Why Fixed Annuities Are Suitable For Safe Money Needs

There is a persistent misunderstanding on the suitability of fixed deferred annuities. Fixed deferred annuities offer life time guarantees and other benefits that set it apart from other financial products. The tax treatment of deferred annuities is different. If you understand these differences, you will see how these features are attractive to seniors, and more importantly, why fixed deferred annuities can be a suitable part of a senior's financial plan.

Some of the features and benefits include:

1. The ability to elect an income that cannot be outlived at guaranteed rates sometime in the distant future. This is a feature unique to annuities for those who require certainty in the income portion of their portfolio. Insurance companies are stepping up to the plate to fill a need, given their unique capability for insuring longevity risk. Moreover, in addition to specified guaranteed rates, the carriers also generally offer to turn the deferred annuity into an income stream at the customer’s discretion guaranteed for a specific time frame, even life, based on current factors that generally even more favorable than the guaranteed rates.

2. The guarantees of fixed annuities are the primary appeal to an older population, a dynamic that has been universally recognized across the financial services industry. Given their ability to safeguard and insure principal and previously credited returns, insurance companies are again in a unique position to meet the needs of seniors who are concerned about having their principal exposed to market risk. It is the convergence of this age group’s need and the unique ability of insurance carriers that has created the substantial interest in fixed annuity products among seniors.

3. A secondary benefit of annuities is their tax-deferred nature. Accumulating and holding retirement funds in tax-deferred vehicles allows the asset to grow more quickly than would otherwise be the case in a similar, but taxable, vehicle. Due to this significant advantage, Congress has imposed a 10% penalty for taxable amounts withdrawn before age 59 ½ in recognition of the public good of holding these products into retirement years. The tax treatment of deferred annuities lead to a significant proportion of owners over age 59 ½. Insurance companies have designed products in conformity with the tax laws and in response to the market demand for the product by those who have the most to gain from the benefits of these products.
While some casual observers may indicate that already-tax-favored funds such as IRA money and pension funds should not be held in an annuity because they are already tax favored and, therefore, there is no benefit to the use of annuity, they forget that it is the guarantees and longevity insurance that drive the use of the annuity in these situations.

4. Penalties for early withdrawal are common among financial products and annuities are no different. Still, most annuities include a variety of withdrawal provisions, some of which provide substantial withdrawal rights without penalty…and without exposure to loss of principal through market risk. Among the circumstances that commonly allow for early withdrawal of the entire proceeds without penalty are death, terminal illness, nursing home confinement, Required Minimum Distributions and unemployment. Furthermore, most fixed annuities also allow for a specified annual withdrawal amount without penalty. Most common is a 10%-of-accumulated-value penalty-free annual withdrawal, but other options may include interest (often cumulative) or a specified annual percentage amount that accumulates annually. No other accumulation vehicle allows the owner to make withdrawals prior to the end of the penalty period without penalty fees or market risk to the asset. Surrender penalties are clearly spelled out in the contract.

5. The maturity date of the contract is also commonly misunderstood. A maturity date is a term of the contract required by state law and it is often the last date by which the funds must be dispersed. This legal requirement also ensures that the annuity complies with federal tax laws. Generally surrender charges will be over before the maturity date is reached—in many cases long before the maturity date is reached. As indicated earlier, in most cases there is liquidity each year and in many cases the client is able to convert the proceeds to a stream of income before the maturity date without penalty.

6. In addition to tax-deferral, there is another significant tax benefit to recipients of Social Security benefits that causes the annuity to be particularly beneficial to older individuals. Social Security benefits can be taxed on up to 85% of the benefit amount at the client’s marginal tax rate if their income is above a certain provisional level. This is true even if the income is left to accumulate in a vehicle such as a CD or is generally considered to be tax-free as with municipal bond interest. Not only do returns left to accumulate in a deferred annuity escape current taxation, they do not count in determining whether, and to what level, Social Security provisional benefits will be taxed. This is a significant benefit to customers, and especially middle-class retirees who derive a significant percentage of their income from Social Security, not currently consuming all of their assets for living expenses.

7. Finally, because an annuity is a contract it generally passes to heirs through beneficiary provisions rather than through the probate process. For those without a will, this is one way in which assets can be passed to a named beneficiary not subject to the intestacy provisions of the state and without the delays and costs associated with state probate. Since the cost of probating assets for a decedent can be significant, again, especially for middle-class retirees, this is another benefit to a senior wise enough to have some of his or her assets in a fixed deferred annuity.

In the end the two most important maxims for suitability are:
1. Target safe money needs, not age or demographic.
2. Diversify products as well as risk by putting savings or investments into more than one financial product.

