Annuities

Traditional fixed dollar (guaranteed) non-variable annuities
by Bill Baker, J.D.

Overview and definition

A traditional fixed dollar (guaranteed) non-variable annuity is an investment offering the following features:

1). Interest rates usually higher than bank Cds
2). A guarantee of principal and interest
3). Guaranteed lifetime income
4). Tax-deferred earnings

Traditional fixed (guaranteed) dollar annuities vs. variable annuities

The purpose of this article is to provide information about traditional fixed dollar (guaranteed) annuities. However, it is useful to understand what the differences are between traditional annuities and variable annuities.

Simply stated, variable annuities [as opposed to traditional fixed dollar (guaranteed) annuities] provide a variable return on your investment as well a variable return of your investment principal. A variable annuity may result in your earning either more or less than the amount of money you receive in interest earnings from a traditional fixed-dollar annuity.

A variable annuity is well suited for growth, high risk, or speculation oriented investors who are willing to assume higher risk(s) and/or reward(s) than those offered by a traditional fixed dollar (guaranteed) annuity. Conservative investors who are more interested in protecting the principal of their investment and receiving a competitive fixed rate of return may be more comfortable with the safety offered by a traditional fixed-dollar annuity.

One of the most important differences between a traditional fixed dollar (guaranteed) annuity and a variable annuity is where your money goes once it is invested.

When you purchase a variable annuity, your money is placed into a “variable annuity account” that is neither guaranteed nor part of the insurer’s general account. In other words, insurers invest variable annuity money separately from their other assets. Variable annuities are often referred to as self-directed investments because the investor can choose to invest your money in a variety of stock or bond portfolios. Your rate of return will fluctuate as the value of the underlying investments move up and down.

Variable annuities are uncertain compared to traditional fixed-dollar annuities. Your principal and the return you earn are not guaranteed; they depend on the performance of the underlying funding options. If the funding options you choose for your annuity perform well, they may exceed the inflation rate or fixed annuity returns. If they don’t, you may lose not only prior earnings, but even some of your principal.

Be particularly careful about investing in annuities offering substantially higher current rates of return than similar competitive products since the higher reward (i.e., rate of interest) offered by an insurance company’s more aggressive investment strategies is almost always accompanied by higher risk. This higher risk may also place your annuity assets at risk since the financial strength of the insurance company may also be placed in jeopardy if the aggressive investment strategy doesn’t work out.

Categorization of annuities

Annuities can be categorized in terms of:

(1). the method of premium payment

(a) single premium,
i.e., single premium deferred annuity, immediate annuity

(b) fixed annual premium, and

(c) flexible premium
i.e., flexible premium deferred annuity

(2). the date benefits begin

(a) immediate*
(b) deferred**

* – immediate annuities create an income stream of periodic payments that begin soon (usually a month or so) after the immediate annuity contract is issued.

** – deferred annuities allow your investment to grow tax-deferred during the accumulation period after your investment is made. Money accumulated in your annuity during the accumulation period can be withdrawn (subject to penalties and/or restrictions dependent upon the timing of the withdrawal) or annuitized (i.e., conversion of the accumulated value into an income stream of periodic payments).

(3). payout options [(a) thru () for deferred annuities after accumulation period; (b) thru () for immediate annuities beginning soon after money deposited]

(a) lump sum;
(b) life only;
(c) joint life only
(d) interest only
(e) term certain
(f) life with term certain
(g) joint life with term certain
(h) life with refund

(4). number of lives

(a) single life
(b) joint life

SPDA (Fixed Annuity)

SPDA is the acronym for Single Premium Deferred Annuity. An SPDA is purchased by depositing a one-time payment (or premium). The money you invest is guaranteed by the insurance company and grows at a competitive, tax-deferred interest rate. Although a current, competitive interest rate is paid, a minimum stated rate of interest is guaranteed. The current interest rate you receive is a function of the insurance company’s current investment earnings and how competitive the insurer wishes to be.

Life insurance companies offering annuities usually invest most of the annuity money they receive from customers in investment grade corporate, utility, and government bonds.

The money you invest in the annuity continues to grow, tax-deferred, until you decide to annuitize you contract and convert it into a periodic stream of payments.

FPDA (Fixed Annuity)

FPDA is the acronym for Flexible Premium Deferred Annuity. An FPDA usually allows a person owning an FPDA to make deposits into the annuity as often as they desire. Deposits can be made monthly, annually, quarterly, etc. for one or more years since there is no specified payment frequency. However, most insurers do set a minimum payment level for administrative purposes.

Since the money you invest in an annuity is guaranteed by the insurance company issuing the annuity it is important for you to be familiar with the financial health and stability of the life insurance company you are doing business with.

Fixed annuities vs. bonds

An important difference between a fixed rate annuity and a bond (municipal or corporate) is interest rate risk. Bonds have it annuities don’t. Interest rate risk is the risk that the value of the bond you invest in will fall if interest rates rise and rise if interest rates fall.

This inverse relationship between bond prices and interest rates can create fluctuations in your investment portfolio that could result in a loss or a profit if you sell your bond(s) prior to their redemption date. Therefoe, on a daily basis, the price of the bond(s) you invest in can fluctuate up and down like the price of stocks. The difference between stocks and bonds is that stocks (may or may not) pay dividends and not interest and are not redeemable on a specific date for a specific amount of money.

