When planning for retirement-readiness, know your client’s investment optionsA new Issue Brief from the American Academy Of Actuaries takes a deep look at today’s annuity options and strategies. Excerpts are presented below. Access the full report at www.actuary.org.
There are many different types of insured annuities in the U.S., but they are all often simply called “annuities,” which can cause considerable confusion. This issue brief provides clarity by explaining the various types of annuities available to individuals and their potential uses, as well as discussing some relevant tax implications.
The scope does not include group annuities that are paid from defined benefit pension plans nor annuities purchased by a pension plan as a means of transferring the risk (“pension risk transfer”) to an insurance company. Although this issue brief discusses general features of annuities, it is important to note that specific features of any individual product will vary by company.
Let’s start with a few definitions of terms that will be used throughout the paper:
Account Value is the value of a deferred annuity (discussed later). It comprises the amount of money paid into the annuity by the owner, plus any interest or investment results (positive or negative) earned, with adjustments (expense charges and charges for optional benefits, which are discussed later).
Annuitant is the person during whose life the payments are made. For example, if benefit payments will be made for the rest of Mr. Smith’s life, he is considered the annuitant. However, if the owner is Ms. Smith, the payments would go to whomever Ms. Smith specifies for the term of Mr. Smith’s life.
Beneficiary is the person or entity (e.g., an estate or trust), if any, named by the owner to receive the value, if any, remaining in the annuity upon the death of the owner and/or the annuitant. Not all annuities have a benefit payable upon death.
Crediting Interest Rate is the interest rate credited to the account value, where applicable. The rate is declared by the insurer in advance, usually at the beginning of each contract year.
Owner generally is the person or entity whose money is used to buy the annuity; however, other arrangements are possible. The owner is responsible for paying any taxes on annuity payouts. The owner maintains any revocable rights in the annuity, such as to change the person or entity to receive the payments or who is the named beneficiary. The owner is typically also the annuitant, but not in every situation. In addition to a person, a corporation, trust, or other legal entity may also be an owner.
There are two primary types of income annuities. Annuities that begin payments within one year are called Single Premium Immediate Annuities (SPIA); annuities that defer payments to a future date are called Deferred Income Annuities (DIA).
Single Premium Immediate Annuity—SPIA
Fixed SPIAs: With a fixed SPIA, the purchaser pays a single premium in a lump sum to the life insurance company. The annuity payment is fixed and guaranteed by the insurance company. The annuity may not be redeemed for cash. The owner chooses the frequency of payments and the payment option (addressed below) at the time of purchase. The insurer makes benefit payments typically monthly, although they could be made quarterly, semiannually, or annually. The benefit payment option cannot be changed after purchase. Each of these choices, along with other factors, such as age and sex of the annuitant(s), determine the amount of the benefit payments.
Additionally, there are features available in the marketplace wherein benefit payments increase by a set percentage, typically between 2% and 3% per year, compounded annually, to mitigate the impacts of inflation. Including this feature will increase the price of the annuity, assuming the same initial benefit payment.
Variable SPIAs are similar to fixed SPIAs, but the periodic payments fluctuate with the change in value of the underlying investments. The owner selects an Assumed Interest Rate (AIR), which influences the amount of the initial income payment and determines what portion of the change in the value of the underlying investments is reflected in the changes in future payments. A high AIR creates a large initial income payment but reduces future increases, and vice versa. Whereas a fixed SPIA provides a predictable income, a variable SPIA provides an income that could initially be greater or less than that with a fixed SPIA, depending upon the AIR, and fluctuates over time, depending upon whether the actual investment return exceeds or falls short of the AIR.
The insurance company makes benefit payments as long as the annuitant is alive, even if that is to age 100 or older, thereby transferring the financial risk of the annuitant living a long life to the insurance company. This option is referred to as “life contingent” because payments are contingent on the annuitant still being alive. Among the life contingent payment types, this is the least expensive. The price of a life contingent annuity is dependent on the interest rate environment at the time of purchase as well as the age and sex of the annuitant (although annuities in all defined benefit and defined contribution retirement plans covered by the Employee Retirement Income Security Act of 1974 [ERISA], like 401(k) plans, as well as other annuities in some states, are required to be unisex). While a life-only annuity can address longevity needs, some people are uncomfortable buying one because of the possibility of an early death, in which case there are no residual benefits, and the life insurance company retains any remaining value. Other payment options (described below) can protect against that possibility, although they involve additional initial cost, assuming the same monthly payment.
Period Certain Only:
The insurance company makes payments for a fixed period of time (the period certain), say, 10 or 20 years, whether the annuitant is alive or not. If the annuitant dies before the end of the certain period, payments continue to the named beneficiary as scheduled. The price of this option is dependent upon the interest rate environment at the time of purchase but is not affected by the age and sex of the annuitant or the named beneficiary. While this may provide a greater income than a life-only option, it does not address longevity risk for a person who lives to a high age.
