dispense the accumulated proceeds according to the plan stipulated in the contract. The distribution possibilities are many. Originally, lifetime annuities guaranteed lifetime income payments, regardless of the longevity of the holder, with any remaining value in the contract reverting to the insurance company upon the holder’s death. The principle of lifetime guaranteed income has remained standard, but annuity distribution plans have developed a multitude of variations on the original forfeiture provision.

During distribution, disbursements are subject to taxation as ordinary income. It is likely that the holder will be in a lower tax bracket in retirement than while working, but income-taxation is still high compared to taxes on capital gains, so deferred annuities may suffer a tax disadvantage when compared to alternative investments that enjoy capital-gains tax status.

Types of Deferred Annuity

Fixed Deferred Annuity

The first type of deferred annuity was the fixed annuity. During the accumulation period, the holder’s investment account is credited with an interest return that is fixed for a period specified in the contract.  This interest-guarantee period may be as short as one year, after which the credited interest rate may fluctuate from year to year in accordance with market conditions. (Many fixed annuities contain a bailout clause, however, allowing penalty-free exit from the annuity if the renewal interest rate should fall too far below the initial guaranteed rate.) Fixed annuities also typically include death-benefit provisions, minimum guarantees for the credited interest rate and income accrued in the investment account and the full range of level-payment-type distribution plans.

Fixed annuities should be viewed as conservative, fixed-income-equivalent investments, suitable for those nearing or entering retirement. Their risk/return characteristics are quite suitable for retirees, but their liquidity limitations make them questionable for older retirees.

Variable Deferred Annuity

Variable annuities get their name from the variability of the interest return credited to the investment account during the accumulation period. In contrast to the investment account of fixed annuities, the investments in variable annuities are selected by the annuity holder rather than the insurance company. Because the selection choice is made between equity mutual funds, bond funds and money-market accounts, ordinary marketplace fluctuations in returns produce considerable variation in credited investment returns. Since risk is defined as variability of possible outcomes, the risk/return profile for investors in variable annuities is more oriented towards growth and higher risk than that for fixed annuities. Recent product innovations have produced variable annuities containing minimum guarantees for lifetime income and withdrawals, as well as death benefit provisions.

Index Deferred Annuity

Indexed annuities developed in the 1990s in an attempt to meld the qualities of fixed and variable annuities. The credited interest return during the accumulation period is tied to an index of economic performance, typically an equity index such as the Standard & Poor’s 500. This provides superior returns to fixed-income investments during periods of peak market performance.

In order to protect principal during market downturns, indexed annuities have minimum guarantees of income and credited interest. Other features act as buffers on variations in credited interest. The participation rate limits the degree to which variations in the index are allowed to affect the credited interest rate. Different formulas for calculating changes in the index itself also affect the degree of index variation. The result of this complicated structure is that, while indexed annuities fall between fixed and variable annuities on the risk/return spectrum and contain elements of both, they are closer to fixed annuities in practice.

CD Deferred Annuity

CD annuities are so named because they share certain superficial properties with bank CDs; namely, credited interest rates with guarantee periods equal to the investment term and duration of surrender charges in the contract. Otherwise, CD annuities are fixed annuities with the standard properties of limited liquidity, surrender charges, death benefits and protection of principal.  Their terms run from 1-10 years.  Whereas bank CDs are primarily short-term investments with almost no liquidity, CD annuities are medium- to long-term investments with very limited liquidity. Thus, the degree of overlap in suitability between the two investments is small.

Deferred Annuity Calculator

Our deferred annuity calculator allows calculation of the final value, or capital sum, of a series of regular payments over a given accumulation period. The user must supply the expected return (a fixed-income rate of return for a fixed annuity, an equity-type return for a variable annuity, etc.). To then determine an annuity payout in retirement, take the final value and treat it as an immediate annuity in our immediate annuity calculator.

Guarantees and Regulation of Deferred Annuities

In addition to the standard limitations on liquidity mentioned above, deferred annuities have terms lasting for years. In order to be sure of receiving the benefits contracted for, the holder must rely on the financial soundness of the issuing company. (There is a limited amount of safety provided by the state insurance-guaranty associations, which enlist member insurance companies to underwrite contracts of companies that suffer bankruptcy.) At least four major rating agencies rate the financial strength of life-insurance companies; these ratings give prospective annuity buyers information on which to evaluate that strength.

For purposes of government regulation, most annuity contracts are considered insurance products, subject to state-government regulation by insurance departments. Exceptions are variable annuities, which are considered securities, regulated by the SEC and required to issue prospectuses to buyers. Some indexed annuities are also considered securities; after January, 2011, all indexed annuities will be considered securities and will be subject to federal securities regulation.