Annuities

Variable annuities

Variable annuities are utilized to provide lifetime income to a person in retirement. They allow unlimited contributions and make fluctuating payments until death. Essentially, an annuity can act as a self-made pension. The investor puts money into the account, then may opt later to receive payments for life.

Contributions (sometimes referred to as premium payments) to variable annuities are made through periodic payments or a lump sum. Variable annuities are considered non-qualified retirement plans*, which results in their contributions being non-tax deductible (no tax benefits simply for contributing). Let’s discuss the two general types of annuities - immediate and deferred. The difference relates to the amount of time needed to contribute to the annuity during the accumulation phase.

*You should assume variable annuities are generally non-qualified, but it’s possible to roll over qualified funds into an annuity. In turn, this creates a qualified annuity. We’ll learn more about this below.

Immediate annuity

When a person has access to a large sum of money in retirement, they can obtain annuity payments for life quickly without the need for a lengthy accumulation phase. Known as an immediate annuity, this type of plan provides retirement income soon after the lump sum is accepted by the insurance company. If the lump sum is made in one big payment, it may be referred to as a single premium immediate annuity. For example, an investor deposits $1 million into their immediate variable annuity, and begins receiving monthly payments starting at $2,500 that then fluctuate depending on the investment performance of the separate account (discussed below).

As with anything else in finance, there are pros and cons to choosing this type of annuity. In particular:

Immediate annuity benefits

• Receive retirement income immediately
• Provides income for life
• No need for a lengthy accumulation phase build-up

Immediate annuity risks

• Typically requires a large lump sum to qualify
• The lump sum is generally inaccessible without significant fees once deposited*
• Low or negative return if death occurs earlier than expected**
• Likely subject to a substantial amount of up-front fees and/or sales charges

*The inaccessibility of the lump sum only becomes an issue if the investor needs more money than they’re receiving in their annuity payments.

**An annuity typically stops making payments once the account owner dies. For example, assume an investor deposits $1 million into an immediate annuity in return for average monthly payments starting at $2,500. If they were to pass away after one year, the investor would’ve only received roughly $30,000 in total payments ($2,500 x 12 months). Exchanging $1 million for $30,000 of payments obviously represents an incredible loss. This is one of the primary risks investors face with annuities.

Sidenote

Annuity bonuses

Some insurance companies offer annuity bonuses as a way to entice investors to purchase annuities. This provides additional money to customers when they originally fund their accounts, typically on a matched basis.

For example, assume an insurance company offers an 8% annuity bonus on the initial premium payment. A customer makes a premium payment of $100,000, resulting in the insurance company crediting their account an additional $8,000 ($100,000 x 8%). With this annuity bonus, the investor’s starting annuity value is $108,000.

Deferred annuities

Deferred annuities require time to grow the investor’s assets. For example, let’s assume an investor signs up to contribute $2,000 a month to their deferred variable annuity starting at age 40. When they reach age 60, they would’ve contributed a total of $480,000 ($2,000 x 12 months x 20 years). Contributions are invested, so the $480,000 would likely grow to a higher amount - let’s say it grew to $1 million. Once in retirement, the investor may annuitize their account, which essentially relinquishes control of the $1 million to the insurance company in return for monthly payments for life.

Deferred annuity benefits

• Longer accumulation period allows for a higher growth potential of contributions
• Provides income for life if annuitized
• No need for a significant lump sum to qualify

Deferred annuity risks

• Assets may not grow as much or lose value if investments perform poorly
• Income is typically not received for years or decades
• Low or negative return if death occurs earlier than expected (once annuitized*)
• Likely subject to a substantial amount of up-front fees and/or sales charges

*Deferred annuities are not required to be annuitized. We’ll learn more about this below.

Accumulation phase

Regardless of annuity type, there are two general phases:

• Accumulation phase
• Distribution phase

The accumulation phase is the period of time when money is contributed to the account as the investor builds their investment. This phase could last a day (immediate annuity) or several decades (deferred annuity). Money received during the accumulation phase is placed into a “separate” account. The name refers to the account being separated from the insurance company’s own assets and capital. When a contribution is placed into the separate account, the investor purchases accumulation units. Similar to buying shares of stock, accumulation units provide a measurement of the investor’s “basis” (amount invested). When funds are contributed to the separate account, more accumulation units are purchased. The more accumulation units an investor owns, the more valuable their investment is.

The investor controls the separate account and dictates where their money is invested. They are given the opportunity to invest in a number of diversified portfolios of stocks, bonds, and other products, which are very similar to mutual funds. The investor chooses their level of risk, which has a big impact on their return.