On a daily basis, the price of any bond you hold may be affected by the solvency/credit worthiness of the company or municipal agency that has issued the bond (i.e., credit risk), abstract market or psychological forces (i.e, market risk), and/or (as mentioned in the previous paragraph) interest rate fluctuations.

For more information about bonds, visit:

Bonds:
http://www.aaii.com/investing/bonds

Why Bond Prices Go Up and Down:
http://www.aaii.com/classroom/why-bond-prices-go-up-and-down

Understanding Bond Credit Ratings:
http://www.aaii.com/classroom/understanding-bond-credit-ratings

The Ins and Outs of Bond Yield:
http://www.aaii.com/classroom/bond-yield

The income you earn from your annuity investment is tax-deferred. Tax-deferral allows you to legally delay the taxes on the interest income your annuity earns. Instead of having a portion of your annuity income taxed away from you each year this income remains in your annuity account earning income. This compounding of otherwise taxable interest is one of the deferred annuity’s most powerful features.

The income from your tax-deferred annuity is not taxable until you receive it. Therefore, you can elect to annuitize, or otherwise receive, the income you earn after retirement when you are in a lower tax bracket.

You can obtain a copy of IRS Publication 575 titled PENSION AND ANNUITY INCOME. This IRS publication discusses the taxation of periodic and non-periodic annuity payments as well as other aspects of annuity taxation.

How and when can I withdraw my money?

You can withdraw money from your annuity by contacting the insurance company from whom you have purchased the annuity and requesting a withdrawal.

Keeping in mind that an annuity is a long-term investment, the quick answer is that your money is available at any time. However, depending upon the terms of the particular annuity you choose to invest in, your withdrawal may be subject to a company surrender charge during the first few years (which can be as many as 9 or more) after you purchase the annuity. After the surrender charge period expires you can withdraw your money without incurring the company related surrender charge. In addition, cash withdrawals from your annuity, prior to age 59-1/2, are generally subject to a 10% penalty tax.

Many annuities offer provisions that allow you to withdraw a certain percentage of the money you have accumulated in your annuity or the accumulated interest without incurring a surrender penalty during the first few years when surrender charges are applicable.

When is investment in an annuity appropriate?

l). As a retirement planning investment vehicle.

2). In most financial planning situations where safety of principal is important or indicated.

3). When a tax deferred accumulation of interest is appropriate and/or desired.

4). Where there is a need or desire to receive a specific level of interest for a long period of time without risking the principal of the investment.

5). In certain instances where a given level of liquidity is desired.

6). Where there is a need for an investment with immediate and high collateral value.

7). Where there is a need to have an investment with an income stream that cannot be outlived.

8). As a device for avoiding probate and passing a large sum of money to an heir by contract in order to reduce the possibility of a will contest.

9). When a person who is already retired wants to have a monthly income that is equal to or higher than other conservative investments.

10). As a replacement for or an alternative to a monthly or other periodic investment plan.

Annuitites / The good and the bad

As is true with any investment, there are advantages and disadvantages to investing in an annuity. Of course, an investment feature that may be an advantage to one person may be a disadvantage to another. In addition, there may be other advantages and/or disadvantages to making an investment in an annuity, not presented below, that are specific to your particular situation.

ADVANTAGES

1). An annuity can be used to protect and build your cash reserve.

2). The insurer from whom you purchase an annuity guarantees (with the exception of variable annuities) the principal.

3). Annuity interest rates that you earn from single premium deferred annuities are adjusted, usually on an annual basis, to increase or decrease in line with current market interest rates.

4). If you are retired, an annuity can provide you with a fixed monthly income with lifetime guarantees.

5). With an annuity you can “time” the receipt of income and shift it into those tax years where the income is taxed at a lower rate.

6). Annuity interest rates compare favorably with most other fixed income investments like bank certificates of deposit (CD s).

7). As compared to a taxable investment, with an equivalent interest rate, such as a CD, an annuity will produce capital more quickly since the effective yield will be higher.

8). An annuity can be used as a method for directing money to your heirs without the hassle of probate. When you fill out an annuity application, you can designate a specific beneficiary or beneficiaries to receive the money you have accumulated in your annuity contract.

DISADVANTAGES

1). If, at retirement, you choose to receive a lump sum distribution instead of a fixed monthly income you may incur a significant tax burden.

2). A cash withdrawal from an annuity prior to age 59-1/2 is generally subject to a 10 percent penalty tax with the following exceptions, see IRS Publication 575 titled PENSION AND ANNUITY INCOME:

3). If it is necessary for a person to liquidate the annuity during the early years of the investment certain fees and costs may be applicable, depending upon the terms of the annuity contract.

4). An annuity (with the exception of variable annuity) is a conservative investment and does not offer the flexibility and liquidity offered by certain other investments. Therefore, annuities should be used in conjunction with other investments to provide you with a well balanced investment portfolio.

A final word

As Will Rogers once said, “I am not as concerned about the return on my investment as I am about the return of my investment”. Traditional fixed-dollar annuities guarantee the return of your original investment while offering a competitive interest rate.