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Annuity Awareness Month

Perspective Matters

June is annuity awareness month. If you've heard of annuities but are not well versed in them, you're probably aware that some people love them while some people hate them. You will read articles that talk about them as the best solution for every financial goal and other articles that will tell you they are the worst products ever created. They are neither. Annuities are a unique product that when used appropriately can do something no other investment product can do but when used inappropriately can make it very difficult for you to align your financial assets with your needs and goals. Annuities are also considered complex products for good reason; they have many variables and features and decisions that must be made about them when the contract is first purchased. Usually, once you purchase a contract there can be penalties and possibly taxes for changing it. Consider consulting CFP® professional who does not sell investment products or receive any kind of commission before purchasing any kind of annuity product. A CFP® professional can help you understand the different features that are available in annuities and help you decide whether or not they are appropriate for you and if they are, which features are best suited for your financial goals. 

The unique thing that annuities can do that no other investment product can do is create a guaranteed income you cannot outlive. That is their primary benefit; income you cannot outlive. 

An annuity is a contract between an individual and an insurance company in which the individual gives the insurance company money, and the insurance company provides an income to the individual as long as they live. The amount of income the insurance company provides to the individual is calculated based on the individual's life expectancy at the time the income starts, interest rates, and the amount of money the individual gives the insurance company. To understand the basic concept, imagine that you are 50 years old with a life expectancy of 25 years. If you put $100,000 into a bank account earning 3% per year, you could withdraw about $5700 every year and run out of money at the end of 25 years. That's the basic math that an annuity works on and then adjustments are made based upon different risks.

For example, the insurance company is taking the risk that they are going to earn enough over 3% that they can cover their costs and make a profit. The insurance company is also taking the risk that you live much longer than your life expectancy. The only risk you have is whether or not the insurance company is around to make these payments as long as you are alive.

Every state has a mechanism for ensuring a certain amount of benefits that have been guaranteed by insurance companies in case they go out of business. Before you purchase an annuity, you can get information about their financial situation and a ranking such as A+ or A, which are assessments of that insurance company's ability to meet its financial objectives today. These rankings are not guarantees and things can change rapidly so generally speaking I encourage you to remember some of the basics I've talked about before, specifically if something sounds too good to be true that it usually is. If you talk to five insurance companies and one of them is willing to pay you a lot more in income than all the others, ask yourself how can they do that? I would describe that company as probably more at risk of not making good on those promises. 

The other risk you are taking is that if you die before reaching your life expectancy, you have not collected what you expected from the insurance company. In this example, there is nothing paid to your beneficiary. 

Once you've decided that an annuity may be appropriate for you, you have some choices to make about adding optional features or benefits, which may be called "riders." Generally, additional features will affect the income you can get from the annuity. It's all about who is taking risk. Features that increase the insurance company’s risk will decrease the income you can receive. Features that increase your risk will increase the income you can receive. For example, if you want to guarantee any kind of benefit for a beneficiary you would need to reduce your income. There are several different types of beneficiary benefits from which you can choose. They fall into three different categories; a single payment, ongoing monthly payments depending on how long you live after starting income and ongoing monthly payments regardless of how long you live and collect payments. 

Typically, a single payment arrangement would allow for a beneficiary to receive one check representing the difference between what you gave the insurance company and what income you have received less some administrative costs. So, if you give the insurance company $100,000 and you collect $40,000 of income over a number of years before you die the insurance company will write a check to your beneficiary for $50,000. The company has kept $10,000 to cover their administrative costs and a profit. Every contract is different and will have all of this explained clearly so make sure you read it carefully. 

Ongoing monthly payments based on how long you live would work similarly to the lump sum example, except that instead of receiving a check for $50,000 your beneficiary would continue to receive the same payment you've received until at least $90,000 has been paid either to you or your beneficiary. 

