Wednesday, December 17, 2008

Fundamentals of Annuities Planning. Wealth Management, Pensions, Annuities & Retirement Planning Guide. Your Learning Resource Centre.


Annuities are the only investment vehicles that can guarantee investors that they will not outlive their income, and they do this in a tax-favored manner. In addition, annuities are available with a host of features to meet a wide variety of investor needs. The income taxation of annuities is governed by IRC Section 72.

Technically, annuities are contracts providing for the systematic liquidation of principal and interest in the form of a series of payments over time.[1.] However, this really refers to the “payout” phase of an annuity; in point of fact, annuities can (and often do) have an accumulation phase that also lasts for a substantial period of time.

An annuity is established when the investor makes a cash payment to an insurance company, which invests the money – this may be a single large cash payment or a series of periodic payments over time. The money remains invested with the insurance company and is periodically credited with some growth factor – this is the accumulation phase of the annuity. In return for making a deposit into an annuity, the insurance company ultimately agrees to pay the owner (or owners) a specified amount (the annuity payments) periodically, beginning on a specified date – this is the payout phase of the annuity.

If the specified date for payouts to begin is within one year of the date the contract is established (i.e., a single cash payment is made and the insurance company begins a systematic liquidation of the payment back to the owner within one year), the annuity is called an “immediate annuity”. If, alternatively, the specified date for payouts to begin is at least one year later, the annuity is called a “deferred annuity” (because deposits are made now, but the payout is deferred). An immediate annuity only has a payout phase; a deferred annuity has both an accumulation and a payout phase.

If the payout phase of the annuity is a life annuity, the company promises that payouts will continue for as long as the annuitant (or annuitants) live; the income stream can never be outlived (NOTE: although often the same, technically the owner of the annuity does not necessarily need to also be the annuitant; occasionally these are different individuals). If the payout phase is a fixed period annuity (also called a term-certain annuity), the company promises to pay stipulated amounts for a fixed or guaranteed period of time independent of the survival of the annuitant. An annuity payout can also utilize a combination of the life and fixed period options, such as “for the greater of 10 years or the life of the annuitant(s).

In addition to differentiating between immediate and deferred annuities, and fixed and term-certain payouts, annuities are also categorized as to whether they are fixed or variable (be careful not to confuse a “fixed annuity” with a “fixed period payout”). Classification as a fixed or variable annuity refers to the underlying investments during the accumulation phase of the annuity; a fixed annuity is invested in the general fixed account of the insurance company, while a variable annuity is invested in separately managed sub-accounts (that function similarly to mutual funds) selected by the annuity owner. Variable annuities often have additional features to help manage the risk of their underlying investments, such as guaranteed death benefits or newer “living benefits” that provide company-guaranteed payments for owners or beneficiaries even if (or especially if) they would be higher than actual investment performance would provide for.

Newer annuities may also offer a variable option during the payout phase (whether for a fixed or term-certain period). A “variable annuitization” has payments that may fluctuate up or down depending upon the performance of the underlying sub-account investments; a “fixed annuitization” has payments that remain the same through the payout phase (or occasionally increase by some set rate to keep pace with inflation; however, this rate is pre-determined and contractual, is still invested in the insurance company’s general account, and is thus still considered a “fixed payout”).

Annuities purchased from an insurance company are called “commercial annuities” while those purchased from a person or entity that is not in the business of selling annuities are called “private annuities.

Annuities grow tax-deferred during the accumulation phase, although withdrawals during this phase are taxed on a LIFO (last in, first out) basis – meaning that withdrawals during the accumulation phase are considered to be withdrawals of growth first (fully taxable) and principal second.[3.] Payouts during the annuitization phase are split; a portion of each payment is considered principal and a portion is deemed interest/growth. The proportion of each is determined at the annuity’s beginning payment date and is based upon the already-accumulated growth, an assumed internal growth factor for the payout period, and the expected length of the payout period. All amounts distributed that are considered interest/growth are taxed as ordinary income, regardless of the phase or timing of the withdrawal. In addition, certain withdrawals before the age of 59 1/2 may be subject to an additional 10% tax penalty.

