How Does an Annuity Work?

By far, the financial products I most often reviewed as a brokerage firm compliance supervisor were annuities. They were often also the most complicated products, and the type of transaction I most often rejected when it came across my desk. The popularity of annuity products has little to do with the consumer, and much to do with the financial professionals selling the annuities. Often annuities are a package deal which requires very little oversight on the part of a financial advisor to manage, the commissions are generally up-front, and quite high. The structure of annuities also means they tend to allow advisors to get paid on the same money multiple times. The way advisors are paid is in flux and regulators are pushing for less financial incentives for inappropriate sales. Still, consumers should be informed and understand the features and benefits of these complicated financial products.

This isn’t to say an annuity is never appropriate. The products exist, and have not been removed from the industry by regulatory authorities, because they are a legitimate and useful way to accomplish clients’ financial goals. Unfortunately, they are designed in such a way that they are also great products for sales people to push.

So what is an annuity? Really there are two broad categories of annuity products, and sub-categories from there. The first category is the IMMEDIATE ANNUITY. Immediate annuities allow you, as the investor, to place a lump sum payment into the annuity product and begin taking income from the annuity in increments over time nearly immediately. Why would people buy annuities just to take their own money back out again? The immediate annuity allows a buyer to stretch payments out over a period of time, while also gaining interest. The idea is that over a specific period of time, you can pull more money out of the annuity than you put in. The period of time is known as an annuitization period (or payout period). Annuitization means to take equal payments from a lump some over time. It can be for a set number of years or for your lifetime. Lifetime payments take into account your life expectancy, and if you life longer, you continue to get paid, even though you did not put enough money into the contract to last that long. This is an over simplification of how immediate annuities work, but it gives you the basic idea.

The second broad category is the DEFERRED ANNUITY. This category breaks down into sub-categories including fixed annuities, variable annuities, and indexed annuities. What the sub-categories have in common is that you can put money into the annuity, known as the accumulation phase, and then wait to a later date to take the income, known as the annuitzation phase. The primary difference between them is how the assets are invested. Fixed annuities offer a fixed rate of return. That return can fluctuate over time, but it should always be based on a fixed positive return for a set period. For example, you purchase an annuity with a 3% guaranteed rate for 5 years, and a 1% guaranteed minimum rate after that. It may be more than 1%, but generally it will not be less. While the rates are always positive and predictable, they are also generally low when complained to some other investments. Variable annuities are invested in the financial markets. The underlying investments are like mutual funds. Unlike a fixed annuity, a variable annuity is in an entirely different risk category. You can gain and lose significant amounts of money in a variable annuity. They also have fees which can have a large impact on your investment value over time. These features do not make variable annuities bad products. For the right investor, a variable annuity can be a great part of an overall asset strategy due to some of the extra and unique features they have available like guaranteed income benefits and enhanced death benefits. Unfortunately, I have seen many clients pay very high fees for features they never benefited from. Indexed annuities are an interesting mix between a fixed and variable product. Instead of investing in the markets, you invest indirectly in one or more indexes, such as the S&P 500. The fees are usually low or non-existent. With many indexed annuities, you cannot have a negative annual return. The downside is that these indexed annuities can have many complicated features, and it is difficult to understand how the annuity company is coming up with your return. It is possible to earn more on an indexed annuity than you would on a fixed annuity, but it is also possible for you to earn nothing. Furthermore, the rate of return on an indexed annuity is capped. While the S&P 500 may earn 12% in a given year, you may only earn 3.5% because that is the rate cap on that annuity. What happens to the difference? The annuity company keeps it. That is how they can afford to offer this type of product to consumers.

What all annuities have in common is that they are insurance products. As insurance products, they have specific tax treatment. The money you invest in an annuity has already been taxed as income. Once money is invested in the annuity, it grows tax deferred. You will not pay taxes on the interest or growth in the annuity until you take the money out. Then you will be taxed on the growth only, and at the same rate you are taxed for income. If you withdraw money from a deferred annuity in the accumulation phase, the IRS will consider any growth to come out first (Last in First out, or LIFO), so you will be taxed on all of it. If you withdraw during the annuitization phase, there is a calculation for how much is growth, and how much is your initial investment, and you are taxed accordingly. It is important to note that if you purchase an annuity in a retirement plan, like an IRA, you do not see any additional tax benefits for investing in an annuity because the IRA already provides tax benefits which cancel out the annuity’s tax treatment. Because annuities are insurance products, they are NOT FDIC insured. The interest rates and the guarantees you get are based on the strength of the insurance company you are investing with.

Another important feature of deferred annuities is the surrender penalty. A surrender penalty is an amount you as the annuity owner have to pay from the annuity assets if you bail on the contract early. For example; you invest $100,000 into a variable annuity. The annuity has a surrender schedule of 7 years. If you withdraw any money greater than a free withdrawal amount (i.e. 10%) you will pay a percentage of what you withdraw based on a surrender schedule. In this case, perhaps the surrender schedule is a 7% penalty in year one of the contract, then 7% in year two, 6% in year three, 5% in year four, 4% in year five, 3% in year six, 2% in year seven, and 0% every year after that. Your annuity does not end when the surrender period is up! You do not have to buy a new annuity at this point. It is highly likely, at least from my experience, that your advisor will try to sell you a new annuity with the proceeds from the current annuity once the surrender schedule is up. This may or may not be in your best interest. If you advisor is contacting you to tell you your annuity has “come due” or has “matured”, you should be skeptical and proceed with caution, especially in the case of variable annuities. You likely have been paying high fees which can only be justified if you use the features you have been paying for. If you replace the annuity, you can NEVER use those features. Furthermore, your advisor has a high incentive to put you in something new, because your advisor gets paid again on the new product.

The information contained in this blog is general in nature and should not be viewed, and is not intended by the author to be viewed, as legal advice. For specific legal advice, please discuss your situation with a qualified attorney.