Understanding Annuities: Maturity Date and Surrender Charges

Maturity Date and Surrender Charges

The recent confusion surrounding the “maturity date” is exacerbated because the term is a misnomer originating from life insurance policy language. There it refers to the date at which the policy matures and an endowment or income is automatically paid. For an annuity, the maturity date or more appropriately, the “income date” is the date at which periodic income will be paid. For most annuities, the income date is flexible, meaning that it can be changed. Thus, an annuity owner can extend the maturity date allowing the owner to have a longer period for the cash value to accumulate tax-deferred. All annuities include a date at which deferral is no longer allowed and income must be taken from the annuity.
While some annuities may initially establish a maturity date that is at the end of the surrender charge period, there is no necessary relationship between the surrender charge period and the maturity date. To suggest that the surrender charge period lasts until the maturity date is incorrect. An egregious example of confusing income date with surrender charge period occurred at a hearing NAFA attended in California this past August. Someone incorrectly testified that annuities lock up your money for 40 or 50 years and used an example of a client who “couldn’t get at his money until he turned age 140.” While we corrected this misinformed testimony, unfortunately, this misinformation continues to occur as it is being repeated in various media.
So, fixed annuities have maturity or income dates that permit the consumer to defer an annuity until some later age typically in the range of 85 to 95. However, saying this is the first date you can get your money free of surrender charges is like saying if you can’t get off Interstate 80 from New York until you reach San Francisco. A fixed annuity is a financial highway with many exits before you MUST because the highway ends.
Simply, the maturity date is the date that annuity payments must begin, which date may in most contracts be changed, and it is not necessarily the first date on which they may do so without surrender penalties.

Surrender Charges

Surrender charges are a way for any financial company to be able to credit higher interest rates and to recoup expenses when the owner prematurely terminates the contract. The surrender charge reduces the likelihood the insurance carrier will have to liquidate its investments prematurely at a loss. It also assures that the company will recoup its expenses over the surrender charge period. With this assurance comes a decreased need to withhold funds to protect against asset loss on excessive withdrawals. That in turn increases the ability to credit a higher interest rate to the contracts. Moreover, reducing the likelihood and potential severity of early surrender is what allows the company to provide the guaranteed benefits under the contract, including a guaranteed interest rate.

The length of surrender charges varies from 3 years to 17 years and the average is 10 years. Policies with longer surrender charge periods often include up front premium bonuses. Longer surrender charge durations also afford the insurance carrier the ability to invest longer term which allows the carrier to offer higher interest credits to the client.

While annuities assess surrender charges, which results in surrender proceeds less than the full contract value, few non-insurance investments offer any kind guaranteed selling price,. Most annuity contracts also waive surrender charges in many circumstances: death, terminal illness, nursing home confinement, federal tax law required minimum distributions, conversion to a stream of income, and unemployment. Most annuities have a specified annual surrender charge free withdrawal amount such as 10% of the accumulated value. No other financial instrument offers the ability to receive all or a part of the value free of penalty and risk of decrease in value under so many circumstances.

As with any insurance product, an annuity should be selected to fit the particular needs of the purchaser. Also, like any financial product, they will be suitable for some, but not all people, and for some, but not all, of their financial assets. Like most insurance retirement products, annuities are designed to be held for a number of years. Accordingly, annuities—whether fixed or variable—may not be suitable for any person, regardless of age, who could not be expected to keep their product in force for the surrender period of the contract or who needs income before annuitization is allowed without penalty.

Understanding Two-Tiered Annuities

A Two-Tiered Annuity is a product with three different values.

The first value is the tier-one value is the premium accumulated with interest earnings, just like a regular fixed annuity. This value is available to the client if they decide to surrender their contract as a lump-sum after the surrender charge period.

The second value is the surrender value, which is the tier-one value less the surrender charge. This value is available to the client if they decide to surrender their contract as a lump-sum during the surrender charge period.

The third value is the tier-two value, which provides a benefit typically higher than the tier-one value and is only available to the client if they annuitize the contract. Tier-two benefits could include higher interest rates, higher index crediting, bonuses or other benefits which encourage the client to annuitize, thereby leaving assets longer with the insurance company. In some products clients must wait a certain period of time before they can access these higher tier-two values.

Why would a client buy a two-tier product?

Two-tier products can be valuable for the right client in several ways. If clients have a need for a lifetime stream of income, they could receive higher lifetime benefits under a two-tier product than under a regular deferred annuity that is annuitized or immediate annuity. Secondly, due to the design and pricing of two-tier products, tier-one credited rates could be higher than a non-tiered deferred annuity in the form of better participation rates, caps or fees.

What are some of the disadvantages of two-tier products?

These products may not be suitable for clients that have short-term liquidity needs or a desire to pass on lump-sum benefits to their heirs. In addition, clients usually have to wait a period of time to receive the higher tier-two values and annuitization is required to receive those values, which spreads the benefits out over a period of time.

Insurance agents should be very clear that their clients who are considering a two-tiered annuity understand the different values, how to access their values and the restrictions or consequences when they do. Clients should assess their needs and examine all aspects of an annuity product before determining if that particular annuity design fits their needs and financial goals.