The third category would be payments based upon how long both you and your beneficiary live. You could choose, for example, Life with Period Certain, or Joint and Last Survivor. Life with Period Certain means you get paid as long as you live, and if you die within the certain amount of time - for example 10 or 20 years - your beneficiary will get payments for the balance of that time. 

Joint and Last Survivor benefits are expressed as a percentage that your beneficiary will receive of the income you get. So, for example, 50% Joint and Last Survivor means that you will get a fixed amount of money as long as you live and at your death your beneficiary will get 50% of that amount as long as they live. Typically, you can choose between 50% Joint and Last Survivor and 100% Joint and Last Survivor, although different companies may offer other choices such as 25% and 75%. Choosing 100% joint and last survivor will provide the biggest decrease in the income you're going to get because the insurance company has the most risk of having to pay the full benefit for as long as you or your beneficiary are alive. 

In these first three examples the insurance company knows in advance the minimum amount of money it is going to be obligated to pay whether to you or your beneficiary. Each of these three options will result in you getting less income but it's math more than it is open-ended risk for the insurance company. The company can calculate the exact minimum it is going to have to pay and then only has to factor in what they expect to earn on the money and the risk of you living long enough so they are paying out more than the guaranteed minimum that they know in advance. The other example in the third category, Joint and Last Survivor, presents a different kind of risk for the insurance company and will therefore usually result in a larger decrease in the income you will receive if you want to provide this kind of survivor benefit. 

Another way that you can shift risk between you and the insurance company is for you to take on more risk related to investment returns in exchange for either higher income initially or potentially higher income in the future. 

Before I talk more about that I want to explain two other differences between annuity products.   

The simple definition I provided above - a contract in which you gave the insurance company money in exchange for a guaranteed income - is called an immediate annuity. That means your income begins within one year of when you give the insurance company money. There is also something called a deferred annuity. That means your income is going to start sometime in the future. When you put money into a deferred annuity you start in what is called the accumulation period. You are allowed to add to the annuity to increase the amount of money the insurance company has when it calculates the income you're going to get in the future. 

Whether you are taking an immediate income or deferring it there are also differences in how the rate of return is calculated on the money deposited with the insurance company. For simplicity’s sake, it would be extremely unusual to start an immediate annuity and have an arrangement with the insurance company that has any kind of variability on investment return, so I am going to focus here on deferred annuities. 

In a deferred annuity you are giving the insurance company money today with the expectation of not taking any money out until sometime in the future. So, what happens to your money while the insurance company has it? There are two components of the answer to that. One is whether your money is segregated from other people's money or if it is pooled on the insurance company’s balance sheet. When the insurance company is bearing most or all the risk related to the investment return on the money, it's usually going to be on their balance sheet; they have an obligation to you, but your money is not held separately from other investors’ money. When you are bearing most or all the risk related to the investment return, it's going to be held in what is called a Separate Account. When your money is on the insurance company's balance sheet you are a general creditor of the insurance company, especially if they run into financial trouble. When your money is held in a Separate Account the insurance company has no access to it to pay any of their other bills. I hope what you see here is a common theme about risk; the more guarantees you want, the more risk the insurance company has, and the more you should be aware of the insurance company’s financial condition. 

One other thing to know about deferred annuities is that whatever they earn before you start taking money out is tax deferred. That means you don't pay taxes on it while it is earning money, but you do pay taxes when you take money out. You may own an annuity inside an IRA, but for now let's assume that this is not an IRA and instead is what we call a non-qualified annuity. With a non-qualified annuity, the money you put into it has already been taxed and whatever you earn is not taxed until you withdraw it. When you withdraw from an annuity anything you have earned is always taxed as ordinary income. If you exchange the accumulated annuity for a lifetime income, a portion of every check you receive will be considered a return to you of the money that was already taxed, and a portion will be interest. If you withdraw from your annuity without converting it into income, you will withdraw earnings first so they will be 100% taxed as ordinary income. In addition, since annuities are meant to be used for retirement if you withdraw before 59 1/2 the earnings could also be subject to a 10% tax penalty just like an IRA. Before withdrawing from an annuity, you should consult your tax professional to make sure you understand the implications which are beyond the scope of this column. 

