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Understanding Annuities

(November 2014)

An annuity is a contract between you and an insurance company. An annuity is designed to be a financial tool for saving money that might increase in value over time and provide a steady income. The most common use for annuities is to build retirement savings. Other uses include building a financial legacy to leave your heirs and creating an income stream. 

Like other financial investments, annuities might not be the best option for everyone. Talk with a financial planner about your situation and goals before buying an annuity.

An Introduction to Annuities 

You can buy an annuity from a licensed life insurance agent, insurance agency, financial planner, or broker. Although annuities may guarantee your money and interest earnings, your money could be at risk if the company goes out of business. Make sure any company you’re considering is financially stable. Financial ratings by independent rating organizations are a good indicator of a company’s financial strength. You can use the Company Lookup feature on the Texas Department of Insurance website to learn a company’s financial rating.

Accumulation Phase and Payout Phase

There are two phases in a deferred annuity: an accumulation phase and a payout phase. During the accumulation phase, you are contributing to the annuity. During the payout phase, you are withdrawing from the annuity.

Accumulation Phase

During the accumulation phase you contribute money to your annuity and the annuity earns interest. 

The Internal Revenue Service (IRS) regulates the taxation of annuities. The IRS allows the tax on earnings to be deferred until you withdraw the earnings. If you withdraw your earnings before age 59 ½, you may be charged an early withdrawal penalty of 10 percent in addition to the taxes you owe on the interest earned. There are a few exceptions to this rule. 

If the annuity is used as a traditional IRA, it is possible that the money you contribute and the earnings are tax-deferred. If the annuity is used as a Roth IRA, it is possible that all of the money and earnings are tax-deferred and then tax-free when you withdraw them. There are specific rules governing the taxation of IRAs. Visit www.IRS.gov or talk to your agent, financial planner, or a tax professional to understand the taxation of the IRA you are considering.

Payout Phase

You may begin receiving payments during the payout phase, also known as the annuitization phase. There are different types of annuities designed to take care of specific goals or needs. 

During the payout phase, you may withdraw funds when you need them or select one of several settlement options for receiving payments from your annuity. These options include:

  • a fixed amount option that provides a payment for the time period stated in the contract
  • a life only option in which the company makes payments to you for as long as you live, but there aren’t any benefits to your beneficiaries after you die. You won’t outlive your money because the company will continue to make payments to you for as long as you live.
  • a life option with a period certain. This means that you receive a payment for your lifetime, but payments are guaranteed to your beneficiary for a period of time such as 10, 15, or 20 years from the beginning of the lifetime payout to you.
  • a joint and survivor life option in which payments are made to you or a survivor for as long as either is alive.

The amount of your payment or the amount paid to your beneficiary will be different under each of these options. Talk to your agent or financial planner to ensure that your selection meets your needs.

Surrender Charges

Most annuity contracts have a schedule of charges if you withdraw money early. Generally, this is during the first few years of the contract, which may extend up to 10 years. The surrender charges decrease the longer you own the annuity. Some annuities may have a free withdrawal option each year, during which you may withdraw a small percentage without being charged a surrender fee. It’s important to understand when you might need to use the money and what surrender charges may apply. 

Regulating Annuities

TDI regulates annuities that are sold in Texas. Agents and companies that sell annuities in the state must have a Texas insurance license. TDI and the U.S. Securities and Exchange Commission (SEC) jointly regulate variable annuities. The Financial Industry Regulatory Authority (FINRA) is an independent nongovernmental agency that regulates security firms and also licenses agents who sell variable annuities. TDI also works with the Texas State Securities Board on issues involving agents that sell variable annuities.

To verify the license status of an agent or company, call TDI’s Consumer Help Line at 1-800-252-3439 or view company profiles on our website at www.tdi.texas.gov.

Is an Annuity Right for You? 

Annuities can provide a place for you to save money for retirement or heirs, or to create an income to you. When you are considering whether an annuity is suitable for you, consider your

  • goals and objectives
  • age
  • annual income
  • financial situation, experience, objectives
  • existing assets
  • liquidity needs
  • liquid net worth
  • how you tolerate risk with your money
  • tax status.

Types of Annuities  

Annuities are usually used as tools for saving, to provide a steady income, or both. There are two primary categories of annuities: deferred and immediate annuities.

