Annuities are complex insurance products that often promise guaranteed retirement income in the future, in exchange for a premium paid upfront, and in advance. The mystique surrounding annuities has led to misunderstandings, confusion, and sometimes-undeserved reputations both among consumers and within the industry itself. So what exactly is an annuity?
Today, we cover an insurance product, the annuity, which is important to many people as they plan for retirement, yet also has a controversial history and is frequently the subject of regulation, such as in the National Association of Insurance Commissioners’ Annuity Suitability model regulation. Knowing the basics of annuities is the foundation of maintaining a compliant approach to these multifaceted products, whether you’re engaged in the sales cycle or serve a more regulatory or operational function. Even if you don’t touch annuities professionally, we hope this piece will give you a solid foundation of what they are and how they can be useful (or not!).
What is an annuity?
An annuity is simply an insurance contract that states an insurer will pay funds to the beneficiary as a lump-sum or as a series of payments, in exchange for the contract holder’s premium, which they may pay as a lump sum or as a series of payments. Depending on the terms, the income stream can be specified to last the rest of the purchaser’s lifetime, or longer. If this seems like a very vague definition, that’s because it is.
Unfortunately, it’s difficult to pin down a very specific definition of annuities because of the variety of ways income can be built, calculated, credited, and paid out. However, what makes this product difficult to pin down also makes it attractive to insureds who need or want a variety of features.
Important benefits of annuities
- They can provide guaranteed income for retirement. Many Americans find they want an income source in addition to Social Security payments in retirement. Annuities can be a great way to diversify your assets and add consistency to your portfolio.
- Annuities can be paid out immediately, which can be attractive if an income stream is needed quickly, or can be deferred for those who are planning for future growth.
- Payments can last a lifetime, depending on the contract. This is a helpful feature, especially as life expectancy increases.
Why are annuities popular for retirement planning?
The popularity of annuities stems from the challenges people face as they exit the workforce and enter retirement. Many people just haven’t saved enough to maintain their current lifestyles. Healthcare alone will be an ever-increasing expense. The income an annuity provides can be one part of the financial solution.
Annuities have grown in popularity to the point that the U.S. Treasury Department has issued new guidance for the use of annuities inside 401(k) plans. For workers using a 401(k) for retirement saving, they can now include deferred income annuities in target-date funds that allow payment to begin as soon as the beneficiary retires. An employee will also be able to still keep other investments in their 401(k) along with the annuities.
What are some drawbacks of annuities?
Along with the benefits, there are some disadvantages to annuities, as well. Historically, consumer complaints about annuities make up the bulk of consumer issues in the life insurance slice of the industry. This has resulted in stricter regulations for business entities selling annuities. Annuity choices for a consumer in 2022 have never been more numerous. There are more products on the market than ever. The biggest drawback of all is confusion. Well, that and deceptive or predatory sales practices, particularly targeting senior citizens.
Fees and expenses can add up
An area which has been a sore spot for purchasers of variable annuities has been the historically high fees associated with buying these insurance products. The average fees on a variable annuity are 2.3 percent of the contract value. In some instances, they can be more than 3 percent. It’s important to understand that these particular fees are only associated with variable annuities.
While this is especially nice income for insurers, consumers have been complaining about these fees since their inception. Investment vehicle fees are always under attack, especially mutual funds and 401(k)s. In fact, the U.S. government has been scrutinizing both recently and Congress has been looking into high investment fees for years.
More drawbacks of annuities include:
- They are illiquid. The purchaser loses their ability to access a large amount of cash without incurring fees.
- Inflation can put a dent in the annuity value, significantly impacting buying power. Currently, this is a major problem in the U.S. So much for “transitory inflation.”
- You may pay more in taxes if you withdraw early, and early withdrawal almost always comes with fees.
- Variable annuities (more on them below) can lose value to stock market volatility, which causes confusion when so many annuity selling points hinge on the products being predictable and providing guarantees.
- Annuitization (see the terminology section below) can mean losing the contract value when the contract holder dies, meaning the contract holder may very well pay in more money than what they received in income over their lifetime.
What annuity terminology is important to know?
Before wading into the river of annuities, it’s important to have a good understanding of the key terminology associated with them. Key terms include:
- Annuitant – The individual whom the payments are based on. In most cases, the contract owner and annuitant are the same person. An annuitant, in the event of his or her death, may also be able to name beneficiaries who can receive the balance of the annuity.
- Renewal rate – The renewal rate is the interest rate the insurance company sets after the annuity’s contract term has expired. This rate could be lower than short-term interest rates. Most often, renewal rates will be set based on the insurer’s current investment holdings.
- Rider – An amendment to an insurance policy that expands or restricts the policy’s benefits.
- Free-look period – A time period within which the annuity owner can cancel and receive their payment back without penalties. Depending on the insurer, 10 days or more is the usual time frame. Outside of the free look period, a carrier may issue penalties if you terminate the contract, so it’s important to pay close attention here.
