Introduction To Annuities

The History Of Annuities

Do you ever lie awake at night, wondering what would happen if you were to outlive your retirement income? The thought of running out of money at a time in your life when you may be totally unable to replace it may be a major source of worry, especially if your nest egg is relatively small. Fortunately, you are not the first person to have this fear. And several decades ago, the life insurance industry decided to create a vehicle that helps to insure against this risk.

What Is an Annuity?

Conceptually speaking, annuities can be thought of as a reverse form of life insurance. Life insurance pays the insured upon death, while annuities pay annuitants while they are still living. The academic definition of an annuity is a promise by one party to make a series of payments of a specific value to another for a given period of time, or until a certain event occurs (such as the death of the person receiving the payments). As an actual investment, annuities are retirement vehicles by nature. Investopedia defines an annuity as “a financial product sold by financial institutions that is designed to accept and grow funds from an individual and then pay out a stream of payments to the individual at a later point in time.”

Purpose of Annuities

Annuities were originally created by life insurance companies to insure against superannuation, or the risk of outliving one’s income stream. Modern annuity products can also help to pay for such things as disability and long-term care, and they can also serve as tax shelters for wealthy individuals whose incomes are too high to allow them to save money in other retirement vehicles such as Individual Retirement Accounts (IRAs).

History of Annuities

Although annuities have only existed in their present form for a few decades, the idea of paying out a stream of income to an individual or family dates clear back to the Roman Empire. The Latin word “annua” meant annual stipends and during the reign of the emperors the word signified a contract that made annual payments. Individuals would make a single large payment into the annua and then receive an annual payment each year until death, or for a specified period of time. The Roman speculator and jurist Gnaeus Domitius Annius Ulpianis is cited as one of the earliest dealers of these annuities, and he is also credited with creating the very first actuarial life table. Roman soldiers were paid annuities as a form of compensation for military service. During the Middle Ages, annuities were used by feudal lords and kings to help cover the heavy costs of their constant wars and conflicts with each other. At this time, annuities were offered in the form of a tontine, or a large pool of cash from which payments were made to investors. As investors eventually died off, their payments would cease and be redistributed to the remaining investors, with the last investor finally receiving the entire pool. This provided investors the incentive of not only receiving payments, but also the chance to “win” the entire pool if they could outlive their peers. European countries continued to offer annuity arrangements in later centuries to fund wars, provide for royal families and for other purposes. They were popular investments among the wealthy at that time, due mainly to the security they offered, which most other types of investments did not provide. Up until this point, annuities cost the same for any investor, regardless of their age or gender. However, issuers of these instruments began to see that their annuitants generally had longer life expectancies than the public at large and started to adjust their pricing structures accordingly.

Annuities came to America in 1759 in the form of a retirement pool for church pastors in Pennsylvania. These annuities were funded by contributions from both church leaders and their congregations, and provided a lifetime stream of income for both ministers and their families. They also became the forerunners of modern widow and orphan benefits. Benjamin Franklin left the cities of Boston and Philadelphia each an annuity in his will; incredibly, the Boston annuity continued to pay out until the early 1990s, when the city finally decided to stop receiving payments and take a lump-sum distribution of the remaining balance. But the concept of annuities was slow to catch on with the general public in the United States because the majority of the population at that time felt that they could rely on their extended families to support them in their old age. Instead, annuities were used chiefly by attorneys and executors of estates who had to employ a secure means of providing for beneficiaries as specified in the will and testament of their deceased clients.

Annuities did not become commercially available to individuals until 1812, when a Pennsylvania life insurance company began marketing ready-made contracts to the public. During the Civil War, the Union government used annuities to provide an alternate form of compensation to soldiers instead of land. President Lincoln supported this plan as a means of helping injured and disabled soldiers and their families, but annuity premiums only accounted for 1.5% of all life insurance premiums collected between 1866 and 1920.

Annuity growth began to slowly increase during the early 20th century as the percentage of multigenerational households in America declined. The stock market crash of 1929 marked the beginning of a period of tremendous growth for these vehicles as the investing public sought safe havens for their hard-earned cash. The first variable annuity was unveiled in 1952, and many new features, riders and benefits have been incorporated into both fixed and variable contracts ever since. Indexed annuities first made their appearance in the late 1980s and early 1990s, and these products have grown more diverse and sophisticated as well. In 2011, sales of annuities were estimated to exceed $200 billion annually.