  • Deferred annuities allow you to save money for retirement or other reasons, while deferring the taxes on your earnings (or contributions if it’s an IRA) until you withdraw the earnings or leave it to your beneficiaries. The deferral of taxes might be an advantage over other investment opportunities.  
  • Immediate annuities allow you to create an income stream of payments for a period of time you choose, which can include payments for the rest of your life. For example, if you get from an inheritance, the sale of a property, or life insurance proceeds, you may use the money to establish an immediate annuity to provide you with income payments monthly for the rest of your life.

Deferred and immediate annuities each include two or three types of products:

  • Fixed annuities are guaranteed to earn at least a minimum interest rate. They are the lowest risk and offer conservative returns.
  • Equity-indexed annuities provide the possibility to earn a higher interest rate, but there isn’t a guaranteed minimum interest rate. They are low-to-moderate risk and offer moderate returns.
  • Variable annuities provide choices between sub accounts that are similar to mutual funds where your earning potential is higher but there isn’t a guaranteed return. They are low-to-high risk, and there is a chance and you could also lose some or all of your money.

Fixed Annuities

Fixed annuities are the least risky because you are guaranteed to earn at least a minimum interest rate, generally between 1 and 3 percent. The company may pay a higher interest rate than the guaranteed interest rate (known as the current interest rate) but the money and the interest it earns aren’t at risk of loss.

The insurance company determines the interest rates, which can change monthly, quarterly, semiannually, or annually. Since the interest rate you earn can change over time, it’s important to talk to your agent or financial planner.

Equity-indexed Annuities

Equity-indexed annuities (EIAs) are similar to fixed annuities because you can’t lose the money you contribute or your interest earnings. They differ from a fixed annuity because there isn’t a guaranteed minimum interest rate. If the index you select to follow is negative, then your earnings are 0 percent. They also differ in the fees that are charged. 

EIAs base returns on changes in indexes, such as the S&P 500, Russell 2000, or the European, Australia, and Far East Indexes or (EAFE).

Two features that have the greatest effect on the amount of interest credited to an EIA are the indexing method and the participation rate.

Indexing Method

The indexing method is how the amount of change in the value of an index is measured. The following are some of the most common indexing methods:

  • annual reset
  • high-water mark
  • low-water mark
  • point-to-point.

Each of these methods relies on the index term, which is when the company calculates the index-linked interest and credits the interest to your annuity at the end of a term.

Participation Rate

The participation rate decides how much of the increase in the index will be used to calculate the index-linked interest. For example, if the calculated change in the index is 9 percent and the participation rate is 70 percent, the index-linked interest rate for your annuity will be 6.3 percent (9 percent of 70 percent is 6.3 percent).

Other important terms or elements in indexed annuities are:

  • rate cap
  • floor
  • averaging
  • interest compounding
  • margin, spread, and administrative fees
  • vesting.

Rate cap. Some annuities may cap the index-linked interest rate. This is the maximum rate of interest the annuity will earn. This means that if the contract has a 6 percent cap rate, then 6 percent would be credited. Not all annuities have a rate cap.

Floor on equity index-linked interest. The floor is the minimum index-linked interest rate you will earn. The most common floor is zero percent. A zero percent floor ensures that even if the index decreases in value, the index-linked interest you earn will be zero and not negative. Like rate caps, not all annuities have a stated floor on index-linked interest rates. All fixed annuities have a minimum guaranteed value.

Averaging. Some companies use the average of an index's value rather than the actual value of the index on a specified date. The index averaging may happen at the beginning, the end, or throughout the entire term of the annuity.

Interest compounding. Some annuities pay simple interest during an index term. That means index-linked interest is added to your original premium amount but doesn’t compound during the term.

Others pay compound interest during a term, which means that index-linked interest that has already been credited also earns interest in the future. In either case, the interest earned in one term is usually compounded in the next.

Margin/spread/administrative fee. In some annuities, the index-linked interest rate is determined by subtracting a percentage from any calculated change in the index. This percentage might be used instead of or in addition to a participation rate.

For example, if the calculated change in the index is 10 percent, your annuity might specify that 2.25 percent will be subtracted from the rate to determine the interest rate credited. In this example, the rate would be 7.75 percent (10 percent minus 2.25 percent equals 7.75 percent). The company subtracts the percentage only if the change in the index is a positive interest rate.

Vesting. If you take out all your money before the end of the term, some annuities will credit no or only part of the index-linked interest. The percentage that is vested generally increases as the term nears the end and is always 100 percent at the end of the term.

Equity indexed annuities can be more complex than a fixed deferred annuity. This makes it critical for you to understand the type of indexed annuity you are considering and the different elements and what they mean to you.

