What is an Annuity?

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Just what is an annuity? The textbook definition of an annuity is “an income stream” or “a fixed sum of money paid to someone each year, typically for the rest of their life”. The word shares a root with our word annual, as the annuity payments were typically made once a year.

When you hear of an annuity, those speaking of it are typically referring to an accumulation vehicle, designed to build an asset base. This is often called the deferral period, or accumulation phase.

Annuity contracts, during the payout or annuitization or income stream period, typically pay for the life of the annuitant. This ability to pay an income stream for someone’s life is an actuarial calculation and assumption which is the domain of insurance companies. Therefore, all annuities are issued by insurance companies, as they are the only business entities engaged in the business of offering life expectancy based products.

Deferred annuities come in two flavors, fixed and variable.

This week we will look at fixed annuities, examining their tax status, return/cost structure, and safety/accessibility features. We will assume you have the opportunity to invest $100,000 in an annuity.

TAXES - Deferred annuities have select tax characteristics. Specifically, the earnings inside an annuity contract grow on a tax deferred basis. This means that, if your $100,000 in the annuity grows 2% this year, this $2000 isn’t taxable in the current year.

At some point in the future, you could choose to “annuitize” the accumulated balance, meaning the assets convert to an income stream. This income stream can be paid to you monthly, quarterly, or annually.

Income taxes are paid when you begin withdrawing money from the annuity contract. Most withdrawals from a deferred annuity are taxed as ordinary income and do not qualify for long term capital gain treatment. Once you have withdrawn all but the original deposit, withdrawals are then deemed a return of principal and not subject to taxation.

If you annuitize the contract, then a portion of the income is taxable and a portion is considered a return of deposit.

RETURN/COST - Annuity sales people often contrast fixed annuities with CDs, comparing the surrender charge on an annuity contract with the early withdrawal penalty on a CD. There was a time, in the distant past, where you could earn 4% annually on a five year CD. Those selling annuities might suggest that instead of earning 4% on a CD and paying taxes on that 4% each year, you instead put that CD money in an annuity with a five year surrender charge. Reasonable argument, right?

Early withdrawal penalties on a CD are typically foregone interest, meaning you give up interest you otherwise would have earned. I’m not aware of a CD which encroaches on your principal as a penalty for early withdrawal.

Surrender charges on an annuity are calculated differently. If the annuity has a five year surrender period, a modest surrender charge would be 5% the first year, decreasing 1% annually (5%, 4%, 3%, 2%, 1%) through the 5th contract year. Sometimes, this surrender charge is assessed against the original deposit, and other times it’s assessed against the entire account balance. All insurance companies of which we are aware do give you the right to withdraw 10% each year without a surrender charge. Again, sometimes this 10% free withdrawal privilege is based on the original deposit and sometimes it is based on the accumulated value.

Fixed annuities offer a current interest rate, which is usually set by the insurance company once a year, and a contractually guaranteed minimum interest rate, which will be credited each year, regardless of the economic environment. Sometimes, depending on the interaction between actuarial and marketing at a particular insurance company, fixed annuities will offer a first year interest rate bonus.

For your $100,000 the sales person explains that the current rate is 2%, the guaranteed rate is 1%, and currently, this contract is offering a 5% interest rate bonus. This outcome by itself isn’t good or bad, as the outcome can only be assessed in light of your personal needs and circumstances, and by comparison to meaningful alternatives. What the 5% bonus means is that the sales and marketing department has the ear of the executive suite at that particular insurance company.

SAFETY/ACCESSABILITY - Is the proposed insurance company financially viable? We would suggest you do your own homework to answer this question. Can you access service forms online, or is your only access to service the agent selling the annuity, and/or a call center? Does the agent insist that you make a buying decision today, at the time the opportunity is being presented? If so, consider this a substantial red flag. Good products and decisions stand up to external scrutiny.

What other considerations would we be wise to take into account? If you are considering the purchase of an annuity, ask yourself a few questions. What is your investment time frame? Are you willing to set your money aside for the full length of the surrender period? Are you sure about your answer to the previous question? Do you have other available reserves, in the event of an emergency, so you won’t have to invade the annuity balance?

And finally, a few closing thoughts.

The street level commission (the amount of money paid to the agent making this recommendation) is typically 1% of the deposit, for every year in the surrender period. To put that in English, if the surrender period is five years, the agent is being paid about 5% of the deposit. If the surrender period is ten years, the agent is being paid 10% of the deposit.

We have found most investors have about a five-year maximum hold period on most assets.

We strongly discourage putting qualified money (IRAs, 401(k) rollovers) into an annuity.

Next week, we will discuss variable annuities.

Centurion Advisory Group was founded to offer clients a place to focus on the integration of life, money, and purpose. Our focus is on offering advice, planning, and investment management services in a way that allows clients to feel as if they have mastered the use of money, have the freedom to enjoy life, and the desire to live with purpose. As a professional services firm, we are paid solely by clients, and receive no compensation from product sales or product vendors. The professionals who are part of the CAG team help families build, maintain, and transfer wealth, consistent with the family's goals.