Despite their original conceptual simplicity, modern annuities are complex products that have also been among the most misunderstood, misused and abused products in the financial marketplace, and they have had more than their fair share of negative publicity from the media. In the next section we will explore the mechanics of these contracts more thoroughly, along with their basic benefits and the parties involved.

In Section 2, we will examine the basic characteristics inherent in all annuity contracts.


Basics of Annuities

In the introduction, we learned about the history and purpose of annuities. In this section, we will explore the mechanics of these contracts and the basic characteristics that apply to all forms of annuities: fixed, indexed and variable.

The Phases of an Annuity Contract

The life of a modern annuity contract consists of three separate phases: accumulation, annuitization and payout. However, not all of these phases apply to all types of annuities. The specifics of each phase are broken down as follows:

Accumulation Phase – This is always the first phase in the life of any annuity contract. It is the period of growth for the annuity that begins after the initial payment is made. This phase will last until payments are scheduled to begin from the contract. In some cases, the investor continues to make regular additional payments into the annuity during this phase.

Annuitization Phase– Annuitization is really more of a definitive event rather than a phase; it represents the point when the insurance company must begin making payments back to the investor. In the case of a variable annuity, annuitization is also the process in which all accumulation units purchased in the contract are converted into annuity units for payout.

Payout Phase – The final phase of an annuity in which payments are made to the investor. This phase can be very brief or quite long, depending upon various factors including payout amount and the total accrued during the accumulation phase.

It should be noted that annuities will continue to grow even after the accumulation phase is over. Interest or market gains will continue to accumulate inside the contract during all three phases, regardless of whether the contract is fixed, indexed or variable. For example, an investor who makes an initial $100,000 deposit into a fixed annuity contract may continue to invest another $1,000 per month for the next 10 years. The contract will pay the investor a guaranteed rate on the initial deposit and all subsequent additions, both during the accumulation phase and after the contract annuitizes. The balance of funds remaining inside the contract will also continue to earn the guaranteed rate until payout is complete and the contract is depleted. However, not all annuities have an accumulation phase (see below).

Methods of Premium Payment

As mentioned in the previous section, there is more than one way to fund an annuity contract. Most annuity carriers offer products that can be funded in one or all of the following ways:

Single Premium – A single, lump-sum payment that fully funds the contract.

Fixed Premium – A systematic investment program that requires the contract owner to make equal payments of a specific dollar amount at regular intervals over a given period of time until the contract is fully funded.

Flexible Premium – An arrangement that largely permits owners to make premium payments whenever and however they choose, above a certain minimum amount. Owners of flexible premium contracts may still opt to make a systematic investment, but they are free to amend the terms of this program at any time, provided the contract has or will exceed the required minimum investment amount. They are also free to add other money at any time as well.

Methods of Payout

There are several different options that the owner/annuitant can choose from when deciding on the method of income payment. These are:Straight Life –The contract pays out to the annuitant as long as he or she lives, regardless of whether the contract value is exhausted or not. If the contract is worth $50,000 and pays out $1,000 a month, then the annuitant can expect to receive that amount every month for life, even if he or she ends up collecting several times the contract value over the remainder of his or her life. This example demonstrates the purpose that annuities were created for: once the contract has annuitized, then the amount of the contract becomes, for all practical purposes, irrelevant to the annuitant, and he or she can simply count on receiving a set monthly or yearly amount for life, no matter what. If there is any principal remaining upon the annuitant’s death, however, it goes back to the insurance company that issued the contract. Usually, a straight life payout will be higher than any other payout option, but it also has the highest risk of forfeiture upon death.

Life Income With Refund (Or Cash Refund Annuity) – As the name implies, the annuitant receives income for life, but if there is any principal remaining upon death, it goes to the beneficiary instead of back to the insurance company. This removal of forfeiture found in straight-life payout options results in a lower initial actuarial payout to the annuitant.

Life Income With Period Certain –The annuitant receives income for life but is guaranteed a certain number of payments regardless of whether the annuitant lives that long. For example, if the period certain is twenty years, and the annuitant dies after thirteen years, the beneficiary will receive the last seven years of payments. Again, the initial payout is less than with a straight life contract.