- Annuitize – This is an important one. This means to convert assets to a stream of income, which the carrier pays monthly, quarterly, or yearly, traditionally tied to the lifespan of the insured. The amount depends on a few factors such as the interest rate and the length of time payments are made.
- Accumulation value – This is the value of your contract representing your initial premium payments plus the contract’s deferred growth accumulation.
- Surrender charges – The amount that will be kept from your contract to pay the insurance carrier if you should withdraw your funds from the annuity earlier than your contractual minimum.
- Cash surrender value – If you happen to cancel your contract before the surrender period, the cash surrender value is what the annuity would be worth. The cash surrender value represents the accumulation value minus surrender charges, administrative fees, and any premium taxes. The cash surrender value won’t ever be less than the guaranteed minimum value. Once the annuity’s surrender period is completed, there are no more surrender charges, and the cash surrender value will equal the accumulation value.
- Guaranteed minimum value – This is the minimum amount defined in the policy that the contract owner is guaranteed to receive.
This is just a short list. A very short list. To learn about many more, read through this glossary of terms.
What are the different variations of an annuity?
Like annuity terminology, there are a plethora of annuity types and variations. All are, at their most basic level, insurance contracts.
Let’s explore some of them:
- Immediate annuities: Also known as the income annuity. You pay a lump sum and you may start receiving income almost immediately after purchasing it. This can allow contract holders to quickly start receiving dependable income, likely for retirement. Remember though, this is not a liquid investment like a stock: Once you purchase the annuity, your money is tied up, unless you’re willing to pay penalties and fees to get it back. When the buyer walks in and plunks down their money, the insurer will take into account age and other variables to determine the amount the annuitant will receive monthly, or on a regular schedule. This is also the contract type that is most likely to use annuitization in order for annuitants to receive their income.
- Deferred annuities: Income payments begin in the future, typically when the buyer retires. These annuities require a minimum of a year before payments can begin.
Deferred annuities allow a timeline to grow the income, and allow for various growth crediting methods with a sliding scale of risk. Once a buyer annuitizes this contract, they may enjoy potential growth afforded by the deferred annuity. However, deferred annuity contracts tend to not be annuitized because of the abundance of growth crediting methods, riders, and withdrawal options.
The following annuities all are considered to be in the deferred annuity category and, as discussed, the buyer is able to take advantage of compounding growth over time. Let’s take a look.
- Variable annuities: This is the riskiest of all annuities as the buyer is taking a chance on the performance of the market. For example, mutual funds are typically the most common investment option underlying variable annuities. Mutual funds can be volatile so the growth of the account may fluctuate, and the mutual fund sub accounts have their own (often undisclosed) fees atop any riders or other expenses inherent to the insurance contract. Once you annuitize (turn on the payment spigot), however, the variable yo-yoing ceases. The annuitant then enjoys the fruits of the yo-yo if the market has been kind.
Agents and brokers must have the proper insurance as well as securities licenses to sell these kinds of annuities.
- Registered indexed linked annuities (RILA): A RILA is very similar to a variable annuity. However, there is a feature that allows you to limit the maximum loss you’re willing to incur (akin to a stock stop loss order). Similar to a fixed index annuity, it still follows a stock index, but unlike a fixed indexed annuity the RILA is invested in the market, which means you can lose money.
Agents and brokers need to have the proper insurance as well as securities licenses to sell a RILA.
- Fixed indexed annuities (also known as equity indexed): This type of annuity is tied to a specific market index like the S&P 500. The annuitant will never lose based on market performance, however, the insurer caps the growth. For example, if the market grows at 16 percent but the growth is capped at 8 percent, the annuitant will only realize 8 percent growth. On the other hand, if the market tanks, the annuitant will not lose money, they just won’t get any additional market-based growth credited to their contract. This annuity comes with less risk than the variable annuity or a RILA, although there is the potential of breaking even or having zero growth credited to the contract.
- Fixed annuities: The name says it all. The Steady Eddie of annuities comes with a set and guaranteed interest rate. This one is for the risk-averse buyer. Unlike the fixed index annuity, it does not see the fluctuations as it isn’t based on a stock index. You won’t enjoy the gains of the stock market or suffer the losses of a down market. This is a “set it and forget it” annuity that allows you to calculate your minimum exact earnings down to the penny and not take on market risk or market reward.
Once again, this is an abbreviated list. In-depth research is a necessity for those working with these products. All of the annuities listed above may allow one or more beneficiaries and can have set deferment and/or set payout periods.
Please note that at AgentSync, we provide data-driven tech solutions to insurance businesses – while we hope you find our perspective useful and interesting, we aren’t providing legal or financial advice. Do your own research and due diligence to follow the guidelines and regulations of your jurisdiction.Producers, carriers, and agencies working in the life insurance and annuity wing of the industry have many regulatory requirements to comply with. If you’d like to have one less thing to worry about, see what AgentSync can do for your producer compliance requirements.