Chapter 3-2-Types of Annuities

An equity-indexed annuity is a specific kind of annuity.  Throughout the growth period, when you either contribute one single payment or an arrangement of payments, the insurance company gives you a return that depends on fluctuations in an equity index, like the S&P 500 Composite Stock Price Index.  The insurance company generally ensures a minimum return.  Guaranteed minimum return rates differ.  Following the growth period, the insurance company will give you fixed payments under the terms of your contract, unless you select to get your contract amount in one single payment.

In an immediate annuity your income payments begin immediately, which is at anytime inside 12 months from the date you bought it.  You decide if you want income guaranteed for a particular number of years or for your life span.  The insurance company measures the total of every income payment depending on the total that you bought it for and your life expectancy.  An immediate annuity can be bought with funds from a number of sources, such as a matured Certificate of Deposit (CD), money that has accrued in a deferred annuity account, money from a tax qualified defined benefit or profit sharing plan, or funds from an IRA account.

A deferred annuity has two stages: the accumulation stage, where you give your money time to accumulate, and the payout stage.  Throughout the accumulation stage, your money accumulates tax-deferred.   You choose when to take income from your annuity and, consequently, when to pay the taxes.  Having control over your taxes is one of the main advantages of annuities.  The payout stage starts when you choose to withdraw income from your annuity, generally when the annuity holder retires.  You can take fractional withdrawals or withdraw the entire amount, known as surrender, or turn your deferred annuity into a flow of income payments, known as an annuitization.  An annuitization is basically the same as purchasing an immediate annuity.  Consider the following timeline that illustrates the accumulation and payout phases of an annuity:

Single Premium Immediate Annuities (SPIAs) are bought by an individual deposit.  They begin making monthly payments immediately following the date of your deposit.  The main component for an immediate annuity is the transfer that happens among the insurance company and the buyer of the annuity.  The company assures to pay a monthly income for the life span of the buyer and the buyer surrenders his privileges to ever collect his deposit back in one individual payment.

There are many advantages associated with a fixed annuity.  One of these advantages is a fixed rate of interest.  The majority of fixed annuities provide interest rates that are more than the lifetime minimum interest rate guarantee of 3 percent.  This is advantageous for people who have retired and would like to have a fixed flow of income.  A second advantage of a fixed annuity is that they are considered by many to be a worry free investment product.  Different from stocks or mutual funds, you do not have to manage a portfolio in a fixed annuity.  For this reason, fixed annuities are the perfect investment tool for people who do not have the time or the desire to manage their investments.  Flexibility is another benefit of a fixed annuity.  For example, an investor can select whether to get the payment on a monthly, quarterly or yearly basis.  The investor can also select to contribute the payment in one individual payment or in installments.  Likewise, you can also look to collect the income for a lifetime or for a particular period.  A fourth advantage is that annuities are a safeguard from volatile markets.  Since the investor collects a fixed rate of interest, volatile markets do not influence the returns.  A fifth advantage is that it protects your money.  Insurance companies distributing annuities are managed by both federal and state laws.  Federal law requires that insurance companies have to maintain a reserve that amounts to the total of every annuity policy.  State law also necessitates the preservation of extra money in addition to contributions to state guaranty funds to offer extra protection.  Tax deference is one of the biggest advantages connected with a fixed annuity.  Tax deference signifies that no taxes pertain when interest is being added to your annuity policy.  Therefore, you are able to profit from compound accumulation.  Another advantage associated with a fixed annuity is a lower tax bracket.  With annuities, the investor is obligated to pay the taxes when he begins receiving the payment from the insurance companies.  But the majority of investors choose to collect the payments only when they retire, at which time they have already fallen into a lower tax bracket.  Fixed annuities are an ideal investment product for investors who do not have a high tolerance for risk.

Variable annuities are securities that are monitored by the SEC, unlike fixed annuities that are not securities and are not monitored by the SEC.  Equity-indexed annuities combine characteristics of traditional insurance products carrying a guaranteed minimum return with traditional securities that have a return tied to the stock markets.  Based on the combination of characteristics, an equity-indexed annuity may or may not be a security.  The general equity-indexed annuity is not registered with the SEC.