Joint Life –This arrangement is just like straight life, except that there are two annuitants, and payments will only continue as long as both of them are living. Upon the death of either, payments will cease. (This option is very seldom selected, for obvious reasons.)

Joint Survivor Life (Or Joint And Survivor Annuity) – This is a much more popular option as payments will continue as long as both annuitants are living. Only upon the death of the second annuitant does the contract pass to the beneficiary.

Period Certain –This is probably the simplest of all options. Payments simply continue for a certain period of time, then stop, at which point the contract value is exhausted.

Joint Survivor Life With Period Certain –A combination of the Joint Life and Joint Survivor Life options. Payments continue until both annuitants are dead, at which time the beneficiary will receive the remainder of the contract if the death of the second annuitant transpired within the period certain.

Fixed Amount –Also a very simple method, the annuitant simply receives a fixed payment until the contract value is exhausted, regardless of when that will be. If the annuitant dies before the contract is depleted, the beneficiary receives the remainder.

Interest Income Only – The annuitant receives all or part of the interest or gain from the contract without depleting the principal. Technically, this isn’t an annuity option, but merely a systematic withdrawal.

Annuitants seldom choose any kind of straight payment option that has no period certain, but many insurance companies offer flexible payout options that can change even after annuitization to allow contract holders a greater freedom in how they receive their income streams. Annuitization is also not always required; some owners opt never to annuitize their contracts in order to retain greater freedom over the distribution.

Timing of Payout

All annuities can be divided into one of the following two categories when it comes to timing of annuity distributions:

1. Immediate Annuities – These contracts do not have an accumulation phase before payout. As their name implies, immediate annuities begin making payments back to the owner as soon as the contract is in force.

2. Deferred Annuities – The principal invested in these contracts will grow for a set period of time until annuitization or systematic withdrawal.

In Section 3, we’ll explore the advantages, disadvantages, distributions and taxation of annuities, as well as the parties involved.


Advantages And Disadvantages

In the last section, we explored the phases of annuities and how contributions are made to them and distributions made from them. This section covers the advantages and disadvantages of annuities and the parties involved, as well as how they are taxed.

Involved Parties

There are four key parties involved in any annuity contract. They are listed as follows:

1. Contract Owner – This is the person who purchases the contract and pays the premiums. Usually, the contract owner is also the annuitant, but not necessarily. There can also be more than one owner on a contract; all forms of joint tenancy are permitted for annuity ownership. Trusts and corporations can own annuities as well.

2. Annuitant – The person named in the annuity contract who is scheduled to receive the annuity payments.

3. Beneficiary – The person who will receive the funds in the event that the annuitant/owner dies before the funds are redeemed.

4. Insurance Carrier – The life insurance company that holds the funds, administrates the contract and is responsible for making payments to the beneficiary.

Annuities are similar to life insurance in that it is impossible (and illegal) for the same person to be listed as owner, annuitant and beneficiary on a given annuity contract.

Advantages of Annuities

Annuities are among the most unique types of investments available, and there are many reasons why investors look to them as a key retirement savings vehicle. Some of the key benefits provided by annuities are:

Tax Deferral – Annuities stand alone as the only investment that is inherently accorded tax-deferred status. All money invested into annuities of any kind grows tax-deferred until it is withdrawn. Annuities have no limit on the amount of money that can be placed into them, and there are also no income phase out schedules that apply to contract owners or annuitants. This gives them a substantial advantage over Individual Retirement Accounts (IRAs) and qualified plans for wealthy investors who can shelter millions of dollars from taxation inside these contracts.

Guaranteed Payout – Annuitants that choose any type of life payout option can rest assured that they will receive some sort of payment until they die, even if they completely exhaust the value of the contract beforehand.

Protection from Probate and Creditors – Annuity contracts are generally exempt from creditors in most cases and are unconditionally exempt from probate proceedings nationwide. Exemption from creditors can vary somewhat from one state to another; for more information on this matter, call your state insurance commissioner.

Exemption from FAFSA Asset Status – Parents and students who apply for financial aid do not have to list any annuity contracts that they own as assets on the Free Application Of Student Aid (FAFSA) form. This can obviously make a huge difference in the amount and terms of loans and grants that the student is eligible to receive.

