An Annuities Primer
by Bill Willard
Annuities are long-term investment tools for supplementing
retirement income. There are no IRS-imposed annual contribution limits, and
annuity earnings grow tax-deferred until the funds are withdrawn or paid out as
income.
Though popular among today’s aging Baby Boomers and members of the Mature or
“Senior” markets, annuities can be traced back to ancient Greece. The term
“annuity” comes from the Greek word “annus”—or “year”—and refers
to annual income payments. Similarly, in ancient Rome citizens would make
one-time payments to a contract called “annua” in exchange for lifetime
payments made once a year.
In 17th century Europe, annuities were used as fundraising devices by
governments to finance their ongoing wars with neighboring nations. These
governments would offer “tontines,” which promised payments into the future
to those who bought shares.
In the 18th century annuities were introduced to North America, with private
insurance companies selling insurance and annuity contracts to individuals
wanting to avoid outliving their resources, In 1759 in Pennsylvania a company
was formed to benefit Presbyterian ministers and their families. The ministers
would contribute to a fund, in exchange for lifetime payments. In 1912, the
Pennsylvania Company for Insurance on Lives and Granting Annuities became the
first American company to offer annuities to the public.
However, annuities experienced a huge growth in popularity during the late 1930s
when the collapsing financial markets turned many people away from equities in
favor of products from more secure institutions—insurance companies that could
and did make annuity payments, as promised.
Early annuities were simple contracts guaranteeing a return of principal and
fixed rates of return from the insurance company during the accumulation phase.
At withdrawal, the annuitant chose either a fixed income for life or payments
over a specific number of years.
Buyers have always been drawn to annuities by their tax-deferred status. As a
consequence of being issued by insurance companies, annuities have always been
able to accumulate without taxes being taken out at year-end, which has added
the time value of money to their list of advantages.
The most recent major development has been the inception in 1952 of variable
annuities, which offer the investment features of separate mutual fund accounts
inside the annuity with the tax-deferral available from life insurance products.
Variable Annuity owners choose the type of accounts to use, often receiving
modest guarantees from the issuer in exchange for the greater risks assumed.
“The shift to investment-linked annuities has been so marked that 25,000
investment-linked annuities were sold [in 2001] - 9.5% of all annuity
business,” reports Peter Quinton is managing director of The Annuity Bureau,
adding that “it's likely that the popularity of these annuity will continue to
increase as they are the only at-retirement products that offer retirees a
half-way house between the two extremes of purchasing a safe conventional
annuity and opting for a investment-linked income drawdown plan, where the
cross-subsidy system does not apply.” Source: Pensions Management; 12/1/2002
Wider Choices
Although long part of well-diversified financial portfolios, annuities have
continued to evolve. Recent developments have included features such as adding
checkbook access to Variable Annuity funds, more attractive "bonus"
rates, shorter maturity periods, and guaranteed death benefits.
But consumers now have wider choices of annuity types, plus more investment
options and guarantees to fit their investment and income goals. For example,
some annuities offer guaranteed bonus interest rates for the first few years or
guaranteed returns for the life of the contract. Other annuities guarantee
beneficiaries the return of principal if the annuitant dies and the annuity
stock market investments have lost value.
Although annuities have evolved, their primary objective remains the same. That
is, being able to lock in a guaranteed payout that cannot be outlived. As people
live longer, healthier lives--and the equities markets remain subject to
unsettling fluctuations--financial products offering safety, flexibility and
guaranteed returns are increasingly appealing to older consumers. However,
investors of all ages are drawn to variable annuities whose return is tied to
the stock market, but which also offer guaranteed minimum returns not tied to
market performance.
Annuities are accessible. Because there are no contribution limits, people can
invest as much or as little as they chose in annuities no matter what their
income levels. And this money grows on a tax-deferred basis until the
accumulated earnings are distributed, usually at retirement.
Moreover, unlike other tax-deferred investments during the distribution phase,
annuities’ tax-deferred earnings are not counted in determining a person’s
income taxes on Social Security benefits. At the same time, while annuitants
cannot outlive their guaranteed benefits, properly structured annuity contracts
and beneficiary designations can:
1) avoid probate,
2) protect assets held in trust from mismanagement by a parent of guardians, and
3) continue benefits to the annuitant’s heirs, thus making annuities effective
multigenerational planning vehicles.
Market Overview
With their unique advantages, a growing market for annuities has grown among
individuals with longer-term wealth accumulation and retirement planning needs,
as well as individuals with immediate income needs. Let's consider how two types
of annuities can be used to address the wealth accumulation and retirement
planning problems we all face. These are:
• Non-qualified Annuities
• Qualified Annuities
Non-Qualified Annuities -- Non-qualified annuities are purchased with
after-tax dollars to meet longer-term wealth accumulation or retirement planning
needs--with emphasis on longer-term.
As noted, deferred annuities may not be appropriate for shorter-term wealth
accumulation purposes — generally those that will materialize before age 59½;
while immediate annuities are designed to provide long-term income — that is,
income guaranteed for life.
Non-qualified annuities are used to fund cash accumulation programs that do not
qualify for a front-end tax deduction; but whether an annuity is qualified or
non-qualified, premiums always accumulate interest that is free of current
income tax until withdrawn. But non-qualified annuities also allow owners to
continue tax deferral beyond the age 70, the mandatory withdrawal age for
traditional IRA's and qualified retirement plans.
Qualified Annuities-- Annuities can also accommodate tax-qualified money.
A qualified annuity is used to fund a tax-qualified retirement plan such as a
traditional IRA or an HR-10. Thus in most cases, premiums paid to qualified
annuities are tax-deductible. For instance, when people change jobs and have
401(k) funds to move or already have IRAs and are seeking a more diversified
portfolio. They can reduce their portfolio exposure by rolling the money over
into an annuity without losing tax advantages.
Or suppose Alice inherits $20,000. If she doesn’t need the money right away
and wants to build a long-term nest egg, she might consider putting the
inheritance into an annuity. By doing so, she’ll gain the advantage of
tax-deferral, and when it’s time to withdraw funds from her non-qualified
annuity, Alice will only be taxed on the accumulated interest, not the
principal.
Generally, annuities are not suitable estate planning vehicles, but are useful
in meeting immediate and retirement income needs. Thus, iif you’re a candidate
for wealth accumulation and retirement planning, remember: "The only
person who can take care of the older person we will someday be is the younger
person we are now."
Want More? Send questions and comments to w.willard3@ knology.net
About
the Author: Bill Willard has been writing high-impact marketing and sales
training for the financial services industry for over 30 years. Through
interactive, Web-based "Do-While-Learning™" programs, e-Newsletters
and straight-talking articles, Bill helps agents and advisors get the job done:
profitably improving performance, skipping expensive mistakes, and making the
journey to success faster, smoother, easier. And fun!