When you buy an annuity, you typically buy either a fixed annuity or a variable annuity. There is a third type called an Index annuity which is sort of a subcategory of fixed annuity. I'll explain that in a minute. With a fixed annuity the insurance company guarantees to pay a specific amount of interest over a specific amount of time very much like a CD. When the time is up it may renew for another specific amount of time or not. Either way your money does not fluctuate in value. Of course, if you withdraw it before retirement, you'll be subject to tax penalties, and the annuity may have penalties for withdrawing prior to the end of the guaranteed interest period. The rates paid on a fixed annuity should be similar to what you can earn on a bank CD or an investment in a treasury bond. The benefit of the annuity is that you can defer paying income taxes on the interest. Of note is that somebody wanting to sell you a fixed annuity does not need to be licensed and may not be obligated to act as a fiduciary. 

I call an index annuity a subcategory of fixed annuity for two reasons. First the person selling them to you does not need to be licensed. Second, your principal is not at risk of daily fluctuation in value, although you could be charged a penalty under certain circumstances. With an Index annuity the rate of return you will be paid is a function of the performance of a stock market index like the S&P 500. You might be offered something like “80% of the performance of the S&P 500 over a one year period with a minimum of 3% and a maximum of 8%.” Of course, it won't be stated that clearly, but that's in essence what you would be getting. There are several different ways that the return is calculated in an index annuity but let's assume here that it is just a comparison of the closing value of the S&P 500 on the first day when you buy the annuity and the closing value one year later. If the S&P 500 is 4000 on the day you buy the annuity and it's 4500 one year later, the S&P 500 has gone up 12.5%. In the example I listed above your annuity would pay 80% of that return (12.5% x 80% =10%) with a maximum of an 8% compound annual return. Your annuity would be credited with 8% interest. Let's say instead of the S&P 500 being valued at 4500 one year later it's valued 3500. Since your annuity has a minimum interest of 3%, you’ll be credited with 3% interest at the end of the year. Index annuities also have a calculation for what's called a market value adjustment or MVA which may apply if you withdraw, surrender or annuitize (start taking lifetime income) the Index annuity. Because the insurance company is bearing interest rate risk, it reserves the right to make an adjustment to your contract if the interest rate environment has changed significantly since you purchased your contract. An MVA can increase or decrease your surrender or withdrawal amount. If interest rates are higher your MVA will probably be negative. If interest rates are lower, it would probably be positive. There are limits to an MVA that will be clearly stated in your contract. I think index annuities can be much riskier than people realize and since they are often offered by people who don't need to be licensed, they may not be fully explained to consumers. Index annuities appeal to our desire to make more money without giving up guarantees. Once again keep in mind that if something sounds too good to be true it usually is. Index annuities, like all annuities, can have a place in your portfolio but make sure you are clear about how they work and the trade-offs between what you're getting and the risk you are taking on. 

A variable annuity can only be sold by somebody who is licensed to sell both insurance products and security products. When you put money into a variable annuity your money is segregated from the insurance company's money in something called a Separate Account. You can choose to have that money invested in funds similar to mutual funds that can allow you to get the benefits of investing in stock funds. Of course you have the risks as well. A variable annuity will also usually include a fixed interest account that has a guaranteed minimum interest rate to be paid. A variable annuity will have more expenses than a fixed annuity because it also provides more features and more upside potential for you.  