Disadvantages of Annuities
Despite their benefits, annuity contracts can also present several disadvantages to investors, although they will vary considerably from one investor to another and depend upon various factors. The main drawbacks of annuities are listed as follows:

Costs and Fees – Annuities are one of the most expensive types of investments available in the financial marketplace. A breakdown of the fees for each type of annuity will be provided in later sections.

Illiquidity – Most annuity contracts charge stiff surrender penalties for early withdrawal, plus a 10% premature distribution penalty to investors who take withdrawals before age 59 ½ (see below).

Complexity – Although annuities can provide tremendous benefits for investors when used correctly, they are by nature complex instruments, especially indexed and variable contracts. Even experienced investors have difficulty understanding these vehicles, and a great deal of education is required in order to sufficiently educate clients in how they work.

Taxation – All withdrawals received from an annuity contract that are not considered to be a return of principal are taxed as ordinary income, regardless of the holding period of the contract (see below). There is no chance to qualify for capital gains treatment.

Annuity Withdrawal Penalties

As mentioned previously, most annuity contracts have a back-end declining surrender charge schedule that usually expires anywhere from one to ten years from the date of purchase. The surrender charge in the first year can be as high as 10 or even 15%, then declines by a percent or two each year before expiring. However, many annuity carriers allow investors to access some or all of the funds in their contracts under certain conditions, listed as follows:

Hardship or Disability – Contract owners who experience a medical or other emergency can apply for a partial or total withdrawal under these circumstances. In many cases the annuity carrier will permit the owner to withdraw some or all of the contract value at no charge.

Partial Withdrawal -Many annuity contracts allow owners to access a portion of their contract values (usually around 10%) each year for any reason. This window generally remains open until the surrender charge schedule expires.

Free Look Period – Virtually all annuity contracts have a free look period, during which the owner can return the contract for a full refund. For example, according to the SEC, variable annuities have a free look period of ten or more days.

Taxation of Annuities

Annuities stand alone in the investment world as unique vehicles in which all interest and other earnings grow tax-deferred until they are withdrawn. However, no tax deduction of any kind can be taken for contributions to annuities, unless the contract is purchased inside an IRA or qualified plan and funded with contributions to the plan or account. If this is the case, all distributions taken from qualified annuities are fully taxable as ordinary income because of the contribution deduction. All normal annuity distributions from non-qualified contracts consist of a combination of earnings and principal. Therefore each distribution is only partially taxable, as the portion of principal that is returned in each payment is tax-free. The taxable portion of annuities is calculated by using the Exclusion Ratio, which is a fraction that divides the amount of principal invested by the total value of the contract. If an investor purchases a $50,000 annuity and it grows to $150,000 after 30 years, then a third of each payment is considered a tax-free return of principal. The remaining balance is taxed as ordinary income. After the investor has recovered all of his or her principal from the contract, 100% of each remaining payment is taxed as ordinary income.

Distribution Penalties

Annuities have the same 10% early withdrawal penalty for investors under age 59 ½ as IRAs and qualified plans. This penalty will be assessed on top of any early withdrawal penalties charged by the contract. Annuitants must also begin taking distributions at age 70 ½, regardless of whether the contract is inside an IRA or qualified plan or not. Failure to do so will result in a 50% penalty being assessed upon the amount of distributions that should have been taken.

In the next section, we will examine the various parties that market annuity contracts and the regulators who oversee them.

Marketing And Regulation

Marketing of Annuities

Although only life insurance companies can issue annuities in the United States, the investment vehicles are marketed by many different types of organizations and individuals. Some of the key entities who offer these products include:

  •     Banks
  •     Life insurance agents and brokers
  •     Stockbrokers and Registered Investment Advisers
  •     Financial planners
  •     Estate and trust officers
  •     Mutual fund companies

Licensing Requirements

Any person directly involved in the selling and marketing of annuities must carry an active life insurance license, regardless of which of the above categories they are in, plus a securities license if dealing with variable contracts. Many personal bankers are licensed to sell fixed annuities to bank customers, although banks can no longer directly issue annuities themselves.

