Annuities
Annuities are insurance contracts designed to provide income, typically for retirement. They offer tax-deferred growth and various payout options. Investment advisers must understand the different types of annuities and their suitability for different clients.
What Is an Annuity?
An annuity is a contract between an individual and an insurance company. The individual pays premiums, and the insurance company promises to make periodic payments, either immediately or at a future date.
Two Phases of Annuities
| Phase | Description |
|---|---|
| Accumulation Phase | Investor makes premium payments; assets grow tax-deferred |
| Annuitization Phase | Investor receives periodic income payments |
During accumulation, the investor owns accumulation units. At annuitization, these convert to annuity units, which determine the payment amount.
Types of Annuities
Fixed Annuities
| Feature | Detail |
|---|---|
| Returns | Guaranteed interest rate set by insurer |
| Investment Risk | Insurance company bears all risk |
| Regulation | State insurance department only; NOT a security |
| Death Benefit | Typically guaranteed principal |
| Suitable For | Conservative investors; guaranteed income seekers |
Variable Annuities
| Feature | Detail |
|---|---|
| Returns | Based on performance of subaccounts (similar to mutual funds) |
| Investment Risk | Investor bears the investment risk |
| Regulation | SEC and FINRA regulated; IS a security |
| Death Benefit | May fluctuate with account value |
| Suitable For | Growth-oriented investors; higher risk tolerance |
On the Exam
Variable annuities are securities because the investor bears the investment risk. They require a prospectus and are regulated by the SEC. Fixed annuities are NOT securities because the insurance company guarantees the return.
Equity-Indexed (Fixed-Indexed) Annuities
| Feature | Detail |
|---|---|
| Returns | Linked to market index (S&P 500, etc.) |
| Participation Rate | Limits upside (e.g., 80% of index gain) |
| Minimum Guarantee | Floor on returns (often 0-3%) |
| Caps | Maximum return per period |
| Regulation | Generally NOT securities (state regulated) |
| Complexity | Complex crediting formulas |
Variable Annuity Features
Subaccounts
Variable annuity assets are invested in subaccounts, which are similar to mutual funds. The investor selects from various options:
- Stock funds (growth, value, international)
- Bond funds (government, corporate, high-yield)
- Money market funds
- Balanced/target-date funds
Separate Account
Variable annuity assets are held in a separate account—segregated from the insurance company's general account. This protects investors from the insurer's creditors.
Death Benefit
Most variable annuities guarantee a minimum death benefit:
- At minimum: Return of premium paid
- Stepped-up options: Higher of premium or account value at periodic intervals
- Some offer enhanced death benefits (additional cost)
Living Benefit Riders
Optional riders provide guarantees during the investor's lifetime (for additional fees):
| Rider | Guarantee |
|---|---|
| GMIB (Guaranteed Minimum Income Benefit) | Minimum income regardless of account value |
| GMWB (Guaranteed Minimum Withdrawal Benefit) | Minimum annual withdrawal amount |
| GMAB (Guaranteed Minimum Accumulation Benefit) | Minimum account value at specific date |
Annuity Costs
Variable annuities have multiple fee layers:
| Fee Type | Typical Range | Purpose |
|---|---|---|
| Mortality & Expense (M&E) | 1.0% - 1.5% | Insurance features and profit |
| Administrative Fees | 0.10% - 0.30% | Record-keeping, statements |
| Subaccount Expenses | 0.25% - 2.0%+ | Underlying fund management |
| Rider Fees | 0.25% - 1.0% | Optional benefit guarantees |
| Surrender Charges | 7% declining to 0% | Early withdrawal penalties |
Surrender Charges
Most annuities impose surrender charges for early withdrawals:
| Year | Typical CDSC |
|---|---|
| 1 | 7% |
| 2 | 6% |
| 3 | 5% |
| 4 | 4% |
| 5 | 3% |
| 6 | 2% |
| 7 | 1% |
| 8+ | 0% |
Most contracts allow 10% free withdrawals annually without surrender charges.
Payout Options (Annuitization)
When the investor begins receiving income:
| Option | Description | Risk |
|---|---|---|
| Life Only | Payments for investor's lifetime; nothing to heirs | Longevity risk for heirs |
| Life with Period Certain | Payments for life OR minimum period (10, 20 years) | Balanced |
| Joint and Survivor | Payments continue for two lives | Lower payments |
| Fixed Period | Payments for set number of years | May outlive payments |
| Lump Sum | One-time payment | No guaranteed income |
In Practice
A retiree choosing between payout options must balance:
- Life only: Highest payment, but heirs receive nothing if retiree dies early
- Joint and survivor: Provides for spouse but lower monthly payments
- Period certain: Guarantees minimum payments to heirs if death occurs early
Tax Treatment
Non-Qualified Annuities (After-Tax Contributions)
| Event | Tax Treatment |
|---|---|
| Contributions | Not tax-deductible |
| Growth | Tax-deferred |
| Withdrawals | Earnings taxed as ordinary income (LIFO) |
| Before 59½ | 10% early withdrawal penalty on earnings |
| Death Benefit | Taxable income to beneficiary |
LIFO (Last In, First Out): Earnings are considered withdrawn first, so early withdrawals are fully taxable until all earnings are distributed.
Qualified Annuities (Pre-Tax Contributions)
Used in retirement plans (IRAs, 401(k)s):
- Contributions may be tax-deductible
- All withdrawals taxed as ordinary income
- Subject to RMD rules after age 73
1035 Exchange
Allows tax-free exchange from one annuity to another (or life insurance to annuity) without triggering taxable event.
Suitability Considerations
Variable annuities may be suitable for:
- Long-term investors (10+ year horizon)
- Those who have maxed out other retirement accounts
- Investors seeking tax-deferred growth with upside potential
- Those who want guaranteed income options
Variable annuities are NOT suitable for:
- Short-term investors (surrender charges)
- Those who need liquidity
- Investors already in low tax brackets
- Use in tax-deferred accounts (no additional tax benefit)
- Young investors prioritizing growth over guarantees
On the Exam
Purchasing a variable annuity inside an IRA provides no additional tax benefit since IRAs are already tax-deferred. This is considered unsuitable unless other features (death benefit, living benefits) justify the cost.
Key Takeaways
- Fixed annuities: Guaranteed returns; NOT securities; insurer bears risk
- Variable annuities: Returns vary based on subaccounts; ARE securities; investor bears risk
- Variable annuity features: Subaccounts, separate account, death benefit, living benefit riders
- Costs include M&E, administrative fees, subaccount expenses, and surrender charges
- LIFO taxation: Earnings withdrawn first, taxed as ordinary income
- 10% penalty on withdrawals before age 59½ (on earnings)
- 1035 exchange: Tax-free transfer between annuities
Variable annuities are considered securities because:
An investor withdraws $20,000 from a non-qualified variable annuity. The account has $50,000 in contributions and $30,000 in earnings. How much of the withdrawal is taxable?
Which of the following is NOT a typical fee associated with variable annuities?
7.5 Life Insurance Products
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