Home Phone

Annuities

Annuities

An annuity is a type of insurance product that provides individuals with a fixed stream of income. They are customizable and offer various benefits like tax advantages, tailored payment periods, investment protection, and the option to leave money to a beneficiary. Most often, they are used for retirement as a means to guarantee a lifetime of income.
Annuities are not short-term investment options. Instead, they are used for retirement income, diversification, long-term financial security, and principal preservation.

What Is An Annuity?

An annuity is a legal agreement between you and an insurance company. The contract transfers the longevity risk (the risk of your outliving your money) from yourself to the insurance company. In exchange, you pay premiums and other fees, all of which are outlined in the agreement.

How Do Annuities Work?

Since annuities in Texas are highly customizable, the way each one works also varies. Before we discuss the specific types of annuities, let’s go through the foundational process by which all annuities work.
Annuities work by taking a lump-sum premium and converting it into a steady stream of income. You will not be able to outlive the income. All of us will need retirement income in addition to our Social Security benefits and investments. An annuity will provide that income by the process of accumulation and annuitization.
The “accumulation” phase of an annuity is the period of time when the person is paying in premiums to the insurance company. They are “accumulating” their lump-sum annuity. The “annuitization” phase is when the insured receives payments from their annuity. Some annuities use a one-time premium payment and begin the annuitization process almost immediately, thereby skipping the accumulation phase.
A deferred annuity, on the other hand, requires you to make premium payments to the insurance company. You can choose how long your accumulation phase is when you set up the terms of your annuity contract. Typically, an accumulation period ranges from ten to 30 years. At the end of your accumulation phase, you will begin annuitizing.
The insurance company of an annuity contract is always the risk bearer. Of course, you can safely assume you will pay for this risk transfer. Insurance companies charge fees for their administrative services, investment management, and for any riders you choose to add to your annuity. In addition, most contracts have surrender periods. You cannot withdraw any money during a surrender period without incurring surrender fees.
Lastly, most companies have caps, spreads, and participation rates that can reduce your return. A cap is a maximum amount you can earn on your indexed annuity in a given year (or another specified period of time). A spread is similar to a cap – the higher the spread, the lower your return. The spread is the amount that comes out of your annuity each year before the interest gains are credited to your principal. Finally, participation rates are found in some indexing strategies. The higher the rate, the more interest you’ll earn if the market index moves up.
Now let’s review some of the features you’ll find in almost every annuity.
Nearly all states require insurance companies to provide a free-look period. This is a specified amount of time that the buyer can choose to cancel their contract without having to pay a surrender charge.
Riders are contract addendums that you can add to your annuity. These allow you to customize your annuity further, but they generally come with additional costs. If you add a death benefit rider to your annuity, you can designate a beneficiary, who will receive a portion of the contract’s value if you pass away.
Fees and commissions are the prices you’ll pay for the risk transfer. The amount will vary based on the insurance company and what kind of annuity you choose. Generally, fixed annuities have the lowest fees.
Favorable taxation is one of the most appealing features of annuities. If you purchased an annuity with money you already paid taxes on, then only the earnings are taxed when you withdraw the money.

Immediate vs. Deferred Annuities

When picking an annuity, the first choice you’ll have is if you’ll want it to be an immediate or deferred annuity. Your financial goals will help you determine which option is best for you. For example, if you want annuity payments right away, you’ll choose an immediate annuity. But, if you are planning for the future and don’t need the payments now, you’ll choose a deferred annuity and specify the payment start date in the contract terms.

Deferred Annuities

If you choose to wait more than one year to start receiving annuity payments, you will pick a deferred income annuity. This type of contract guarantees the owner an income at a specified date in the future. You will not pay taxes on any earned income until you begin the annuitization phase – the interest is tax-deferred until it is withdrawn.
There are two ways to purchase a deferred annuity. You can purchase one with either a single premium or a flexible premium.
As their name implies, a single-premium deferred annuity is purchased with just one single premium payment. A flexible premium allows you to make a series of payments into your annuity. They can be fixed amounts, also called scheduled premiums, or they can change as your plans or ability to pay changes.
Deferred annuities are expected to have the largest growth rate over the coming years.