Controversial Marketing Practices

Despite their advantages, annuities are among the most misunderstood and mis-marketed financial products in existence. Although they are designed as retirement vehicles, they are sometimes used as one-size-fits-all investments. Clients and prospects should be aware that most brokers and planners are paid a much larger commission on annuity sales than just about any other type of product that they can sell. Although the standard range of payout is usually about 4-6% for fixed and variable contracts, some indexed annuities pay commissions of up to 12-15%. For this reason, many financial professionals are biased toward selling these products to clients, regardless of suitability or other factors.

One marketing practice that has received a fair amount of negative publicity in both the financial and mainstream media pertains to indexed annuities. Some agents have aggressively pursued the senior market with long-term, high surrender charge indexed annuity products, into which they attempt to put virtually all of their clients’ liquid assets. This practice has been and is being closely scrutinized by state regulators nationwide. Another debate rages over the practice of funding IRAs and qualified plans with fixed and variable annuity contracts. This strategy is controversial because the tax-deferred feature of annuities is irrelevant inside a plan or account that is already tax-deferred. This issue will be covered in greater detail in a later section.

State Regulation

The annuity marketplace is primarily regulated at the state level because all life insurance companies, and all agents and brokers who sell annuities, must have a life insurance license issued by their state of residence. Fixed and indexed offerings are regulated almost solely at this level because they are not considered securities and therefore fall outside the jurisdiction of the Securities and Exchange Commission (SEC). Every state has an insurance commissioner that oversees all of the life insurance and annuity business done within the state. The insurance commissioner’s office also has a disciplinary record of every registered life insurance agent and broker in the state, and investors can call the commissioner’s office to get the background on any person who sells them annuities. They can also call here to register a complaint about their agent or contract.

Federal Regulation

In addition to state regulation, annuities are ultimately defined and governed by the Internal Revenue Code (IRC). The SEC and FINRA oversee the variable annuity market as well, since they require a securities license to be sold. Indexed annuities are presently still considered a type of fixed annuity, but there is a definite possibility that these vehicles will eventually be classified as securities due to their market participation.

In the remaining sections of this tutorial, we will examine the three major categories of annuities:

1. Fixed Annuities – Appropriate for conservative investors who want or need a guarantee of principal and interest.

2. Indexed Annuities – Appropriate for moderate investors who want to participate in the markets without risking their principal.

3. Variable Annuities – Appropriate for moderate to aggressive investors who are willing to risk their principal while saving for retirement. These contracts can also be used by conservative investors with the purchase of guaranteed income riders.

We will examine fixed annuities in Section 5.

Fixed Contracts

In the previous two sections, we covered the basic characteristics common to all annuity contracts. In this section we will explore fixed annuities and the features unique to them in more detail.

What Is a Fixed Annuity?

As its name implies, a fixed annuity is a type of contract that guarantees to return both the investor’s principal plus a fixed rate of interest. These contracts essentially function much like Certificate of Deposits (CDs), except that they grow tax-deferred.

Safety of Principal

Fixed annuities are among the safest investments available, almost on a par with CDs. Although they are not backed by Federal Deposit Insurance Corporation (FDIC) insurance, fixed annuity carriers are required by state law to back their outstanding annuity contracts with cash reserves on a dollar-for-dollar basis. If an annuity carrier becomes bankrupt or insolvent for any reason, then reinsurance groups will step in and cover most or all of any investor losses. Although it has happened on occasion, it is extremely uncommon for investors to lose money in fixed annuities. However, investors who do get caught holding a contract with an insolvent company should be prepared to wait for a while to get their money back, just as bank customers at insolvent banks must wait to get their cash back from the FDIC.


The history of fixed annuities essentially mirrors the general history of annuities described in the introduction. All early annuities in any form were fixed annuities; they were the only kind of annuity that existed until 1952.