Although annuities have tax-deferral features that can be quite advantageous, the primary reason annuities should be purchased are for their risk management features. Annuities can provide a variety of guarantees, whether protecting against interest rate risk, reinvestment risk, market volatility risk, or the risk of living too long and outliving one’s assets. Annuities are first and foremost a risk management tool.

1. The guarantees of safety, interest rates, and particularly lifelong income (if selected) give the purchaser peace of mind and psychological security.
2. An annuity protects and builds a person’s cash reserve. The insurer guarantees principal and interest (in the case of a fixed annuity; a variable annuity is subject to the performance of the underlying selected sub-accounts), and the promise (if purchased) that the annuity can never be outlived. This makes the annuity particularly attractive to those who have retired and desire, or require, fixed monthly income and lifetime guarantees.
3. An annuity allows a client to invest in the market while moderating risk. The insurer may provide guarantees of death proceeds or a certain annuitization amount (if purchased) within a variable annuity, thus providing guarantees that would otherwise be unavailable to a client that purchased the underlying investments directly. This makes a variable annuity particularly attractive to those who have retired or are nearing retirement and need (or want) to hold risky investments while trying to moderate risk.
4. A client can “time” the receipt of income and shift it into lower bracket years. This ability to decide when to be taxed allows the annuitant to compound the advantage of deferral.
5. Because the interest on an annuity is tax-deferred, an annuity paying the same rate of interest (after expenses) as a taxable investment will result in a higher effective yield.
6. Because of the risk-management factors available, especially in variable annuities, a client may be able to take on greater risk in the underlying investment options (e.g., equities, smaller-capitalization equities, high-yield bonds, etc.) while still maintaining a reasonable overall risk exposure due to the underlying guarantees.
7. Adjusted Gross Income (AGI) may be reduced in years where the annuity is held with no withdrawals (thanks to the tax-deferral features of the accumulation phase). In addition, lower taxable income may be recognized during the payout phase, due to the partial recovery of basis associated with each payment. A reduced AGI can bring tax savings, as many other income tax rules are calculated based upon AGI and generally a lower AGI results in lower taxation (and vice versa). A reduced AGI can create tax savings by lowering the amount of Social Security includable in income, reducing the floor threshold for deduction of medical expenses (7.5% of AGI) or miscellaneous itemized deductions (2% of AGI), and avoiding the threshold for phase-out of exemptions and itemized deductions.

1. Receipt of a lump sum (either at retirement, or to a beneficiary at death) could result in a significant tax burden because income averaging is not available (however, this can be moderated if the proceeds are annuitized).
2. The cash flow stream of a fixed payout may not keep pace with inflation, particularly for longer-term payout phases such as a life annuitization.
3. A 10% penalty tax is generally imposed on withdrawals of accumulated interest during the accumulation phase prior to age 59 1/2 or disability (this may also apply to the annuitization phase if the annuity was not an immediate annuity and certain short payout terms are selected).[6.]
4. With a few limited exceptions, if an annuity contract is held by a corporation or other entity that is not a natural person, the contract is not treated as an annuity contract for federal income tax purposes. This means that income on the contract for any taxable year is treated as current taxable ordinary income to the owner of the contract regardless of whether or not withdrawals are made.
5. If the client is forced to liquidate the investment in the early years of an annuity, management and maintenance fees and sales costs could prove expensive. Total management fees and mortality charges can run from 1% to 2 1/2% of the value of the contract (occasionally as high as 3% in the case of variable annuities with a number of underlying guarantees). There may be a “back end” surrender charge if the contract is terminated within the first few years to compensate the insurer for the sales charges that are not typically levied “up front.”
6. Investment earnings are taxed at the owner’s ordinary income tax rate when the owner receives payments, regardless of the source or nature of the return. Consequently, investment earnings attributable to long-term capital appreciation (typically in variable annuities) do not enjoy the more favorable long-term capital-gain tax rate that would otherwise generally apply. This has become even more disadvantageous with the reduction of the maximum long-term capital-gain rate to 15% (or even 5% for lower-income taxpayers). Furthermore, investment earnings attributable to dividends on stocks that would qualify for the 15% maximum tax rate if the stocks were held outside an annuity will also be taxed at the owner’s ordinary income tax rate (although these dividends will not be taxed until withdrawal). Consequently, variable annuities where the annuity owner is inclined to invest in equities are much less attractive than previously.