Immediate Annuities

An immediate annuity provides a stream of income directly following (or within a year of) the premium payment. All immediate annuities are funded with a single lump-sum premium payment. You might hear these called income annuities or immediate payment annuities.
There are generally two instances when someone would purchase an immediate annuity contract. Most often, it is used by individuals who are nearing retirement. Unlike 401(k) plans or IRAs, there are no contribution limitations on annuities. Older adults can make large contributions to an annuity and then use that income to supplement their Social Security benefits and other retirement investment accounts. They can even choose to roll their 401(k) plants into an immediate annuity to provide guaranteed income for life.
Another common use for immediate annuities is when younger adults are left with a large, lump-sum inheritance. To ensure the inheritance is not spent too quickly, it can be transferred into an immediate annuity. This provides income for the person now and in the future.
You can customize your immediate annuity in a few different ways. You can choose to receive payments monthly, quarterly, semi-annually, or just once per year. The payments can span one life or two and can include beneficiary protection. You can also choose a specific payment period, such as over ten or 20 years. These are referred to as “period certain” payments. The payment you receive will consist of your premium plus earned interest.
Immediate annuities are simpler to understand than deferred ones, yet they are much less common. Of all the annuities sold each year, only about 10% are immediate annuities.

Split-Funded Annuities

A split-funded annuity combines the immediate and deferred strategies to provide both immediate and future income. The immediate portion gives you income right away, while the deferred portion allows you to have dependable income in the future. While you receive income in the early years, the rest of your annuity is growing tax-deferred.
The thought behind a split-funded annuity is that by the time your deferred portion begins to payout, it will have accumulated enough interest so that its balance equals the amount of your starting principal (the original sum of money).
Once you’re ready to receive payments from the deferred annuity, you can choose to split the annuity again. Be aware that there could be additional fees to make a second annuity split.

Types of Annuities

There are several types of annuities in Texas to fit our diverse market needs. Your personal financial goals will be a determining factor in which type of annuity is best for you.

Fixed Annuities: Guaranteed Income

A fixed annuity contract guarantees the buyer a specific interest rate on their contributions. You pay the insurance company a premium, and they guarantee a minimum interest rate. (The growth rate could also be a set dollar amount or another formula specified in the contract.) The interest rate and the period of time in which the guarantee is provided are outlined in the terms of the contract. The cash in the annuity will accumulate interest tax-deferred.
Fixed annuities are straightforward and are the simplest type of annuity. They provide a reliable and predictable income and typically have the lowest fees. They are a great investment for people who are looking for premium protection, lifetime income, and low investment risk. However, fixed annuities do not offer inflation protection, which could be a disadvantage at times.
A fixed annuity can be deferred or immediate. You can also choose how long you’d like to receive payments. A single-life annuity guarantees payments for life. Or, you can choose a set number of years to receive the income, which is called a “term-certain” or “period-certain” annuities. Your contract will outline the annuity payout options. Lastly, you can choose to receive a lump-sum annuity payment.
Pros of Fixed Annuities
●      Guaranteed minimum interest rate
●      Premium protection
●      Lifetime income
●      Simple to understand
●      Predictable
●      Minimal risk
Cons of Fixed Annuities
●      No protection against inflation
●      No potential for extra growth
●      Taxed as ordinary income (versus lower capital gains rates)
●      Early withdrawal penalties
●      Surrender charges

