What is an Annuity?

When it comes to financial planning and insurance products the annuity is traditionally regarded as the product that disperses or liquidates a sum of money.  Long known for their reputation as the safe product used for creating guaranteed income streams.

Annuities have evolved as much (if not more) than life insurance contracts over the past 100 years and their use in practice has dramatically shifted to more closely complement modern day financial planning.

Does an annuity belong in your portfolio?  I don't want to make a blanket statement, but rather equip people with the knowledge to be able to reasonably think either they should or shouldn't entertain this idea further.

Let's Start with the Text Book

So we'll expend a paragraph or two starting this discussion with the mundane explanation behind annuities.  There are two technical periods for an annuity, the accumulation period and the annuitization period.  They probably don't need a lot of further elaboration, but for the sake of clarity here goes.

Accumulation Period

The name is rather self explanatory, but the accumulation phase of an annuity is the period where the annuity grows in terms of its cash surrender value.  There are a multitude of ways in which this phase can play out and this depends on the type of annuity (we'll get to that in a minute).

If you are reading a stuffy text book about what an annuity is, you'll often see the term accumulation credits thrown about.  This is the analog the industry used in the past to define the cash surrender value.  Its a reference to the old rigid nature of annuities, and is rarely used in modern vernacular.

Annuitization Period

The annuitization period is the point when you turn an annuity into a guaranteed income stream.  For those who really care about the technical details (and the archaic minutia) this is the point when you “convert” your accumulation credits into annuitization credits which afford you a guaranteed income stream.

Without the convoluted terminology: you hand your money over to the insurance company and tell them to keep sending you a check until an agreed upon condition is met where they are no longer obligated to send the check.  Again for bonus points by talking the talk, annuitizing an annuity is was commonly referred to as “entering on” or “upon” the annuity.

What's the Income Based On?

This shouldn't come as a huge surprise, income from an annuity is based on an assumed interest rate and (if using a life contingent annuitization, which is common) mortality assumptions.  Meaning…life annuities (those paid for the remainder of a life or lives if it's a join annuity) have income streams that are effected by the age of the annuitant (person or persons whose life the annuity income is based).

For example a 60 year old male would receive less per year than a 65 year old male if both were to annuitize equal amounts in cash value in a an annuity because the 60 year old is assumed to live longer.  At the same time a 65 year old female would receive less money than a 65 year old male since statistically women life longer and therefore have a longer assumed mortality.

Types of Annuities

There are 4 major types of annuities they are:

  1. Fixed
  2. Indexed
  3. Variable
  4. Immediate

Fixed Annuities

Fixed annuities are one of the oldest  and most basic form of annuities.  They credit interest on the cash values inside of them by guaranteeing a certain rate and then declaring a current rate that can vary in terms of additional guaranteed rate for a certain number of years (i.e. guaranteed at 1% with a current rate of 2.05% for 1 year, or guaranteed at 1% with a 3% guarantee for the next 5 years).

Fixed annuities are sometimes compared to certificates of deposit (CD's), which I think is a mistake on the behalf of  many insurance agents.  They are different financial products entirely, and need not be compared.  CD money is however, a large source of funds when it comes to new annuity business, especially among older individuals.

Indexed Annuities

Indexed annuities are the newest among the bunch.  They are technically defined as a fixed annuity contract and you may run into the term fixed-indexed annuity.  They credit interest a little differently than traditional fixed annuities.  They do have a guaranteed minimum rate of interest, however they have a second declared interest rate that is dependent upon an indexing strategy.  We've discussed indexed insurance products in the past, so you can get more information on indexing strategies there.   To be very brief, the interest rate is based on a percentage change calculation based on an index (usually stock index) of some sort.

Indexed annuities are also a product that receives a lot of CD money and, lately, funds from a lot of other places (like stocks or mutual funds) based on the idea that indexed annuities can maintain some market upside exposure while keeping principal safe.  Indexed annuities have also been at the heart of a power struggle between the insurance industry and the investment industry as the Securities and Exchange Commission (SEC) and the Financial Industries Regulatory Authority (FINRA) has pushed to make indexed annuities (and indexed life insurance) a registered product subject to their regulation and licensor.

The most recently proposed legislation seeking to accomplish this has failed to make this reclassification a reality.

Variable Annuities

Variable annuities are annuity products that make use of an insurance derivative of a mutual fund known as a separate account.  Separate accounts take their name from the fact that they exist outside of the insurance company's general account.  One additional layer of protection here is that separate accounts are not subject to creditor liabilities if the insurance company were to ever become insolvent (because that happens so frequently).

The owner of the variable annuity has the ability to allocate investment options among a list of separate account offerings inside the variable annuity.  One would likely find investment options like general stock funds (both foreign and domestic), bond funds, commodity funds, target date funds, and pre-made model portfolios based on investment risk tolerance.

Variable annuities also typically have fixed account options.  Generally the owner of the contract can move between investment choices at will without worry of paying fees to get in and out of a certain separate account.

Variable annuities do not generally have sales loads, and instead make use of Contingency Deferred Sales Charges (CDSC) commonly referred to in the insurance industry as Surrender Costs or Charges (more on that in a little bit).  This fact is actually true of most all annuities except immediately annuities.

For years variable annuities were criticized for having exorbitant fees (they charge a mortality and expense fee over and above the separate account fee, plus an administrative cost that typically comes out to 100 to 250 bps in total charges per annum).  In their defense, the insurance industry pointed to the fact that all variable annuities came with a refund of premium guarantee that would pay the original amount placed into the annuity to a beneficiary if the owner or annuitant (depending on the driving factor behind the annuity, which is a topic beyond today's introductory discussion) died.