There are five typical fees or charges that are usually incurred when purchasing annuities, particularly variable annuities. These include:
1. Investment Management Fees – These fees run from a low of about 0.25% to a high of about 1%.
2. Administration Expense and Mortality Risk Charge – This charge ranges from a low of about 0.5% to a high of about 1.3%. However, additional riders and features can increase this cost to as high as 2.0%.
3. Annual Maintenance Charge – This charge typically ranges from $25 to $100. However, it is often waived once total investments exceed a specified amount, such as $25,000.
4. Charge per Fund Exchange – This charge generally ranges from $0 to $10, but most funds will permit a limited number of charge-free exchanges per year. In addition, automatic rebalancing programs usually do not count towards this limit.
5. Maximum Surrender Charge – Surrender charges vary by company and policy and generally phase-out over a number of years. If the charge is lower, the phase-out range tends to be longer. For example, typical charges and phase-out periods are 5% of premium decreasing to 0% over 10 years or 8% of premium decreasing to 0% over 7 years.

Items 1 through 4 in the above list must be explicitly stated in the prospectus for a variable annuity. In a fixed annuity, these costs are generally incorporated into the management of the insurance company’s general account and are simply netted out of the return credited to annuity-holders. Thus, when comparing fixed annuities, cost comparisons (although other non-cost aspects are also analyzed) are generally restricted to an evaluation of the comparable crediting rates of the general account and the surrender charges.

1. Compare, on a spreadsheet, the costs and features of selected annuities. Consider all of the five costs discussed above as well as how much can be withdrawn from the contract each year without fee. Be certain to fully read through the full details of costs/ charges, guarantees, riders, and special features in the prospectus of a variable annuity.
2. Compare the total outlay with the total annual annuity payment in the case of fixed annuities. Be certain to incorporate the time value of money if the payment schedules are different.
3. In an analysis of variable annuities, evaluate the total return for the variable annuity sub-accounts over multiple time periods (Lipper Analytical Services, Inc., and Morningstar, Inc., both have information to help assess this).
4. Compare the relative financial strength of the companies through services such as A.M. Best. Insist on a credit rating of A+ (or at the very least, thoroughly discuss with the prospective buyer the risks involved in purchasing from a company with a lesser rating).

For more Information:
Pensions, Annuities & Retirement
Pension and Retirement Plans. How to Retire Happy. Variable Income Annuities, Pension System, Endowments



  1. Great information about Annuity. the advantage and disadvantage nicely explain. Thanks

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  3. In one joint and survivor option, monthly payments are made during the annuitants' joint lives, with the same or a lesser amount paid to whoever is the survivor. In the option typically used for retired employees (employment model), monthly payments are made to the retired employee, with the same or a lesser amount to the employee's surviving spouse or other beneficiary. The difference is that with the employment model , the spouse's (or other co-annuitant's) death before the employee won't affect what the survivor employee collects. The amount of the monthly payments depends on the annuitants' ages, and whether the survivor's payment is to be 100% of the joint amount or some lesser percentage.

  4. Annuities are the only investment vehicles that can guarantee investors that they will not outlive their income, and they do this in a tax-favored manner,Thanks for this informative blog.


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