The assets in the separate account grow tax-deferred, similar to other retirement plans. When dividends or capital gains are realized, the investor does not owe taxes until a distribution is taken (usually in retirement). When the separate account is growing, the investor must reinvest all income received. Variable annuities are also subject to many of the same rules as other retirement plans. Investors must wait until age 59 ½ to take funds out and are subject to a 10% penalty if taken early.

Variable annuities typically provide a death benefit that applies only in the accumulation phase. This benefit kicks in if the account owner dies before annuitizing the contract (electing for lifetime payments). For example, let’s assume a 30-year-old begins contributing $500 monthly and plans to continue these contributions until age 60. They pass away unexpectedly at age 50 after contributing $120,000 over 20 years ($500 per month x 12 months x 20 years). The death benefit guarantees a payment to the account owner’s listed beneficiary. In particular, the beneficiary will receive the GREATER of the account owner’s basis or the current account value.

Continuing our example above, let’s assume the investor’s separate account investments performed poorly, resulting in a balance of $100,000 at the time of death. In this scenario, the investor’s beneficiary (which they declare when opening the account) would receive $120,000 (the basis). The death benefit ensures no matter how the investments in the separate account perform, at least the original amount contributed will be returned if the account owner dies prior to taking funds out.

The beneficiary would receive the current account value upon death if the investments performed well. Resetting with our same $120,000 basis example, let’s assume this time the account grew to $200,000. Upon death of the account owner, the beneficiary would receive $200,000.

Sidenote

M&E charges

In the first example above, the investor’s account value at death was $100,000 while their basis was $120,000. At death, the insurance company was on the hook for paying the $20,000 difference to the beneficiary. This added cost is known as mortality risk, which occurs when the account owner dies earlier than expected.

Another risk the insurance company faces is rising expenses. Running an insurance company can be a costly venture, especially in the face of unexpected claims, higher regulatory costs, and/or rising general business expenses. For example, what if an insurance company’s costs exceed the amount of premiums received for its products? Facing these added complexities is known as expense risk.

To compensate for these risks, insurance companies typically assess M&E (mortality & expense) charges. This charge typically averages around 1.25% annually.

Distribution phase

When an investor is ready to take payments from a variable annuity, they have a few choices. At this point, the investor enters into the distribution phase and can withdraw the entire value of the separate account out as a lump sum payment. Alternatively, they could take random or systematic withdrawals. For example, an investor could request $2,000 a month to be sent to them until the account is exhausted. When distributions are taken, only the growth is taxable. If you recall, contributions (basis) are made after-tax (and therefore are not taxed again). If an investor made $50,000 of contributions and the account grew to $75,000, they would only owe ordinary income taxes on $25,000 of growth.

If a lump sum or periodic withdrawal is taken from a deferred annuity*, the investor is not guaranteed income for life. Eventually, the separate account will be emptied if enough money is taken. Investors concerned about running out of funds should avoid these payout options.

*We are not discussing this option with an immediate annuity because they are almost always annuitized (payments for life). Otherwise, an investor with a large lump sum would be better off placing those funds in a brokerage account, investing what they didn’t need, and taking distributions as needed.

If an investor seeks guaranteed income for life, they annuitize their contract. Annuitization is the act of handing over ownership of the separate account in return for payments for life. When an investor annuitizes, their accumulation units convert into a fixed amount of annuity units. The performance of the separate account determines their value, which directly influences future payouts.

Sidenote

Taxes at distribution

In this section, we’ve learned the following about non-qualified variable annuities:

• Growth is taxable as ordinary income when withdrawn
• Two primary methods of withdrawal:
  • Not annuitizing and withdrawing funds when needed
  • Annuitizing and receiving periodic payments until death

Let’s dive a bit further into these points to better understand the tax consequences investors face when they request distributions (withdrawals).

If the account is not annuitized, Internal Revenue Service (IRS) rules require the growth to be distributed first. Known simply as LIFO (last in, first out), the after-tax contributions are taken out after all growth is distributed. For example, let’s assume an investor contributes $50,000, which grows to $70,000 at the time the first withdrawal occurs. A distribution of $25,000 is requested - how much is taxable?

In this example, the investor has $20,000 of taxable growth in their account. When they request the $25,000 withdrawal, the $20,000 of taxable growth comes out first, alongside $5,000 of basis. Therefore, $20,000 would be taxable as ordinary income, while the remaining $5,000 would represent a tax-free return of principal (basis).

