Annuities — Investing for Future Retirement

An annuity is a contract between an investor and an insurance company.  “In exchange for a lump sum or series of payments, the insurance company agrees to make regular payments back to you for a fixed period of time (e.g., 20 years) or for the life of you or you and your beneficiary,” says Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely).

The payments can begin immediately or at a specified date.  Typically annuities offer tax-deferred growth of earnings and in most cases they may offer a death benefit that will pay your beneficiary a guaranteed minimum amount, such as your total purchase payments.  Annuities are most often purchased for future retirement income.

Swanson explains there are three types of annuities – fixed, variable, and equity-indexed.  With a fixed annuity the insurance company guarantees a fixed rate of interest for a specified period of time (e.g., a period of 1 to 5 years after purchase) and then may be adjusted annually according to market conditions.  A fixed annuity is an insurance product and so is regulated by the state insurance commission. 

With a variable annuity you select how you want to invest your payments from a range of investment options – typically mutual funds.  The rate of return and the amount of the periodic payments you will eventually receive may vary depending on the performance of the investment options you have selected.  Variable annuities, although issued by insurance companies, are considered securities due to the risk being born by the purchaser.  So, these products are regulated by the Securities and Exchange Commission (SEC), the National Association of Security Dealers (NASD), and state insurance commissions.  All of these regulators require that the product be suitable for the purchaser. 

There are several things to be aware of before you invest in a variable annuity, according to Swanson. Withdrawals can be made after age 59-1/2  but the withdrawals are taxed as ordinary income at your regular tax rate, which can be as high as 35 percent,as opposed to long-term capital gains taxed at 15 percent.  Withdrawals prior to age 59-1/2 are subject to income tax and a 10 percent penalty.

“The fees associated with variable annuities can be a concern,” Swanson says.  “You may pay an annual fee on the variable annuity subaccounts that is higher than the average mutual fund fee.  Also there may be sales charges on the subaccounts and an annual contract charge.  Additionally, surrender fees should be considered.  Your money is locked up for several years and if you withdraw prior to that time, you may pay a surrender fee that may be 10 percent or more.”

If you die with money remaining in an annuity, your beneficiary will have to pay any taxes not yet paid.  “Compare this with owning a mutual fund where the beneficiary may cash them in and pay no tax,” Swanson adds.

“If after considering the pros and cons you still want to invest in a variable annuity,  it is important to buy one with low costs and good investment options,” Swanson says.  The SEC requires that an investor be given a prospectus prior to investing in a variable annuity.  “Read it carefully because it will give you important information including fees and other charges, investment options, death benefits, and annual payout options.”           

The third type of annuity, an equity-indexed annuity, is a more complicated product. The interest earned is linked to a stock index such as the Standard & Poor’s 500 Composite Stock Price Index (the S&P 500).  Using a formula, the interest is calculated based on changes in the index to which the annuity is linked. This annuity pays a minimum guaranteed rate of interest, but it may be higher if the index increases.   For example, an equity-indexed annuity might give you 85 percent of the annual increase in the S&P 500 with a maximum of 12 percent a year and a minimum of 3 percent. Due to the fixed rate, these products are regulated by state insurance commissions.

According to Craig Goettsch, director of Investor Education for the Iowa Insurance Division, investors should always understand the product they are purchasing and the long term nature of the purchase when considering any annuity.  “Always ask your agent for an explanation of anything you don’t understand.  Review the contract and compare information for similar contracts, as well as comparing products.”

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The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors.  It is funded by a grant from the Investor Protection Trust (IPT).  The IPT is a nonprofit organization devoted to investor education.  Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions.  www.investorprotection.org.