7.4 Annuities

Annuities are insurance contracts designed to provide income, typically for retirement. They offer tax-deferred growth and various payout options. Investment advisers must understand the different types of annuities and their suitability for different clients.

What Is an Annuity?

An annuity is a contract between an individual and an insurance company. The individual pays premiums, and the insurance company promises to make periodic payments, either immediately or at a future date.

Two Phases of Annuities

Accumulation Phase: Investor makes premium payments; assets grow tax-deferred

Annuitization Phase: Investor receives periodic income payments

During accumulation, the investor owns accumulation units. At annuitization, these convert to annuity units, which determine the payment amount.

Types of Annuities

Fixed Annuities

Returns: Guaranteed interest rate set by insurer

Investment Risk: Insurance company bears all risk

Regulation: State insurance department only; NOT a security

Death Benefit: Typically guaranteed principal

Suitable For: Conservative investors; guaranteed income seekers

Variable Annuities

Returns: Based on performance of subaccounts (similar to mutual funds)

Investment Risk: Investor bears the investment risk

Regulation: SEC and FINRA regulated; IS a security

Death Benefit: May fluctuate with account value

Suitable For: Growth-oriented investors; higher risk tolerance

On the Exam: Variable annuities are securities because the investor bears the investment risk. They require a prospectus and are regulated by the SEC. Fixed annuities are NOT securities because the insurance company guarantees the return.

Equity-Indexed (Fixed-Indexed) Annuities

Returns: Linked to market index (S&P 500, etc.)

Participation Rate: Limits upside (e.g., 80% of index gain)

Minimum Guarantee: Floor on returns (often 0-3%)

Caps: Maximum return per period

Regulation: Generally NOT securities (state regulated)

Complexity: Complex crediting formulas

Variable Annuity Features

Subaccounts

Variable annuity assets are invested in subaccounts, which are similar to mutual funds. The investor selects from various options:

- Stock funds (growth, value, international)

- Bond funds (government, corporate, high-yield)

- Money market funds

- Balanced/target-date funds

Separate Account

Variable annuity assets are held in a separate account - segregated from the insurance company's general account. This protects investors from the insurer's creditors.

Death Benefit

Most variable annuities guarantee a minimum death benefit:

- At minimum: Return of premium paid

- Stepped-up options: Higher of premium or account value at periodic intervals

- Some offer enhanced death benefits (additional cost)

Living Benefit Riders

Optional riders provide guarantees during the investor's lifetime (for additional fees):

GMIB (Guaranteed Minimum Income Benefit): Minimum income regardless of account value

GMWB (Guaranteed Minimum Withdrawal Benefit): Minimum annual withdrawal amount

GMAB (Guaranteed Minimum Accumulation Benefit): Minimum account value at specific date

Annuity Costs

Variable annuities have multiple fee layers:

Mortality & Expense (M&E): Typical Range 1.0% - 1.5%. Purpose: Insurance features and profit

Administrative Fees: Typical Range 0.10% - 0.30%. Purpose: Record-keeping, statements

Subaccount Expenses: Typical Range 0.25% - 2.0%+. Purpose: Underlying fund management

Rider Fees: Typical Range 0.25% - 1.0%. Purpose: Optional benefit guarantees

Surrender Charges: Typical Range 7% declining to 0%. Purpose: Early withdrawal penalties

Surrender Charges

Most annuities impose surrender charges for early withdrawals:

Year 1: 7%

Year 2: 6%

Year 3: 5%

Year 4: 4%

Year 5: 3%

Year 6: 2%

Year 7: 1%

Year 8+: 0%

Most contracts allow 10% free withdrawals annually without surrender charges.

Payout Options (Annuitization)

When the investor begins receiving income:

Life Only: Payments for investor's lifetime; nothing to heirs. Risk: Longevity risk for heirs

Life with Period Certain: Payments for life OR minimum period (10, 20 years). Risk: Balanced

Joint and Survivor: Payments continue for two lives. Risk: Lower payments

Fixed Period: Payments for set number of years. Risk: May outlive payments

Lump Sum: One-time payment. Risk: No guaranteed income

In Practice

A retiree choosing between payout options must balance:

- Life only: Highest payment, but heirs receive nothing if retiree dies early

- Joint and survivor: Provides for spouse but lower monthly payments

- Period certain: Guarantees minimum payments to heirs if death occurs early

Tax Treatment

Non-Qualified Annuities (After-Tax Contributions)

Contributions: Not tax-deductible

Growth: Tax-deferred

Withdrawals: Earnings taxed as ordinary income (LIFO)

Before 59 1/2: 10% early withdrawal penalty on earnings

Death Benefit: Taxable income to beneficiary

LIFO (Last In, First Out): Earnings are considered withdrawn first, so early withdrawals are fully taxable until all earnings are distributed.

Qualified Annuities (Pre-Tax Contributions)

Used in retirement plans (IRAs, 401(k)s):

- Contributions may be tax-deductible

- All withdrawals taxed as ordinary income

- Subject to RMD rules after age 73

1035 Exchange

Allows tax-free exchange from one annuity to another (or life insurance to annuity) without triggering taxable event.

Suitability Considerations

Variable annuities may be suitable for:

- Long-term investors (10+ year horizon)

- Those who have maxed out other retirement accounts

- Investors seeking tax-deferred growth with upside potential

- Those who want guaranteed income options

Variable annuities are NOT suitable for:

- Short-term investors (surrender charges)

- Those who need liquidity

- Investors already in low tax brackets

- Use in tax-deferred accounts (no additional tax benefit)

- Young investors prioritizing growth over guarantees

On the Exam: Purchasing a variable annuity inside an IRA provides no additional tax benefit since IRAs are already tax-deferred. This is considered unsuitable unless other features (death benefit, living benefits) justify the cost.

Key Takeaways

- Fixed annuities: Guaranteed returns; NOT securities; insurer bears risk

- Variable annuities: Returns vary based on subaccounts; ARE securities; investor bears risk

- Variable annuity features: Subaccounts, separate account, death benefit, living benefit riders

- Costs include M&E, administrative fees, subaccount expenses, and surrender charges

- LIFO taxation: Earnings withdrawn first, taxed as ordinary income

- 10% penalty on withdrawals before age 59 1/2 (on earnings)

- 1035 exchange: Tax-free transfer between annuities