If the account is annuitized, IRS rules require a different type of taxation. Each payment received is taxed on a pro-rata basis, meaning they will contain part tax-free basis and part taxable growth. This is sometimes referred to as being taxed on an exclusion ratio basis. For example, assume an investor receives $1,000 in their first variable annuity payout. It’s possible that $300 of the payment is taxable growth, while the remaining $700 is a tax-free return of principal*.

*Don’t worry about the specifics or how to calculate each portion. The test is most likely to focus on generalities.

As with other retirement plans, variable annuities are subject to an early withdrawal penalty if a non-qualified distribution occurs prior to age 59 1/2.

Annuity payments are typically made on a monthly basis. The first payout to the investor is predetermined based on the structure of the annuitization (discussed later in this section). After the first payout, future payments depend on the performance of the separate account. When an investor annuitizes, they’re provided with an 'assumed interest rate,’ which is usually referred to as the AIR. The AIR is a conservative estimate of the projected growth of the separate account.

The performance of the separate account is continually compared to the AIR. Assume the assigned AIR is 3% (annualized). If the separate account performs better than 3%, the investor’s monthly payout increases. However, if the separate account performs worse than 3%, the investor’s payout decreases. This structure is why these annuities are considered “variable.”

There are three specific annuitization structures to be aware of. First, the investor can choose a straight life annuitization, which pays them for life. After the investor dies, the payments stop and the insurance company keeps the assets in the separate account. Depending on how long the investor lives, they may or may not receive a desirable return.

Assume an investor chooses a straight life annuity when their separate account is worth $200,000. If they were to pass away one month later after receiving one payment of $1,000, the insurance company makes a profit of $199,000. In this situation, the insurance company “wins.” It could go the other way, though. The investor could live much longer than expected and receive payouts equaling $450,000 until they die, profiting $250,000. In this case, the investor “wins.”

As you can see, variable annuities are a game of life and death. To estimate how long an investor will live, insurance companies often require full disclosure of medical history and/or a check-up by a doctor of their choosing. The medical data is then given to an actuary, whose job is to analyze risk and estimate how long they expect their customer to live. From there, the insurance company makes payouts that represent their estimate of the investor’s life expectancy.

The actuary and insurance company are not always right, though. If an investor’s health is misjudged and they live longer than expected, payouts still must be made until they pass away. This is known as longevity risk, which is a detriment to the insurance company, but a beneficial guarantee to the investor. Pensions face this same risk regularly.

For investors concerned about the risks associated with a life annuity, they can choose a life with period certain annuitization. Assume an investor chooses a life with a 10-year period certain. They are guaranteed payments for life, regardless of how long they live. However, if they were to die within 10 years, payments continue to their listed beneficiary. For example, if they died after 8 years of payments, 2 years of payments continue to their beneficiary.

With a period certain setup, the investor knows payments are guaranteed for a specific amount of time. Because there is less risk for the investor, life with period certain annuities result in lower payouts than life annuities.

Primarily utilized by married couples, there is also a 'joint with last survivor’ annuitization. This type of payout structure pays two account owners until both pass away. After the death of one of the annuitants, the payments are typically reduced by some amount.

Definitions

Annuitant

A person who receives annuity payments (typically the original account owner)

Investors may also choose a unit refund annuitization. This type of annuity makes payments for life, but “refunds” the account owner’s beneficiary if they pass away prior to receiving their basis. For example, assume an investor contributes $100,000 to their unit refund annuity, annuitizes the contract, then passes away after receiving $70,000 in payments. $30,000 would be paid to the annuitant’s beneficiary in a lump sum or on a payment schedule (depending on how the annuity is structured).

Sidenote

Qualified annuities

You should expect the exam to primarily focus on non-qualified variable annuities. In fact, we recommend you assume an annuity is non-qualified unless otherwise stated in a question. This type of retirement plan allows for unlimited non-deductible (after-tax) contributions and tax-deferred growth. At distribution, only the growth is taxable as ordinary income.

In some circumstances, you may encounter a question on a qualified annuity. These are annuities that have been funded with pre-tax money from another source. For example, an investor contributes $100,000 to their 403(b) plan at the charity they work at. At retirement, the account has grown to $150,000 and they roll the account over into a variable annuity.

In this example, all future withdrawals would be taxable as ordinary income. While a non-qualified variable annuity is only subject to taxation on the growth, the entire amount withdrawn from a qualified annuity is taxable. To be clear, let’s assume the investor requests a lump sum distribution of their $150,000 qualified annuity. They would be subject to ordinary income taxes on the entire amount - the $100,000 basis and the $50,000 of growth.

Like all other qualified plans, qualified annuities are subject to required minimum distributions (RMDs) starting at age 73. Non-qualified annuities are not subject to RMDs.