Interest Rates

One of the chief benefits of fixed annuities is the rate of interest that they pay. Fixed annuity rates tend to be slightly higher than those of CDs, treasuries or savings bonds. This is because insurance carriers invest their clients’ assets into a portfolio of long-term bonds and assume all of the naked risk from them, passing the majority of the earnings on to the contract holders. Many fixed contracts attempt to lure investors by offering an initial “teaser” rate that will eventually drop to a much lower rate for the duration of the contract. For example, a five-year fixed annuity could offer a first-year rate of 6%. However, the contract might only pay 3% for the remaining four years. Risk of Default and State Guaranty Associations
Investors who shop for the best fixed annuity rates should also take care to check each carrier’s financial rating. Insurance companies are rated the same way as banks, stocks, bonds and mutual funds. The rating system varies depending upon the rating company, but the highest rating will be something like AAA or A++. Most investors should probably stick with insurance companies that have at least an A+ or equivalent rating. Although it is rare, insurance carriers can and do become insolvent on occasion. When this happens, state guaranty associations will step in and insure every annuity contract with the insolvent company up to a certain dollar limit, such as $100,000, $250,000 or more. However, investors should be prepared to wait for at least several weeks to get their money back, and in some cases it can take much longer. Each state guaranty association is also a member of the National Organization of Life and Health Insurance Guaranty Associations. Although virtually all life insurance companies are required by state law to join these associations in order to receive their protection, the public at large is largely unaware of their existence. This is because state laws forbid the use of this protection as a marketing incentive, unlike banks and credit unions which proudly display their federal insurance to their customers.

In Section 6, we will examine indexed annuities.


Indexed Annuities

In the last section, we examined fixed annuities and the type of investor for whom they are appropriate. This section covers indexed annuities, one of the newer offerings in the insurance marketplace. These contracts mirror fixed annuities in that they offer a guarantee of principal and a set term, but they do not pay a fixed rate. Indexed annuities, as the name implies, will invest in one of the major stock market indices, usually either the S&P 500 or the Nasdaq (although the latter option has diminished considerably since the dotcom bubble burst). The contract owner receives a share of the market’s growth (if there is any), while avoiding any possible downside risk. There are several different methods that companies use to credit their contract holders with market gains, including:

Annual Reset – The annuitant is credited with a return each year that the market exceeds its previous year’s level. If it does not, then no gain is credited, but no loss it taken either.

Point to Point – Measures the change in the index from the start of the contract to the end of the term (which is usually five years). In a continuous bull market, point to point annuities will usually offer the highest returns. High Water Mark with Look Back – A simple design that will “look back” over the term for the highest anniversary value over the term.

Many indexed annuities base increases on average values of the index over a term. An annual reset contract may calculate index gains on the average value of the index between anniversary dates, as opposed to the anniversary value itself. Some fixed contracts also charge a spread or asset fee that is subtracted from the total return realized. Other contracts also pay based on an index’s average value over a given period of time instead of its closing value, which can reduce the amount credited to the investor.

There are several other parameters that most indexed annuities contain. One of these is a guaranteed fixed rate that will pay out if the market offers no net gain during the contract term. For example, if no market gains of any kind were realized during the term, then the contract owner might get a 3% increase. The rate that will be paid in this scenario will generally be much less than the prevailing fixed annuity rates and could most accurately be described as a consolation rate. It will provide the owner with a nominal gain in return for keeping the contract invested with no gain for the full term.

Another major characteristic of indexed annuities is the rate cap. While indexed annuities are designed to offer market gains with no downside, there is a price to this security. If the market jumps by 30% in one year, it is unlikely that the contract owner will enjoy the full amount of this gain. Usually, most indexed contracts stipulate a maximum amount of gain (or cap) that may be paid to the owner in a given year. The excess gain goes to the insurance company to cover costs. This type of restriction may also manifest as a percentage limitation on market gains. Instead of the absolute kind of limit imposed by a cap, the investor may only get 70% of the market gain in a given year, although there may not be any ceiling on the amount of gain. If the market goes up 30% in one year, then the investor will get 70% of that 30% gain, which comes to 21%. In some cases, both types of restrictions will be in the same contract.

Behind the scenes, insurance companies are able to fund indexed annuities by investing the contract proceeds in a combination of derivatives and guaranteed investments. If the market goes up, the derivatives will increase enormously in value, thus providing the upside necessary to credit the contract owners accordingly. If the market decreases or stays flat, the guaranteed investments will provide the consolation interest instead.

We will examine variable annuities in Section 7.


Variable Annuities

In the last section, we examined indexed annuities and their components. In this section, we will examine the third major category of annuities. Traditionally, variable annuity investors have been subject to the same market risks as investors of taxable stock and bond funds, but in recent years many different features have become available within variable contracts that have reduced, or in some cases even eliminated, this risk.