I could do an entire column just on variable annuities; in their simplest form they allow you to deposit after tax money over a period of time, invest that money in stock funds to get stock market returns, defer taxes on the money you've earned until you take it out, and have different choices of guarantees available to you for things like death benefit, accumulation value, income withdrawal, and annuitization. Most variable annuities will provide a minimum guaranteed death benefit equal to the amount of money you've put into the contract. So, if you put $100,000 in, invest in stock funds, but the value goes down to $90,000, your beneficiaries would still get $100,000 if you die. Often you can pay a little bit extra and have additional guarantees to increase the minimum death benefit. Two common options are Highest Anniversary Value (HAV) and guaranteed annual increase. 

You may also purchase a rider to provide a Minimum Accumulation Value, which is money you can withdraw during your lifetime. For example, you could put money in, choose your stock funds, and have a guarantee that 10 years from now the amount of money you could take out would be the equivalent of at least a 5% return. 

Income and withdrawal benefits can also have guarantees. These benefits are known as Living Benefits. An income benefit would allow you to know when you purchase the contract the minimum amount of income you would be able to get later assuming you annuitized the contract. (Keep in mind that annuitizing means you give up access to the principle.) It's that basic contract I outlined at the beginning of this post. Usually if you put money into a variable annuity and you want to take income 20 years from now, the amount of income you're going to get is going to be based on whatever interest rates are at the time you want to start income. If interest rates are very low, you would get less income than if interest rates are high. Keep in mind that when you annuitize, the insurance company is taking on the risk that they make enough on the money you've given them. They are also taking on the risk that you outlive your life expectancy. You can pay extra to guarantee up front that your annuitized income would be a certain minimum, usually based on your age when you start the income. That can give you some peace of mind when doing your financial planning. You can know today the minimum amount of guaranteed income you can get at some point in the future. That's an income you can't outlive, even if the investments in the annuity underperform expectations.

A withdrawal benefit allows you to have a minimum amount you can withdraw every year starting at some point in the future without having to annuitize. The amount of income you would be able to take out as a withdrawal benefit would generally be less than an income benefit because you would retain the ability to access any remaining principle in the contract. For example, if the contract value is $300,000 when you're 70 years old, annuitizing it might generate $20,000 a year of income as long as you live but if at 75 you decided you wanted to take an extra $50,000 out you wouldn't be able to do that. If you have a withdrawal benefit your guaranteed annual withdrawal amount might be $15,000 but you still have access to the contract value. So, the $15,000 is deducted from the $300,000 but that money stays invested so you could dip into it if you wanted to. Now if you take money out above and beyond the $15,000 a year you're guaranteed, that will change the guaranteed withdrawal amount but if you get a bad diagnosis at age 75 and want to cash out the rest of it and take your family on a big trip you have that option. 

Once again, it's always about trade-offs. As I said at the beginning, annuities can do things that no other investment product can. It's too simplistic to try to say annuities themselves are good or bad. When used properly they could be an important part of providing guaranteed income later in life. When used improperly they can be expensive and reduce your flexibility. One way to know if an annuity is being used appropriately in your situation is to pay attention to how much focus is given to words like safety and guarantee. Very often when annuities are used inappropriately, they are positioned to appeal to people's fears about outliving their money. If you are feeling very anxious about running out of money later in life somebody may try to take advantage of that anxiety by making an annuity seem like a magic bullet. That might be a red flag that you need to take a step back. Annuities are complex products, and no one should pressure you to put money into one quickly. Always take time to do some research and ask the person suggesting you purchase the annuity if they are acting as a fiduciary when providing that recommendation. If they are not, consult a fiduciary such as a CFP® professional to help you understand the trade-offs of different kinds of annuities with different kinds of features. If the annuity is the right solution, it'll still be as right a solution next week as it is today.   

Neither Prism Planning and Solutions Group nor Insight Advisors provide tax advice, and nothing in this communication should be treated as such. This communication should not be interpreted as a recommendation for a specific investment or tax-

planning strategy. We are providing this material for informational purposes only. We have made every attempt to verify that information contained in this communication is accurate as of the date published but make no warranties. Before making any decisions related to your own tax and/or investment situation you should consult the appropriate professionals.   

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.


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