Fixed annuities

Now that you understand a variable annuity, we’ll briefly cover a fixed annuity. You shouldn’t expect many test questions on this product as it is not considered a security. This is because the investor does not face investment-related risk (e.g. market risk).

Instead of the investor’s assets being placed in their control within the separate account, a fixed annuity places contributions into the insurance company’s general account. The insurance company invests the funds on behalf of the account owner and guarantees a (typically low) rate of return (e.g. 3%).

As compared to a variable annuity, there are pros and cons. The pros - money grows at a guaranteed rate of return and the investor does not need to concern themselves with investment-related risks like market risk or interest rate risk. For conservative and risk-averse investors, this may seem like a suitable retirement option.

The cons - variable annuities may grow more over time (more risk, more return potential) and the fixed rate of return is especially subject to inflation (purchasing power) risk. Remember, any investment with a fixed rate of return is subject to this risk. If prices of goods and services rise more (on a percentage basis) than the guaranteed rate of return, the investor is technically losing money to inflation.

Equity indexed annuities

Equity indexed annuities (EIAs) share characteristics of both variable and fixed annuities. They provide returns linked to an equity index like the S&P 500, similar to a variable annuity. EIAs offer minimum guaranteed returns, similar to a fixed annuity. They are not considered securities primarily because investors do not face investment risk when the index declines.

Although the returns of an EIA are linked to an index (during the accumulation and distribution phase), gains obtained by the investor are limited. Insurance companies restrict returns in one of three ways:

• Participation rate
• Cap (ceiling)
• Spread rate (margin, asset fee)

Participation rate
EIAs including a participation rate only allow the investor to keep part of their linked index returns. For example, an EIA with an 80% participation rate connected to the S&P 500 in a year it returns 10% would only be credited with an 8% return (80% participation rate x 10% index return).

Cap (ceiling)
An EIA with a cap (a.k.a. ceiling) assigns a specified maximum return the investor may achieve. For example, an EIA with a cap of 7% would not credit more than 7% to the investor, no matter how well the linked index performed.

Spread rate (margin, asset fee)
EIAs containing a spread rate (a.k.a. margin or asset fee) perpetually deduct a specified percentage from the returns of the linked index. For example, an EIA linked to the S&P 500 while it is up 12% with a spread rate of 3% would only credit a 9% return to the investor.

An EIA may include any one of the above or a combination. For example, a participation rate and a cap may exist, but no spread rate. Or, a cap and spread rate exist, but no participation rate. Or, all three or just one. The combination of restrictions enforced depends on the contract between the investor and the insurance company.

In return for restricting index-linked gains, EIAs provide minimum growth guarantees. In particular, EIAs include a floor of at least 0%*, if not more. A floor represents the minimum amount of growth guaranteed to an investor. While a floor of 0% may not seem superb, it essentially guarantees the investor will not experience losses should the linked index go negative. Some EIAs contain minimum growth rates as high as 3%, ensuring the investor will experience positive returns consistently. However, greater floors are usually coupled with lower caps and participation rates, and/or higher spread rates.

*Test questions may not specifically mention a floor. You should always assume a floor of 0% exists if a floor is not identified.

Let’s look at an example together to better understand how these features work:

An investor contributes to an equity-indexed annuity with a 70% participation rate, 8% cap, and a 1% floor. The linked index returns a positive 10% return over the specified period just before the contract is adjusted. What return will be credited to the investor’s annuity?

A) 5.6%
B) 7.0%
C) 8.0%
D) 10.0%

Can you figure it out?

How exactly an insurance company calculates the return of an index is an important feature for investors to be aware of. For example, are index returns calculated from January 1st to December 31st with adjustments being made annually? Or does the insurance company consider the highest or lowest value of the index during a specified time period? In general, these are the most common index crediting methods:

• Annual reset
• Point-to-point
• High water mark
• Low water mark

Annual reset
This crediting method is what it sounds like. At the anniversary date of the initial contract, the insurance company measures the difference between the index value at the starting point versus its value one year later. For example, assume an investor enters into a contract to annuitize their EIA on July 1st, 2022 when the linked index was at 4,000. One year later on July 1st, 2023, the linked index is at 4,400. The change in 400 points would result in a 10% positive gain (400 point increase / 4,000 starting index value). From there, any applicable participation rate, cap, floor, and/or spread rate would be applied.

Point-to-point
This crediting method is very similar to annual reset, but the two points used to determine the change in index value aren’t necessarily the anniversary date on an annual basis. The two points considered could be as short as a month or as long as a few years. Otherwise, it is essentially the same as annual reset.

