05/28/99

What are Annuities?

In my meetings with clients and prospective clients, I have come to realize that probably the least understood financial vehicle is the annuity. Unfortunately, this holds true for many people who own annuities. In this article I will explain the main features of this product and point out its advantages and disadvantages.

An annuity is an investment contract between the buyer and the company offering the product. Most often, annuities are offered by insurance companies. You put money into the annuity contract and at some point your investment, plus any growth of the investment, is paid out to you. There are three primary characteristics that distinguish the different types of annuities. They are:

1. Immediate vs. Deferred Annuity - In an immediate annuity, payments begin to the buyer immediately (with 1 to 13 months) upon purchasing the contract. An immediate annuity is used when an investor needs to have a consistent income stream from a lump sum investment. A deferred annuity delays payments to the buyer until a future time -- at retirement for example. The money invested in the contract grows during this deferred period. (This is called the "accumulation" period.) A deferred annuity is appropriate for someone wanting tax deferred growth on their assets.
2. Single Premium vs. Flexible Premium - A single premium annuity is purchased with a single payment. Flexible premium contracts are purchased with a minimum down-payment and subsequent payments to be made at the discretion of the investor. Flexible premiums are usually associated with deferred annuities as they give the investor the chance to add to the contract over numerous years.
3. Fixed vs. Variable - A third characteristic is how the funds invested in the contract grow in value. In a fixed annuity, the rate of return has a guaranteed minimum. The actual rate may fluctuate some, but it will never go below the guaranteed amount. Sometimes there are two guaranteed amounts, one only lasting for a short period of time. Naturally, the limited period rate is often the higher of the two fixed rates and the one promoted in the sales literature to lure the prospective buyer.

Within a variable annuity contract, the money invested, less expenses, is allocated to a "separate account" from which the dollars are most often invested in mutual funds offered by the contract and chosen by the investor. Thus, your return on investment will vary with the return earned by the funds you selected. Some annuities offer a relatively limited number of funds, while others have a large selection sometimes including well known funds. The fund selection most often includes a money market account in which money can be held in cash. Some variable annuities offer returns on your investment linked to an Index , such as the Standard & Poors 500.

Main Features of an Annuity

• Tax-deferred Growth - a deferred annuity is comparable to a tax qualified retirement plan ( IRA, 401k, etc.) in that your money grows tax deferred until you withdraw it. Similarly, you are subject to a 10% penalty if you withdraw funds before age 59 1/2.
• Move assets between funds - Furthermore, it acts like a like a retirement plan in that you can move money between funds in the contract (variable) without tax consequences.
• Death Benefit - The specific benefit varies with each contract, but it often provides the investor with a guarantee of the original money invested upon death. For example, within a variable annuity if the value of the contract fell below the principal you invested, upon your death your beneficiary would be paid out the value of your initial investment.
• Transfers/Surrender Charges - You can transfer directly from one annuity product to another without tax consequences. However, you may have to pay surrender charges to the contract holder. Surrender charges generally last for about 7 years from the date of purchase and decline each year, 7% the first year, 6% in the second year, etc.
• Various Expenses/Fees - total yearly expenses can range over 2% in some variable contracts. Look closely at the total charges before buying. Contract charges may include:

1. Contract Maintenance Charge - a yearly fixed amount covering the maintenance of the contract.
2. Mortality & Expense Fee - a mortality risk charge to cover the contract holders obligation to pay a death benefit; an expense risk charge to cover the risk that actual expenses exceed other fees.
3. Premium Taxes - certain state & local government asses premium taxes.
4. Separate Account Expenses - a management fee charged for the management of the assets in the individual fund accounts (variable contracts.)
• Withdrawals & Loans - many variable annuities do allow withdrawals during the accumulation period. Contracts will generally allow you to withdraw up to 10% of the contract value without a surrender charge from the contract holder. However, you would still be subject to a possible 10% tax penalty prior to age 59 1/2. The 10% penalty is avoided on withdrawals after age 59 1/2, and in the event of death, disability, or use of "substantial equal payments". Sometimes contracts provide loan privileges that avoid surrender charges.
• Payout Options - there are a wide variety of payout options available if the contract is "annuitized" -- the process by which you receive payments under specific terms of the contract. I will not elaborate on them in this article. Alternately, you do not have to "annuitize" the contract and be subject to specific terms of payment. You can simply withdraw money if and when you prefer.

Advantages - significant advantages of an annuity include:

1. No investment limit: you can put as much money into this tax shelter as you would like.
2. Protection from creditors: if you get sued, the assets in the annuity are protected. A very attractive feature for people in professions of risk.
3. Tax treatment: if you want to "protect" investments from taxes in non-retirement accounts, the annuity is a great place to "hide." In addition, you avoid tax consequences when you choose to switch funds within the contract.
4. Death benefit guarantee: protection of your original investment for your beneficiary.

Disadvantages - significant disadvantages of an annuity include:

1. High fees: an indicated above, the expenses of some contracts can be high relative to direct mutual fund investment.
2. Surrender Charges: if you need to cash-in all or part of your contract, these charges truly discourage you in the early years after purchase.
3. Taxation of Withdrawals: all capital gains earned in the variable annuity are eventually taxed as ordinary income.

In conclusion, annuities can be excellent vehicles for certain investors, but may be less attractive or necessary for others. One attractive scenario for the use of an annuity is for the investor wanting to shelter investments from taxes beyond allocations to the company retirement plan; annuities offer a great shelter with no investment limits. A time when the use of an annuity is less than ideal is within certain qualified retirement plans -- such as 403B plans offered to teachers. In most cases, the use of an annuity is not necessary within a qualified retirement plan as you are already receiving tax deferred growth on your investments. In such cases, direct investments into mutual funds are usually more cost effective. In addition, like all products, there are annuity contracts that have a history of good performance and low fees, while others are very expensive and have below average returns.

Please send questions or comments to dcoffin46333@wradvisors.com.