The second usage for the term
annuity came into being during the 1970s. Such a contract is more properly referred to as a
deferred annuity and is chiefly a vehicle for accumulating savings with a view to eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment. All varieties of deferred annuities owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth. A deferred annuity which grows by interest rate earnings alone is called a
fixed deferred annuity (FA). A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is called a
variable annuity (VA). A new category of deferred annuity, called the
fixed indexed annuity (FIA) emerged in 1995 (originally called an Equity-Indexed Annuity). Fixed indexed annuities may have features of both fixed and variable deferred annuities. The insurance company typically guarantees a minimum return for EIA. An investor can still lose money if he or she cancels (or surrenders) the policy early, before a "break even" period. An oversimplified expression of a typical FIA's
rate of return might be that it is equal to a stated "participation rate" multiplied by a target
stock market index's performance excluding dividends. Interest rate caps or an administrative fee may be applicable. Deferred annuities in the United States have the advantage that taxation of all capital gains and ordinary income is deferred until withdrawn. In theory, such tax-deferred compounding allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when amounts held under a deferred annuity are withdrawn or inherited, the interest/gains are immediately taxed as ordinary income. A type of deferred annuity, the
Multi-Year Guaranteed Annuity (MYGA), offers a fixed interest rate for a specified number of years. MYGAs are typically used by conservative investors seeking stable returns over a set period, often as part of retirement income planning.
Features A variety of features and guarantees have been developed by insurance companies in order to make annuity products more attractive. These include death and living benefit options, extra credit options, account guarantees, spousal continuation benefits, reduced contingent deferred sales charges (or surrender charges), and various combinations thereof. Each feature or benefit added to a contract will typically be accompanied by an additional expense either directly (billed to client) or indirectly (inside product). Deferred annuities are usually divided into two different kinds: • Fixed annuities offer some sort of guaranteed rate of return over the life of the contract. In general such contracts are often positioned to be somewhat like bank
certificates of deposit (CDs) and offer a rate of return competitive with those of CDs of similar time frames. Many fixed annuities, however, do not have a fixed rate of return over the life of the contract, offering instead a guaranteed minimum rate and a first year introductory rate. The rate after the first year is often an amount that may be set at the insurance company's discretion subject, however, to the minimum amount (typically 3%). There are usually some provisions in the contract to allow a percentage of the interest and/or principal to be withdrawn early and without penalty (usually the interest earned in a 12-month period or 10%), unlike most CDs. Fixed annuities normally become fully liquid depending on the surrender schedule or upon the owner's death. Most equity index annuities are properly categorized as fixed annuities and their performance is typically tied to a stock market index (usually the
S&P 500 or the
Dow Jones Industrial Average). These products are guaranteed but are not as easy to understand as standard fixed annuities as there are usually caps, spreads, margins, and crediting methods that can reduce returns. These products also don't pay any of the participating market indices' dividends; the trade-off is that contract holder can never earn less than 0% in a negative year. • Variable annuities allow money to be invested in insurance company "separate accounts" (which are sometimes referred to as "subaccounts" and in any case are functionally similar to mutual funds) in a tax-deferred manner. Their primary use is to allow an investor to engage in tax-deferred investing for retirement in amounts greater than permitted by individual retirement or
401(k) plans. In addition, many variable annuity contracts offer a guaranteed minimum rate of return (either for a future withdrawal and/or in the case of the owner's death), even if the underlying separate account investments perform poorly. This can be attractive to people uncomfortable investing in the equity markets without the guarantees. Of course, an investor will pay for each benefit provided by a variable annuity, since insurance companies must charge a premium to cover the insurance guarantees of such benefits. Variable annuities are regulated both by the individual states (as insurance products) and by the Securities and Exchange Commission (as securities under the federal securities laws). The SEC requires that all of the charges under variable annuities be described in great detail in the prospectus that is offered to each variable annuity customer. Of course, potential customers should review these charges carefully, just as one would in purchasing mutual fund shares. People who sell variable annuities are usually regulated by FINRA, whose rules of conduct require a careful analysis of the suitability of variable annuities (and other securities products) to those to whom they recommend such products. These products are