This means if the annuity had lost money in its investments and the owner died, his or her cost basis would be paid to a named beneficiary, not the surrender value (i.e. what the investments were worth).  If the investments were higher, then the beneficiary would receive this.

In fact, Suze Orman was once tangled in a slightly embarrassing moment on CNBC when she went on an “I hate variable annuities” tirade and a caller asked her what she should have done.  The caller was a recent widow whose husband's rollover to an annuity got spanked by the 2008 stock market plunge, but when he died all of the original rollover was returned to his wife.

Suze backtracked and basically said when you know that's going to happen, that's when you should buy an annuity.  If you know when something like that is going to happen, please let me know, your skills as a fortune teller could really come in handy!

Variable annuities also picked up additional “living benefits” riders over the course of the last few decades.  These benefits bring further “benefit” to variable annuities beyond just the return of premium pitch.  However, they also come with additional charges that cane bring total fees up to the 400 to 500 bps area.  Yikes!

Immediate Annuities

Immediate annuities are the original annuity idea.  They take a lump sum of cash and immediately turn it into a cash flow.  They are commonly referred to as Single Premium Immediate Annuities.

Again income streams are based on interest and mortality assumptions.  For the less healthy among us, there are also companies that underwrite medical immediate annuities.  They pay higher amounts to individuals in poorer health under the assumption that they will die sooner.

Immediate annuities have become somewhat of a star among the annuity crowd within financial conventional wisdom.  The old, mostly disregarded, self-absorbed, narcissistic, screw-everyone-but-yourself book Die Broke regarded immediate annuities as the ultimate retirement weapon.

I'd contend while useful, they are more often used to try and stem the tide of poor personal retirement planning than they are strategically to maximize overall situation.  I'd also note that due to their use of gross premiums (i.e. expense factors) rather than net premiums (expense factors excluded) they tend to be more costly (i.e. worse for you and me) than annuitizing one of the other annuity options.

 Criticism, are they Warranted?

Annuities have long been derided by the investment community for obvious reasons (they are competition).  However, for years annuities followed a rigid and expense ridden rule of thumb that made them less attractive.

Let's just say,they've come a long way since then.

Some of these changes are more robust, and certainly more accommodating.  But with this comes a little bit of poison.

Annuities were once the road map for retirement planning, but the modern day Vegas style to savings has shifted way from focusing on the savings need and more on the status symbol of you are investing in.  And the investment world ingeniously introduced the idea of risk tolerance analysis to legitimize its speculative nature.

Annuities have played to this hand.  Becoming a product more about the cash surrender value, and less about the guarantee.  Annuitization is a rare trigger pulled these days, so annuities have fought harder and harder to compete with other options on the table.

Surrender Charges and Market Value Adjustment

The low hanging fruit criticism about annuities (or at least he investment community thinks so) is the surrender charges that come along with them.  Since annuities don't charge upfront sales loads, sales commissions, or management fees (like mutual funds, stocks, and managed investment accounts respectively)  insurance companies instead amortize the cost of acquiring the money over the course of several years through a surrender charge (money the insurance company keeps if you bail within the surrender period).

These charges can, admittedly, seem a bit high at times and last for quite a while.  It's going to depend a lot on the product and the company.

Further, some annuity contracts are subject to Market Value Adjustment (MVA), which is a calculation to recapture the earned interest on a contract if you surrender the contract before the insurance company has recaptured their cost of acquiring your business.

Interestingly, MVA calculations used by most insurance companies actually increase the surrender value of a contract in conditions where interest rates are declining (this happened from 2007 through present as we watched interest rates decline somewhat rapidly).

Some agents like to compare surrender charges to CD's, a move I think is a mistake, and most state insurance departments agree with me.  CD's surrender earned interest and return principal in most cases.  Surrender charges can result in your receiving less money upon surrender than you put in.  MVA, perhaps we can make an analogue there, but surrender charges no.

Are these criticisms warranted?  Everything has it's good and bad points.  We like to say there are no bad products, just bad parings done by agents and/or investment advisors et. al. (they make mistakes, too).

Something to think about Improved Mortality

Since annuity income upon annuitization is based on mortality tables assumed when the annuity was created and approved each states' insurance department where the contract is planned to be sold older annuities (based on older mortality tables) have an antiquated assumption behind them that is beneficial to the owner/annuitant.

For this reason, it's wise for everyone to consider having an older annuity lying around come retirement.  This doesn't mean just any old annuity will do.  There are some intricacies that we didn't dive into today that will be important considerations.  We'd be happy to elaborate more to anyone who'd like to know.   Simply contact us.

It's certainly not the end all be all product.  It's not the savior of your retirement.  But, when employed strategically and properly, the annuity can bring a lot of benefits to your overall financial situations and deserves your serious consideration.

3 thoughts on “What is an Annuity?”

  1. Can you 1035 cost basis of old annuities into a new annuity? Was that what you were hinting at?
    Great article! I noticed you didn’t cover deferred annuities or equity indexed (is that just index annuities?).

    • Yes you can carry cost basis over through 1035 exchange. If you’re referring to my final point about annuitization on an old annuity, my point is having a smaller non-qualified annuity that you could dump a bunch of money into a then annuitize for the income stream isn’t a bad idea–especially since you can make use of the old mortality table if you set this up at a younger age.

      • Also, indexed encompasses equity indexed. There are certain state laws that prohibit the term “equity indexed” FYI.

        All annuities that aren’t immediate would be deferred. An area that I didn’t get into that we will in the future is single premium vs. flexible premium deferred annuities.


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