While annuities have been around for centuries as a way to provide a guaranteed income stream, deferred annuities are a relatively new variation that offers a savings component. For people, who didn’t have an immediate need for income, life insurers came up with a way for them to “defer” the income into the future while providing them with a way to accumulate the capital needed for the income.
Deferred annuities became a preferred savings instrument during the Great Depression when savers lost confidence in the banking system. At the time, life insurance companies were considered to be much more financially stable than the banks, and people were looking for alternative ways to save for their retirement. In the last 80 years, deferred annuities have grown in popularity and they continue to form the foundation of millions of people’s retirement plan.
Deferred Annuity Basics
To better understand deferred annuities, it is helpful to understand immediate annuities, which are based on the original annuity concept. With people living longer, the growing fear among retirees is the prospect of outliving their income source. An immediate annuity is a form of insurance that protects against that possibility. It is, essentially, a contract between a life insurance company and an individual in which the insurer, in exchange for a lump sum deposit, guarantees an income stream for a specific period of time, or for the life of the individual.
One way to think of a deferred annuity is that it is a savings component that has been added to the front of an immediate annuity. The lump sum deposit is placed into an account that accumulates interest for the period of time the investor has to save before requiring the income. Because it is an insurance contract, deferred annuities have some very unique characteristics which make them very attractive retirement planning tools.
Deferred Annuity Characteristics
Fixed rate annuities offer competitive interest yields that are guaranteed for varying lengths of time. Typically, the longer the guarantee period is, the higher the yield. Unlike bank CDs which offer yields based on market interest rates, annuity rates are based on the yield that a life insurance company generates from its investment portfolio which consists of a basket of interest bearing securities such as long term bonds. Based on the actual performance of their investments, life insurers can potentially generate higher yields than are available from market interest rates.
Some deferred annuities offer investors the opportunity to invest in separately managed accounts consisting of stock and bond portfolios. The rate that is credited to the account is based purely on the performance of the portfolios, so while the potential is there to earn higher rates of return, so is the risk of loss in the portfolio’s value.
Guaranteed Minimum Rate
For fixed rate annuities, the contracts include a minimum rate that is guaranteed to be credited even if the yield falls below it. This feature is what makes fixed rate deferred annuities more predictable as a retirement planning tool. With variable annuities, a minimum rate guarantee can be purchased as an option which provides insurance against market risk.
Perhaps the number one reason why deferred annuities have gain in popularity over the years is the fact that they are favored by the tax code which allows the account values to grow without incurring taxes. They are treated similarly to qualified retirement accounts, such as IRAs, in that the tax is only applied when funds are withdrawn. It is then that they are taxed as ordinary income. For people in high tax brackets, deferred annuities offer an opportunity to accumulate funds more quickly.
Deferred annuities are considered to be long term investment vehicles, and investors should be willing to commit their funds for the duration in order to realize their maximum benefits. Still, they also include provisions for accessing funds in the near term should it be necessary. Generally, investors can withdraw up to 10% of their account value each year without incurring a charge. Any withdrawals that exceed 10% will be charged a fee if it is made within the surrender period, which can be as long seven to ten years.
The fees start as high as 10% and then are reduced be a point each year until it falls to zero. So, in this example, all of the account values can be accessed after 10 years without a charge, however, if done so prior to the age of 59 ½, the IRS may assess a 10% penalty unless certain requirements are met.
Guaranteed Death Benefit
A distinguishing feature of deferred annuities is the guaranteed death benefit which ensures that the beneficiaries will receive no less than the principle amount of the annuity should the annuity owner die prematurely. This feature is especially valuable for variable annuity owners who would otherwise risk leaving less money than they originally invested if their separate accounts didn’t perform well. In both cases, many deferred annuities include an option or a provision that also protects the gains of the account values.
Fees and Expenses
All of the benefits that deferred annuities provide don’t always come without a cost. The primary expense common to all annuities is the cost of insurance, or the mortality expense which covers the insurers risk in providing the guaranteed death benefit. Variable annuities also have investment management fees that pay the expenses associated with the professionally managed accounts. Administrative fees are sometime charged to cover record keeping and service costs. Some annuities are sold with front end sales charges; however, there are a growing number of annuity products that are sold with no sales loads as well.
How the Distribution Phase Works
After a sufficient amount of capital has been accumulated, and additional income is needed by the investor, a deferred annuity can be converted into an immediate annuity. When that happens, the total account balance is turn over to the insurer, irrevocably, so that the insurer can commit to a schedule of period payments that are guaranteed for a lifetime, or some specified period of time. This is known as the distribution or income phase of an annuity.
To determine the amount of income that the recipients, or annuitants, will be paid, the life insurer takes into account the total capital that is available, the age of the annuitant, the minimum interest rate, and the length of the income period. The length of the income period can be a specific number of years, or the life expectancy of the annuitant. Using standard life expectancy tables, the insurer determines the number of years an annuitant is expected to live which becomes the income period.
Income Payout Rate
Applying those factors, the insurer then establishes a payout rate which, for a fixed annuity, is set for the income period. A variable annuity may have a variable pay out based on the fluctuation of the underlying investments. The payout rate is a combination of the principle balance and interest or gains, so a portion of the income received is a return of principle which is not taxed.
In its most basic form, an annuity is designed to pay an income on the life of an individual. But when that individual dies, the income stops, and the remaining account balance is retained by the life insurer. If annuity owners want to have all or portions of the remaining account balance go to a beneficiary, they can select from a number of refund options that will pay the proceeds in installments. The cost to add these options is paid by reducing the payout rate.
For married annuitants, the spouse becomes the automatic beneficiary, and with most contracts, the annuity payments will continue to the spouse. If a joint life payment option was selected, the annuity payments will continue through the death of the second spouse.