What most people don’t know about annuities would fill a book. That is because annuities are contracts that contain many features, benefits, and costs. Rather than attempt an encyclopedic recitation, this article will focus on basic elements of annuity structure that are not well understood by many people.
What Backs Up Annuity Guarantees?
A guarantee is a contractual promise. While people and companies are legally obligated to fulfill contracts, that does not mean that they will be fulfilled. Annuities are issued by insurance companies. At bottom, a company’s promises are limited by its means of fulfillment. The financial strength of insurance companies gives them the means of delivering on their guarantees. Delivery becomes problematic as financial strength becomes shaky. Fortunately, five major rating agencies exist to assess the financial strength of insurance companies and report on it.
Although the necessity to monitor the financial strength of annuity issuers is well advertised, it is less well known that most states have insurance guaranty funds that promise to assume the liabilities of failed insurance companies or supervise their assumption by other insurance companies. Once again, this guarantee is only as good as the resources backing it up. The state guaranty funds are limited, but this does provide a second line of defense in the event of insurance-company bankruptcy.
What are the Costs of the Annuity?
At one time, many people were unaware of the nature and magnitude of investor costs imposed by annuities. They did not realize that each benefit conferred by an annuity implied a corresponding cost. Insurance companies incur costs by supervising investments and providing insurance products. Variable annuity sub-accounts – akin to mutual funds – are products whose costs create a second layer of insurance-administrative fees in addition to the usual management expenses.
Annuities are very useful financial products, but they are more useful to some people than others. Investors must be able to compare annuity benefits with their costs. This requires that the costs be known. Today, these costs are well-advertised. They should nevertheless be stressed.
It is less well-known, however, that no-load and low-cost annuities are available. Mostly, these are offered by the same or affiliated companies of the ones offering other low-cost investment products, such as no-load mutual funds and indexed funds.
Liquidity in an Annuity is Limited, but Not Non-Existent
Years ago, annuity surrender charges, sometimes lasting ten years or longer, were not well understood by many purchasers. These may be between five and ten percent in the first year or two of annuity possession, then successively less each year thereafter. Today, it is likely that annuity purchasers will discover those surrender charges early in the purchase process. They will also learn about IRS taxation and penalties that lie in wait for anybody withdrawing funds before they reach age 59 ½.
They should also learn the terms for withdrawing funds, which provide a modicum of liquidity – usually either 10% of total annuity value per year or the amount of accrued interest in the year of withdrawal.
How are Annuities Affected by Taxes? How Do These Effects Affect Legacies?
The tax-deferral feature of annuities receives lots of attention in sales presentations. The fact that annuity distributions are subject to taxation at ordinary-income rates gets less stress. This disadvantage might partially or wholly cancel out the benefits of tax deferral. In turn, this might mean that an alternative asset (such as a taxable mutual fund) might offer superior after-tax investment returns. Much more likely, though, is the possibility that a superior alternative is available for estate-planning purposes. If legacy dominates your thinking about investments and insurance, explore the implications of an annuity purchase with a competent advisor.
Read the Annuity Contract
Annuities are investment products inside an insurance wrapper. This dual identity is what generates the number and size of annuity costs. The best way to appreciate this is by reading the annuity contract. There is no substitute for this procedure. The ancient proverb “Always read the fine print” might have been tailored to fit annuities.
A related advisory can be gleaned from another ancient proverb: “You can negotiate anything.” Despite the impressive number of features and benefits in an annuity contract, beneficial components may still be omitted. Reading the contract affords the opportunity to ask for the inclusion of missing benefits. Another venerable maxim is: “If you don’t ask for it, you won’t get it.” There is normally scope for negotiation on the terms of the annuity, so there is no reason not to ask for anything you want.
Many examples to support this advice can be developed. Fixed annuities often guarantee the rate of return to the annuityholder’s accumulation account for an introductory period, after which time the insurance company may lower it. You should know the length of the initial guaranty period and the extent to which the rate can be reduced. (The contract probably limits rate reductions by the company.) Indexed annuities provide a formula to calculate the amount of index gain that is passed on to the purchaser. There are over a hundred of these formulas, so you, as purchaser, should know which one applies to you. Variable annuities sometimes charge a fee for asset transfers between different sub-accounts, and this fee may apply only after a threshold number of annual transfers are made. You should learn whether and when this fee will be charged. Annuities offer a large number of insurance-related provisions. Some of these relate to benefits available to beneficiaries in the event of your death. Others concern the investment performance of the annuity. There is no excuse for failure to read and understand these features.
Summary
The large number of features, benefits, and costs makes it difficult to be fully informed about annuities. The financial strength of the insurance company, the costs incurred by the insurance company and passed along to you, the scope for liquidity, and the tax implications of the annuity sometimes surprise annuity purchasers.
The importance of these things varies from person to person, so you should make it your business to discover the information most pertinent to your situation. The final authority on factual annuity details is the annuity contract. Read it before making the purchase.