Indexed Annuities: Growth Potential

Indexed annuities are also called fixed-index annuities or equity-indexed annuities. Their payments are tied to a stock index, like the S&P 500. If the financial markets perform well, the indexed annuity performs well. Some people refer to these as hybrid annuities, with features of both fixed and variable annuities.
Indexed annuities were created in the mid-1990s, during the stock market boom. Investors were interested in benefiting from the higher gains of the stock market instead of the lower returns found in bonds and CDs.
An indexed annuity will offer a minimum guaranteed interest rate, just like a fixed annuity does. However, they also offer an interest rate that is tied to the market index, making them somewhat variable as well. This protects the owner against market losses but gives them the opportunity for more interest from market gains.
Once you sign an indexed annuity contract, your money is invested in the market of your choice. You can select a single index fund or spread the money out across several indexes. The most common funds are the Nasdaq, S&P 500, and Russell 2000. An insurance company will limit the amount you can earn in an indexed annuity since it is bearing the investment risk. So, even in strong markets, you will be limited on how much you can earn. However, that’s why indexed annuities are considered less risky compared to investing in the stock market.
Insurers use several mechanisms to determine the change in the index over the length of the annuity.
An annual rest (or rachet) compares the index change from the start of the year to the end of the year. High water marks look at the index value at several points in time, and then take the highest value and compare it to the level and at the contract’s start. A point-to-point mechanism uses to preselected points in time and compares the index difference. Lastly, some indexed annuities use index averaging, either on a daily or monthly basis.
Pros of Indexed Annuities
●      Tax-deferred growth
●      Potential for growth
●      Possible hedge against inflation
●      Guaranteed growth in an underperforming market
●      Locked in index gains
●      Higher rates than CDs
Cons of Indexed Annuities
●      Gains are capped
●      Fees lacking transparency
●      Sales commissions
●      Surrender charges

Variable Annuities: Flexible Income

The performance of a variable annuity is directly tied to the performance of an investment portfolio. Payments during the annuitization phase will increase when the portfolio is doing well but will decrease if the portfolio loses money. Variable annuities have the potential for higher returns than other types of annuities, but they do not offer a guaranteed payout.
The premiums you pay into a variable annuity are allocated to an investment portfolio. You’ll be given several investment options (or subaccounts), which can include bonds, money market funds, stocks, mutual funds, and other types of investments. Your income from a variable annuity will depend on how well your portfolio performs.
You might be able to invest part of your premiums into an account that earns a fixed interest and is not tied to the stock market.
Even with variable annuities, most insurance companies guarantee a return of premium (ROP), which guarantees that you will not lose your initial investment.
Pros of Variable Annuities
●      Hedge against inflation (possibly)
●      Tax-deferred growth
●      Initial investment protection
●      Death benefit to beneficiaries
●      Lifetime income
Cons of Variable Annuities
●      No guaranteed return
●      Earnings are taxed as income
●      Complex structure
●      Surrender charges
●      Mortality and expense risk charges
●      Administrative fees
●      Sales commissions
●      Underlying fund expenses

Who Should Consider an Annuity?

Anyone who wants to create long-term income should consider an annuity. Older adults who are close to retirement are the main buyers of annuities, but they can benefit individuals of any age and suit a variety of financial goals.
You might purchase an annuity if you want:
●      Principal protection
●      Tax-deferred growth
●      Inflation adjustments
●      Long-term income security
●      Death benefit for heirs
●      Probate-free estate distribution

Pros and Cons of Annuities

Annuities aren’t for everyone. You should consider the advantages and disadvantages of annuities, as well as other investment options, before choosing which one is right for you. Let’s review the pros and cons of annuities.
Advantages of Annuities
●      Guaranteed lifetime withdrawal benefit
●      No contribution limits
●      Tax-deferred growth on earnings
●      Death benefit rider to transfer the contract to your heirs
Disadvantages of Annuities
●      Higher commissions and fees
●      Complex structure
●      Conservative returns
●      Lack of liquidity
●      Opportunity cost

Conclusion

Do you still have questions about your annuity options in Texas? We don’t blame you! Investments of any kind can be quite confusing, but that’s where CoverMile can help. We take the time to get to know you and your personal financial goals. Then, we can help you determine what kind of investments fit your unique situation. Give us a call to schedule a complimentary consultation and get all your investment questions answered.