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Robert Schneider, CFP®, RICP®

Your Annuity Guide – Part Two: Deferred & Equity Indexed Annuities

This post is the second part of our four-part series, “Your Annuity Guide.” For the series, we’re reviewing the various types of annuities, and sharing insights into when and how each type can be used most effectively. Part One of the series discussed Immediate and Longevity Income Annuities.

Fixed Deferred Annuity

What is it?

Unlike Single Premium Income Annuities described in my last post, fixed deferred annuities are purchased with the intent of deferring an income stream until a later date. Most fixed deferred annuities are single premium, meaning you make one lump-sum payment, but some accept multiple deposits. While in deferral, the fixed annuities are credited with interest similar to how savings accounts or certificates of deposit earn interest. The interest rate can typically be locked in for 1, 3 or 5 years. When selected, the annuitized income stream can be set up for a specific number of years or the remaining life of the individual.

How is it taxed?

Fixed deferred annuities grow tax deferred regardless of the type of dollars (post tax or pre-tax) used to fund them. Since they grow tax deferred they are subject to tax treatment similar to IRAs and other retirement accounts. Withdrawals taken from IRA annuities will be fully taxable at ordinary income tax rates. For non-tax qualified annuities, the ordering of withdrawals is last in first out. This means gains come out first. Gains will be taxed at ordinary income tax rates and are subject to a pre age-59 ½ withdrawal penalty of 10%. If converted into a payment plan, the tax treatment is the same as described for the SPIA.

How can it be used most effectively?

Fixed deferred annuities are best suited for conservative investors, or for a pot of money that isn’t needed now and cannot be exposed to risk.

Any reason for caution?

Most fixed annuity contracts require you to pay a significant penalty if you surrender (sell) before a set date (usually 5-10 years). This means you must be able to lock up this money for the duration of that surrender period. Otherwise, you will be hit with charges if the contract is surrendered early. Like with SPIAs fixed deferred rates are quite low right now (2.5-3%) so consideration should be taken when deciding if locking up the funds for up to 10 years is worth it.

If you decide a fixed annuity at current rate levels is right for you, we suggest purchasing a product with the shortest surrender period.

Variable Deferred Annuity

What is it?

The funds deposited into a variable annuity are allocated among variable investment options similar to mutual funds. When an owner converts their contract from deferral to income they may elect to receive fixed or variable payments. Under a variable payment scenario, each payment is determined by the market performance of the underlying variable units in the contract. Like the other annuity products, payment frequency can be monthly, quarterly or annually and payments can be guaranteed for a certain period of time or for life.

How is it taxed?

Variable annuities are taxed the same as fixed deferred annuities.

How can it be used most effectively?

Variable annuities are good savings vehicles because they accept multiple deposits and grow tax deferred. They can be especially useful for someone without an employer sponsored retirement plan or someone with the ability to save on a tax deferred basis beyond the limits allowed in employer plans and IRA’s.

Variable annuities are subject to equity and bond market fluctuation and therefore exposed to the possibility of incurring significant losses. However, most contracts offer optional riders that will provide a minimal level of income or accumulation regardless of what happens to the market value of the contract. These riders add significantly to the cost of the contract. They are also very complicated and easily misunderstood.

Any reason for caution?

Yes, fees. According to the American Association of Individual Investors the average total annual fee of a deferred variable annuity is 3%. Fees this high can significantly reduce returns. Fees associated with variable deferred annuities include:

  • An insurance fee referred to as mortality and expense charge;
  • The variable investment options have internal management fees similar to the fees on mutual funds;
  • Guaranteed death benefits are available at an additional cost; and
  • Each optional rider has a fee associated with it.

Furthermore, variable annuities have a limited number of investment options to choose from. Most variable annuities have only 20-30 variable investment options available. In comparison, a traditional investment account with your advisor allows access to a much wider range of investments including individual stocks and bonds, exchange traded funds and mutual funds.

Equity Indexed Annuity (EIA) 

What is it?

Equity indexed annuities are deferred annuities with returns that are tied to the performance of one or more equity indices. The contract owner funds the contract and chooses from a selection of indices. The contract will be credited with a percentage of the return achieved by whichever index is chosen. For instance, if the chosen index is the S&P 500 and it returns 10% over a given period, the client’s contract might be credited with 7 or 8% – subject to the terms of the contract. The difference between the return achieved by the index and the amount credited to the client’s contract is essentially the fee.

Perhaps the most attractive feature of equity indexed annuities is that most contracts aren’t affected by negative performance. So if the index goes up, the contract value goes up. But, if the index goes down, the contract value does not go down. Of course, this is subject to individual contract provisions.

How is it taxed?

Equity indexed annuities are taxed the same way as other deferred annuities.

Any reason for caution?

As described earlier, the great thing about EIAs is the protection against loss. One significant drawback is the limited upside. Most contracts include cap rates or participation rates. A cap would mean that regardless of the return achieved by the index, the client will only be credited up to a certain limit. This means if the index has a terrific year and returns something like 25%, the client’s returns could be limited to only where the cap is set. The participation rate is similar in that purchasers are limited to receiving only a certain percentage of what the index returns.[1] Some EIAs allow for the insurer to change the participation rate annually or at the start of the next contract term. If so, returns could be limited even further.

An additional drawback to the EIA is the surrender charge period Most EIAs charge significant fees if you sell the contract before the stated surrender period. Some have surrender charges as long as 15-18 years. The average is probably in the 10-year range.

The next post will discuss hybrid long term care products. Look for it two weeks from today, Tuesday, November 8th.

Cleary Gull Advisors does not provide tax advice. Investors should consult with their financial and/or tax adviser prior to purchasing an annuity.

[1] These examples are very simplified for this entry. Most EIA returns are calculated in a far more complex manner.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.