Mechanics of Variable Annuities

Variable annuities are the most complex type of annuity in the market today. In fact, they are one of the most complex investments in existence, probably second only to variable universal life insurance. In a nutshell, these contracts consist of a bundled offering of mutual fund subaccounts that grow under a tax-deferred umbrella. The groups of subaccounts offered and the specific annuity products that they are in will vary according to the agreements made between the fund families and insurance companies. Most of their complexity resides in the various riders and other benefits that are commonly offered in modern contracts. These riders are aimed at reducing market risk through various means. For example, many variable annuities offer a rebalancing feature, where the initial asset allocation between the various funds offered within the contract is preserved by automatically reallocating the growth of each fund from the higher-yielding funds to the lower performing ones. Over time, this can be an extremely effective method of profiting from normal market cycles among various sectors. Dollar-cost averaging (DCA) programs are another method of increasing return while decreasing risk. Many companies will offer a high guaranteed rate of interest in a fixed account for a short period of time, such as six months or a year. The contract proceeds are initially invested in this fixed account and then moved into a preselected allocation of funds in equal shares over the prescribed period of time.

Many companies have gone even further in providing their clients with peace of mind while investing in the market. There are now riders available inside many of the contracts offered by major carriers that will guarantee not only the investor’s principal, but also a set rate of growth. Furthermore, if the underlying funds outperform this rate, then the investor can reap the difference in growth between the two as well. However, this guarantee comes at a price, which will be examined more closely in an upcoming example.

The investor is not the only party privy to security features within the contract. If the annuitant dies, most beneficiaries in modern contracts will receive the highest of the current contract value, the highest anniversary value or a hypothetical amount based upon a fixed interest rate if the current value of the contract is less than that. Any withdrawals that the annuitant received are, of course, subtracted from the calculation of these amounts.

The various features that variable annuities offer come with corresponding charges that must be deducted from the contract value, either on an annual or quarterly basis. These fees cover a number of expenses, and can be broken down as follows:

Mortality and Expense Charges – These are standard base fees found in all variable annuities. These fees covers the death benefit provisions commonly found in most contracts.

Contingent Deferred Sales Charge – This is a back-end charge that declines to zero over time, usually by 1% per year over five to 10 years. This charge provides a substantial deterrent to an investor seeking to withdraw funds from the contract until a reasonable period of time has elapsed. However, most contracts today offer a free withdrawal window of 10% per year, as well as total liquidity provisions for such things as nursing home expenses. But if the contract owner is below age 59 ½, then the 10% early withdrawal penalty assessed by the IRS still applies.

Administrative Service Charge – This charge covers the money management features discussed earlier, such as asset rebalancing and dollar-cost averaging, as well as confirmation and monthly statements.

Contract Maintenance Charge – This cost is usually $15-$50 and is for the general maintenance of the contract. It covers the cost of issuing the contract, along with general administrative costs.

Fund Expenses – Fees charged by the mutual funds within the annuity contract and passed to the contract owner. They include 12b-1 fees and other management-related fees.

It is clear that the various features offered within today’s variable annuity contracts do not come for free. Normally, the average contract owner can expect to pay 2-3% per year in combined fees, which are deducted on either a quarterly or annual basis from the contract value. The number of riders that are chosen will determine the exact percentage that is assessed.

To better illustrate this concept, let’s examine a hypothetical annuity contract where the investor chooses a normal array of riders and benefits.

Billy Bones buys a $100,000 contract with a major insurance carrier. He decides to participate in the dollar-cost averaging special which pays 7% in the fixed account over a one-year period during which $12,500 is moved monthly into the allocation of funds that he has selected. He has also opted for the 7% guaranteed minimum benefit rider, which guarantees that he will receive at least 7% growth over the life of the contract as long as he adheres to certain withdrawal provisions. Finally, he adds the asset rebalancing feature as a growth and safety measure. Here is a breakdown of what these features will cost him:

Mortality & Expense Charge 1.4% $1,400
Contract Maintenance Charge $0 Waived for contracts of $100,000 or more
Mutual Fund 12-1 fees 0.75% $750
Minimum Income Rider 1.25% $1,250
Total 3.4% $3,400

This total is fairly high in terms of relative fee structure. For example, most professional money managers (meaning Registered Investment Advisors, who trade individual securities directly for clients) charge less than this (often less than half this amount, in fact) per year.