Certain and Life:
This is a combination of the previous two payment options. The insurance company makes payments as long as the annuitant is alive, but if the annuitant dies during the certain period, payments continue to the named beneficiary until the end of the certain period. For example, if Ms. Smith buys a 10-year certain and life annuity making monthly payments and then dies in four years, monthly payments will continue to her named beneficiary for six years after her death. The price depends on the age and sex of the annuitant (but not the named beneficiary), the length of the certain period, and the interest rate environment at the time of purchase. The monthly income will be less than that from a life-only option because of the income continuation after death. This option can mitigate the concern of a purchaser by reducing the value that could be lost at
This option is almost the same as a certain and life annuity, except that the certain period is set equal to the premium paid divided by the monthly payment. For example, Ms. Smith pays $100,000 to buy an installment refund annuity paying her $500/month. The certain period would be 16 years and 8 months because that is how long it takes for the sum of the $500 monthly payments to equal the premium ((16 x 12) + 8) x $500= $100,000. The price depends upon the same factors as the certain and life option. The monthly income will be less than that from a life-only option because of the income continuation after death. This option can mitigate the concern of a purchaser by reducing the value that could be lost at death.
This option is similar to an installment refund annuity except that if the annuitant dies before the sum of the benefit payments made at least equals the premium, a lump sum payment will be made to the named beneficiary equal to the premium paid less the payments previously received. For example, Ms. Smith pays $100,000 to buy a cash refund annuity paying her $490/month. If she were to die at the end of the fourth year, she would have received 48 payments totaling $23,520. Her beneficiary would receive a single payment of $76,480 ($100,000-$23,520) upon her death. The monthly income will be less than that from a life-only option because of the payment after death. This option can mitigate the concern of a purchaser by reducing the value that could be lost at death.
Joint and Survivor:
The insurance company makes payments contingent on the lives of two people and the price depends on the age and sex of both of them. This helps protect income for a couple. Payments typically remain level as long as either of the two people are alive, or they can decrease upon the death of either or just a specified one of the annuitants. For example, Mr. and Mrs. Smith buy an annuity to pay them $1,000/month while they are both alive. However, they believe that when one of them passes away, the surviving spouse will need only $750/month. This would be referred to as a 75% joint and survivor annuity. 100%, 75%, and 50% survivor are all common options.
Deferred Income Annuity (DIA)
(Qualifying Longevity Annuity Contract [QLAC] if in a tax-qualified retirement plan) A DIA is similar to a SPIA, except those payments begin at some point beyond one year from the date of purchase, generally five to 20 years in the future. When payments begin at an advanced age, such as 85, a DIA is often referred to as longevity insurance. Its primary use is to provide a lifetime income if the annuitant lives beyond the deferral period and lives a long life. A DIA might be preferable to a SPIA for people who think they are likely to have enough money for a certain number of years in retirement but are concerned about what might happen if their other investments are exhausted or perform poorly.
The deferral of benefit payments can result in a significantly higher monthly income once payments begin than under a SPIA for the same premium.
A risk is that if the annuitant dies between the date of purchase and the start of income payments, no benefit payments are made. To mitigate against this risk, people can add a death benefit that would provide a payment to a named beneficiary equal to the premium in case of death before payments begin; however, this adds to the cost. In today’s interest
rate environment, adding this death protection raises the cost by about 11% for a DIA purchased at age 65 with income beginning at age 75; if the income begins at age 85, the cost increase is about 26%.
Deferred annuities have two distinct phases: an accumulation phase and a payout phase. During the accumulation phase, the purchaser’s contributions accumulate with interest (or the net investment return in a variable annuity). During the payout phase, the contract owner receives either a single lump sum payment or a series of payments such as the payment options described above. Deferred annuities are different than deferred income annuities, which solely provide an income.
Deferred annuities can be purchased with pre-tax funds, personal savings after-tax funds, or funds in a Roth account. The various types of deferred annuities (Fixed, Fixed Indexed, Variable, and Structured Variable) are differentiated by how the value of the annuity grows and the degree of investment risk borne by the owner. Some deferred annuities increase in value based on fixed interest rates and others based on the performance of the underlying investments or an index, or a combination of these. The NAIC Buyer’s Guide for Deferred Annuities includes more information about deferred annuities.
Costs of Deferred Annuities
The costs for deferred annuities vary from product to product. In some cases, all the costs are embedded in the interest crediting. This structure is common with fixed annuities and FIAs, where the crediting interest rate or the basis for the indexed credits is less than what the insurance company expects to earn on the invested premiums. This margin provides the insurance company with the funds needed to pay all its expenses and earn a profit.
Some deferred annuities, such as variable annuities, will often have explicit charges because these products have no crediting interest rate to adjust. The charge will be a percentage of the account value and will be deducted periodically. Each subaccount in the separate account will generally have its own investment management charge. Finally, the annuity owner may have to pay a surrender charge (discussed above) upon withdrawing funds or canceling the contract.
Read the full issue brief here.