Variable annuities have emerged as a component of the retirement and investment preparations of numerous Americans.  Prior to purchasing a variable annuity, you should be familiar with a number of the fundamentals, and be ready to ask many questions about if a variable annuity is suitable for you with your insurance agent, broker, financial planner, or other financial professional.  Prior to purchasing any variable annuity you should also learn about the specific annuity you are thinking about purchasing.  Ask for a prospectus from the insurance company or from your financial professional, and review it thoroughly.  The prospectus includes essential data about the annuity contract, fees and charges, investment alternatives, death benefits, and annuity payout alternatives.  You should compare the advantages and expenses of the annuity to additional variable annuities and to additional kinds of investments, like mutual funds.

A variable annuity provides a spectrum of investment alternatives.  The amount of your investment as a variable annuity owner will differ based on the performance of the investment alternatives you select.  The investment alternatives for a variable annuity are generally mutual funds that invest in stocks, bonds, money market instruments, or some mixture of the three.

Although variable annuities are generally invested in mutual funds, they vary from mutual funds in many distinct ways.  Variable annuities allow you to receive fixed payments for the remainder of your life, your spouse’s life, or any additional person you designate as your beneficiary.  This characteristic provides security against the chance that you will outlive your investments following your retirement.  The second distinction between mutual funds and variable annuities is that variable annuities have a death benefit.  If you die prior to the payout stage your beneficiary is assured to get a particularized total, generally the total of your purchase payments.  Tax-deferment is a third difference between the two.  Tax-deferment signifies that you do not pay taxes on the income and investment profits from your annuity prior to withdrawing your money.  You may also switch your capital from one investment to a different one in a variable annuity without having to pay taxes at the time of the switch.  Following the withdrawal, you will be required to pay taxes on the profits at regular income tax rates instead of the lesser capital gains rates.  Usually, the advantages of tax deferral will overbalance the expenses of a variable annuity solely if you keep it as a long-term investment to satisfy retirement or another long-term objective.

Additional investment tools, like IRAs and 401(k) plans, may also offer you tax-deferred accumulation and additional tax benefits.  For the majority of investors, it will be beneficial to make the maximum contributions allowed to IRAs and 401(k) plans prior to investing in a variable annuity.  Moreover, if you are investing in a variable annuity through a 401(k) plan or IRA, you will get no other tax benefit from the variable annuity.  The tax rules that pertain to variable annuities can be more difficult.  Prior to investing, you may wish to ask a tax adviser about the tax effects to you of investing in a variable annuity.

Variable annuities are created to be long-term investments, to satisfy retirement and other future objectives.  Variable annuities are not appropriate for satisfying short-term objectives due to significant taxes, and insurance company charges may occur if you withdraw your money too soon.  Like mutual funds, variable annuities also include investment risks.

The most common starting point for information about variable annuities is the prospectus.  Go through the prospectus thoroughly prior to distributing your purchase payments between the investment alternatives provided.  You should take into consideration an array of determinants concerning every fund alternative, in addition to the fund’s investment goals and strategies, management fees and additional costs, the risks and volatility of the fund, and if the fund adds to the diversification of your entire investment portfolio.

Throughout the accumulation stage, you can generally switch your capital from one investment alternative to an additional one without having to pay taxes on your investment income and profits, however, you may be charged by the insurance company for the transfer.  If you take out money from your account in the beginning years of the accumulation stage, you may have to pay surrender charges.  Moreover, you may need to pay a 10 percent federal tax penalty if you take out money before 59½ years of age.

Throughout the payout stage, your annuity contract may allow you to select among getting payments that are fixed in value or payments that vary dependant on the performance of mutual fund investment alternatives.  The value of each fixed payment will be based, to a degree, on the time interval that you choose for getting payments.  Remember that a number of annuities do not permit you to take out money from your account after you have begun getting periodic annuity payments.  Moreover, a number of annuity contracts are designed as immediate annuities, which signifies that there is no accumulation stage and you will begin getting annuity payments immediately after you purchase the annuity.

A number of variable annuities let you select a stepped-up death benefit.  With this characteristic, your ensured minimum death benefit may depend on a higher value than purchase payments less withdrawals.  For instance, the guaranteed minimum may be your account total as of a certain date, which may be higher than purchase payments less withdrawals if the underlying investment alternatives have performed favorably.  The aim of a stepped-up death benefit is to lock in your investment performance and warding off a later decrease in the total of your account from disintegrating the total that you anticipate on leaving to your beneficiaries.  This characteristic comes with a charge, which will lower your account total.