often criticized as being sold to the wrong persons, who could have done better investing in a more suitable alternative, since the commissions paid under this product are often high relative to other investment products. There are several types of performance guarantees, and one may often choose them à la carte, with higher risk charges for guarantees that are riskier for the insurance companies. The first type is a guaranteed minimum death benefit (GMDB), which can be received only if the owner of the annuity contract, or the covered annuitant, dies. GMDBs come in various flavors, in order of increasing risk to the insurance company: • Return of premium (a guarantee that you will not have a negative return) • Roll-up of premium at a particular rate (a guarantee that you will achieve a minimum rate of return, greater than 0) • Maximum anniversary value (looks back at account value on the anniversaries, and guarantees you will get at least as much as the highest values upon death) • Greater of maximum anniversary value or particular roll-up Insurance companies provide even greater insurance coverage on guaranteed living benefits, which tend to be elective. Unlike death benefits, which the contractholder generally cannot time, living benefits pose significant risk for insurance companies as contractholders will likely exercise these benefits when they are worth the most. Annuities with guaranteed living benefits (GLBs) tend to have high fees commensurate with the additional risks underwritten by the issuing insurer. Some GLB examples, in no particular order: • Guaranteed minimum income benefit (GMIB, a guarantee that one will get a minimum income stream upon annuitization at a particular point in the future) • Guaranteed minimum accumulation lbenefit (GMAB, a guarantee that the account value will be at a certain amount at a certain point in the future) • Guaranteed minimum withdrawal benefit (GMWB, a guarantee similar to the income benefit, but one that doesn't require annuitizing) • Guaranteed-for-life income benefit (a guarantee similar to a withdrawal benefit, where withdrawals begin and continue until cash value becomes zero, withdrawals stop when cash value is zero and then annuitization occurs on the guaranteed benefit amount for a payment amount that is not determined until annuitization date.) • Guaranteed Lifetime Withdrawal Benefits (GLWB, a guarantee similar to the income benefit, but one that doesn't require annuitizing, payments continue for life regardless if the cash value goes to zero.) Recently, insurance companies developed asset-transfer programs that operate at the contract level or the fund level. In the former, a percentage of client's account value will be transferred to a designated low-risk fund when the contract has poor investment performance. On the fund level, certain investment options have a target volatility built within the fund (usually about 10%) and will re-balance to maintain that target. In both cases, they are stated to help buffer poor investment performance until markets perform better (where they will transition back to normal allocations to catch an upswing). However, there are criticisms of these programs including, but not limited to, often mandating these programs on clients, restricting flexibility of investing, and not catching the upswing of markets fast enough due to the underlying design of such programs. Be careful in regard to using GLB riders in non-qualified contracts as most of the products in the annuity marketplace today create a 100% taxable income benefit whereas income generated from an immediate annuity in a non-qualified contract would partially be a return of principal and therefore non-taxable.
Criticisms of deferred annuities Some annuities do not have any deferred surrender charges and do not pay the financial professional a commission, although the financial professional may charge a fee for his or her advice. These contracts are called "no-load" variable annuity products and are usually available from a fee-based financial planner or directly from a no-load mutual fund company. Of course various charges are still imposed on these contracts, but they are less than those sold by commissioned brokers. It is important that potential purchasers of annuities, mutual funds, tax-exempt municipal bonds, commodities futures,
interest rate swaps, in short, any financial instrument understand the fees on the product and the fees a financial planner may charge. Variable annuities are controversial because many believe the extra fees (i.e., the fees above and beyond those charged for similar retail mutual funds that offer no principal protection or guarantees of any kind) may reduce the rate of return compared to what the investor could make by investing directly in similar investments outside of the variable annuity. A big selling point for variable annuities is the guarantees many have, such as the guarantee that the customer will not lose his or her principal. Critics say that these guarantees are not necessary because over the long term the market has always been positive, while others say that with the uncertainty of the financial markets many investors simply will not invest without guarantees. Past returns are no guarantee of future performance, of course, and different investors have different risk tolerances, different investment horizons, different family situations, and so on. The sale of any security product should involve a careful analysis of the suitability of the product for a given individual. ==Taxation==