- Annuities are designed to provide tax-deferred growth by taking dollars that you would have otherwise invested and placing them within an “insurance wrapper.”
- Annuity payouts can be immediate or deferred, with the deferred option being either fixed or variable.
- Before taking the annuity plunge, make sure you have exhausted all other pre-tax retirement plans and have a long-term time view. Also your tax bracket should be high, so the annuity’s tax deferral benefit is worth its higher cost.
When I mention the word “annuity” to clients I’m often met with looks of confusion. To some, an annuity implies a monthly check they receive year-in and year-out from their insurance company. To others, it could mean a tax-deferred investment that is never turned into a stream of income. The key to understanding annuities is recognizing that they come in all shapes, colors and sizes – some good and some not so good.
Webster’s dictionary defines an annuity as follows:
- fixed amount of money that is paid to the recipient each year.
- An insurance policy or an investment that pays [the policy holder] a fixed amount of money each year.
It gets confusing because in wealth management, we often refer to this as “annuitization,” or the income phase of an annuity. The term annuity can also refer to the investment vehicle used to fund the future payments and not just to the future payments themselves. This distinction is important because many annuities are owned purely as tax-deferred investments and they may never be annuitized and turned into streams of payments.
The basic idea is that by taking dollars that you would have otherwise invested and put them inside an “insurance wrapper,” the government allows you to achieve tax-deferred growth. However, it’s critical to remember there are always additional costs associated with this insurance aspect, referred to as a mortality and expense (M&E) charge.
Immediate vs. deferred annuities
In a broad sense, annuities fall into one of two categories–“immediate” or “deferred.” With an immediate annuity, you simply turn over a lump sum of money to an insurance company and in return the insurer promises to pay you a monthly check based on the initial principal for as long as you live.
A deferred annuity on the other hand, is typically purchased as a tax-deferral vehicle. You may contribute a lump sum to get started, or in some cases, you pay multiple premiums. However, rather than annuitize the value of the annuity and turn it into a stream of payments, your dollars are invested for long-term tax-deferred growth.
Deferred annuities: Fixed vs. variable
Deferred investments are broken down further into the subcategories of fixed and variable annuities. These terms refer to the type of investment return you can expect with the annuity.
A fixed annuity provides a set interest rate on your tax-deferred deposit, similar to a bank CD. Variable annuities however, give you that same benefit of tax-deferral, but as the name implies, your rate of return varies. Your return becomes a factor of how you choose to invest your annuity among a selection of mutual-fund-like subaccounts.
Back in 1999 (I remember the year because of the “Y2K” craze), I was working in Vanguard’s variable annuity marketing department and I spent most of my time discussing the suitability of variable annuities with individuals. There were a few standard questions we asked to determine whether or not a variable annuity was right for a particular individual:
- Have you exhausted all other pre-tax savings opportunities such as retirement plans and IRAs?
- Do you have a long-term time horizon for these assets (at least 10 years)?
- Are you in a high enough tax bracket to make the tax deferral worth the higher costs?
In addition to tax-deferral, one of the most common benefits of an annuity is a perceived “guarantee” of income. It may be a promise to pay you income for the rest of your life, or a promise to pay a minimum death benefit to your heirs, or a guaranteed rate of return on your investment, just to name a few.
Just remember the old adage–there is no free lunch. These annuity features are sold on their stated benefits, typically with little emphasis on the annuity’s underlying costs. Each of the additional bells and whistles associated with a “guarantee” adds more to the cost of the annuity. I have seen annuities with annual expenses as high as 4 percent, even 5 percent. Additionally, any guarantee you receive is only as good as the company providing it to you. And anything can happen – think Lehman Brothers or Enron – so nothing is really guaranteed.
Under the right circumstance, annuities can be used as a tax-deferred investment vehicle or to create an income stream for yourself. They can fit nicely into your comprehensive financial plan provided you are a “suitable” investor. However, it’s important to look at annuities in the context of your goals and priorities, because they are certainly not right for everyone. Most importantly, if you are considering purchasing an annuity, understand exactly what the costs are up front so you can make a well-informed decision.
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