Purchasing the minimum income rider should also have an effect on the investor’s investment strategy. Since the rider guarantees a rate of 7%, the mutual fund portfolio should therefore be invested aggressively. The reasoning is that since a conservative rate is already guaranteed, there is nothing to be gained by investing in funds that will yield that amount or less.

Plus, the funds already have a 3.4% annual charge to overcome as it is, so a 10.4% return is needed just to break even with the guaranteed rate. This should direct the investor to look at funds that have historically yielded 12-14% per year over time, such as small cap funds, some international funds or perhaps a developing sector fund, like a healthcare fund. That way, there is at least some chance of reaping excess growth above and beyond the 7% guarantee.

But investors should carefully weigh the income withdrawal provision against their income needs during the payout phase. Guaranteed income riders often require annuitization, which irrevocably locks the contract into a set payment schedule that cannot be altered. This means that if the investor’s income needs change after payout begins, he or she cannot alter the income from the annuity to accommodate those needs. Therefore, guaranteed income riders need to be considered carefully from several angles by an investor before being chosen.

It should be noted that some insurance carriers are now starting to offer unbundled benefits within contracts, thus allowing investors to choose the riders and benefits that they think they will need and not be forced to pay for other provisions that they think are unnecessary.

Use of Variable Annuities in Retirement Plans

This issue deserves special attention for two main reasons. First, a substantial percentage of all retirement plans, qualified or otherwise, are invested in annuity contracts. Second, there is some controversy about whether annuities belong within a tax-deferred retirement plan to begin with.

Many retirement planners and insurance advisors use annuities as the de facto investment vehicle for funding any type of retirement plan, regardless of whether it is group or individual, qualified or nonqualified. Virtually all 403(b) plans are invested in Tax Sheltered Annuities. But what is to be gained by doing this? Annuities are inherently tax-deferred by nature, just as retirement plans and accounts are. There is no such thing as double tax-deferral! So why is this practice so common? This question has more than one answer. The response usually given by the insurance industry is that annuities offer many other features and benefits besides tax-deferral, such as money management features and insurance protection. This latter feature has been substantially developed over the last five years via the guaranteed contract riders discussed earlier. Admittedly, these options do allow for a guaranteed stream of retirement income that conventional retirement plans and accounts alone cannot duplicate, but they come with a cost that must be borne by all participants, and not just those whose need for income happens to fit the guaranteed option riders offered within the annuity contract.

It is important to note that inside a retirement plan, when all possible investment choices are offered within a variable annuity, then all plan participants are forced to pay the commensurate contract fees. Many participants do not need or want a guarantee of principal, and while it is of course possible to waive many of the protection riders, there are certain mortality and expense fees that cannot be avoided. As stated previously, these fees effectively reduce the overall return that participants will realize from their plans over time. Furthermore, most plan participants do not understand enough about the plans they participate in to separate the plan from the annuity contract or the investment. Most advisors will simply tell participants that they are investing in mutual funds. They are, of course, but within the variable annuity contract that the plan has been placed in. In reality, there is a large percentage of plan participants who do not even know that their retirement plan is contained within an annuity contract at all, thinking that the fees and expenses are just part of the plan’s administration costs. It must also be noted that both the SEC and FINRA are taking an increasingly dim view of annuities within tax-deferred accounts. In fact, FINRA recently gave notice to all financial, retirement and insurance planners, brokers and agents that they are now required to notify plan participants that the annuity contract within their retirement plan is technically unnecessary. It is likely that this issue will continue to receive attention from both regulatory bodies and the financial media for some time to come.


Though annuities started out as fairly simple investing and income vehicles, they’ve evolved into complex products that can be misunderstood and misused in the financial marketplace. Still, with the right research and due diligence, you can use annuities to give you an income stream that you can count on throughout your retirement. With the shaky state of pensions and Social Security, an annuity might be the perfect retirement income vehicle for you. Before you get involved, however, it’s important to consult with a financial specialist to ensure that it’s the right choice for you.

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