High water mark
The high water mark crediting method compares the index value at the starting point (typically the contract anniversary date) to the highest point the index reached over a specified period (usually a year). For example, assume an investor enters into a contract to annuitize their EIA on July 1st, 2022 when the linked index was at 4,000. One year later on July 1st, 2023, the linked index is at 4,400, but in March 2023 the index reached a high point of 4,600. The high water mark crediting method would discard the ending value of 4,400 and instead utilize the highest index point at 4,600. Therefore, the 600 point change would result in a 15% positive gain (600 point increase / 4,000 starting index value). From there, any applicable participation rate, cap, floor, and/or spread rate would be applied.

Low water mark
The low water mark crediting method is essentially the inverse of the high water mark method. The lowest point of the index is compared to the ending index value to determine the amount credited. For example, assume an investor enters into a contract to annuitize their EIA on July 1st, 2022 when the linked index was at 4,000. One year later on July 1st, 2023, the linked index is at 4,400, but in November 2022 the index reached a low point of 3,500. The low water mark crediting method would discard the beginning value of 4,000 and instead factor in the lowest index point at 3,500. Therefore, the 900 point change (3,500 low point vs. 4,400 ending point) would result in a 25.7% positive gain (900 point increase / 3,500 low point). Like all other methods, any applicable participation rate, cap, floor, and/or spread rate would be applied from there.

Sidenote

Surrender charges

Annuities of all kinds are notorious for surrender charges, which are fees assessed if an investor withdraws funds before a specified period of time. For example, an investor begins contributing to a variable annuity at age 40 with a goal of annuitizing at age 65. They run into financial troubles at age 42 and request a withdrawal of half their contributions. In a scenario like this, insurance companies are likely to impose surrender charges as high as 10%. Additionally, the investor may be faced with taxes and early withdrawal penalties on gains made.

In most circumstances, insurance companies impose surrender periods of at least 6 years, if not 10 years or more.

Key points

Variable annuities

• Unlimited non-deductible contributions
• Contribution options:
  • Lump sum
  • Periodic contributions
• Offers tax-deferred growth
• Distributions taxable above basis

Immediate annuity

• Investor contributes a large lump sum
• Immediately annuitizes and receives payments

Deferred annuity

• Investor contributes over time
• Takes withdrawals or annuitizes later in retirement

Accumulation phase

• When contributions are made
• Death benefit applies

Death benefit

• Beneficiary keeps GREATER of:
  • Amount invested
  • Account value
• Applies if the account owner dies during the accumulation phase

Variable annuity insurance company risks

• Mortality risk
  • Investor dies earlier than expected, triggering the death benefit
• Expense risk
  • Business expenses rise
• Longevity risk
  • Investor lives longer than expected, forcing annuity payments to be paid longer

Separate account

• Where assets are held
• Customer in control of investing
• Investment choices:
  • Equity-based portfolios
    • Hedge against inflation
  • Debt-based portfolios
    • Subject to inflation risk

Distribution phase

• Investor receives income in retirement
• Non-annuitization options
  • Lump sum
  • Periodic payments
• Annuitization options:
  • Straight life annuity
  • Life with period certain
  • Joint and last survivor

Non-qualified annuity taxation

• Growth is taxable as ordinary income
• Withdrawals (non-annuitization)
  • Growth is distributed first (LIFO)
• Annuitization
  • Basis and growth distributed simultaneously
  • Taxed on a “pro-rata” basis (a.k.a. exclusion ratio)
• Not subject to RMDs

Qualified annuity taxation

• All distributions taxed (growth and basis) as ordinary income
• Subject to RMDs starting at age 73

Fixed annuities

• Like a variable annuity, but:
  • Not a security
  • General account instead of a separate account
  • More exposed to inflation risk

Equity indexed annuity (EIA)

• Annuity with both variable and fixed features
• Returns are linked to an equity index (e.g. S&P 500)
• Returns are guaranteed at a minimum level even if the index declines
• Not a security

EIA features

• Participation rate**
  • Percent of index returns credited to the investor
• Cap (ceiling)
  • Maximum return granted regardless of index gains
• Floor
  • Minimum return granted regardless of index declines
• Spread rate (margin, asset fee)
  • Fees deducted from index returns

EIA crediting methods

• Annual reset
  • Beginning value vs. end value after 1 year
  • Typically reset at the anniversary of EIA contract signing
• Point-to-point
  • Beginning value vs. end value
  • Points may vary (monthly, annual, every few years)
• High water mark
  • Beginning value vs. highest index value over a specified period
• Low water mark
  • Low index value vs. ending value over a specified period

Surrender charges

• Fees assessed if withdrawing funds prior to surrender period elapsing