Variable Annuities

Variable annuities provide the potential for greater returns than fixed and index annuities, but they also have greater risk. If you purchase a variable annuity, you might want to check it often and  work with your agent to adjust your choices as necessary. The performance of these annuities is dependent on returns from sub accounts that are similar to mutual funds. These sub accounts invest in stocks, bonds, money market, and other investments. These sub accounts don’t provide a guaranteed return. If the sub accounts you select perform poorly, you could lose some or all of your original investment.

Your agent or financial adviser should walk you through an assessment of your ability to handle the risks associated with variable annuities. This information, along with other suitability information about you, will help you and your agent or financial planner determine whether a variable annuity is suitable for you and how your money should be diversified within the sub accounts. 

Most variable annuities allow you to change your allocation a certain number of times per year without a charge. The company may charge you if you exceed the amount of changes allowed.

Some variable annuities will offer a fixed sub account within their investment options. This sub account is essentially a fixed annuity within the variable annuity and guarantees a minimum rate of return.

Unlike fixed annuities, variable annuities are classified as securities by the SEC because the performance of the sub accounts is derived from stocks, bonds, and other financial investments. An agent selling variable annuities must have a state license and a license from FINRA

Making Contributions or Premium Payments

You may have several options on how you can contribute to an annuity, depending on the type of annuity you buy. The followings options may be available to you:

  • Flexible and periodic payments allow you to choose the time and amount of the payment.
  • Single premium allows you to make one payment at the beginning of the annuity.
  • Fixed payments allow you to make the same payment at the same interval, either monthly, quarterly, or annually.

Withdrawing Contributions or Receiving Premium Payments

Once the accumulation phase has ended, an annuity enters its payout phase and you receive the return on your accumulated account value. You will start receiving payouts on your annuity immediately or over time, depending on what type of annuity you buy.

Immediate annuities begin the payout phase generally one to 13 months after you buy the annuity. Typically, you make one payment to an immediate annuity. The payment you receive is based on this amount and the interest rate applied to the annuity. Immediate annuities are used to

  • provide income during retirement
  • provide income for a specific time.

Deferred annuities begin the payout phase anywhere from shortly after purchase to several years into the future, depending on when you need to receive payments. It’s important that you understand your annuity contract, any surrender fees that apply, and any taxes or penalties that might be due when you withdraw money from the annuity. 

Administrative Fees and Charges    

Surrender Charges

Many annuities charge a penalty if you withdraw money from the accumulated value before the payout phase begins. This penalty, called a surrender charge, is typically highest in the early years of the annuity, and may get smaller or go away over time. The charge is often a percentage of the amount of the withdrawn money, and generally starts at about 10 percent and drops each year until the surrender period is over.

Annuities are tax-deferred to encourage saving for your retirement years. In exchange, for the deferral of tax during the accumulation phase, the IRS imposes a 10 percent penalty for withdrawing your money before age 59½. There are a few exceptions. 

Your contract may also include a free withdrawal option. This means you can withdraw a certain amount each year without being charged a surrender penalty from the company. Typically, the free withdrawal amount is 10 percent of the accumulated value. You might still owe taxes and be charged the early withdrawal penalty from the IRS.

The Load or Commission

Annuities also have other charges and fees, referred to as loads or commissions. In some cases, these fees can be as much as 2 percent of an annuity’s value. It’s important that you include the amount of these fees when estimating the cost to buy an annuity and the amount you will earn from it. For example, if an annuity is projected to earn 7 percent annually and charges a 2 percent load, your earnings would be 5 percent.

Shopping Smart for Annuities  

If you decide that an annuity might be a good option for you, use these tips to help you shop:

  • Shop around. Premiums, benefits, and the company’s financial strength can vary from company to company, so it’s useful to talk to more than one company and compare.
  • Understand the financial risk you are comfortable with as you decide which annuity best fits your needs.  Remember, fixed annuities guarantee a minimum rate of return while variable annuities have the potential for higher earnings but also pose a greater risk to lose your money. Be cautious about putting all of your liquid assets into an annuity.
  • Make sure that the agent and company are licensed. Agents and companies must have a Texas insurance license to legally sell annuities. Agents who sell variable annuities must also have a federal securities license. Knowing if an agent or company is licensed helps ensure that an annuity is legitimate and meets minimum state requirements. Check the company’s complaint index. The complaint index is an indication of a company’s customer service record. Learn about a company’s licenses status, complaint history, and financial rating from an independent rating organization by calling TDI’s Consumer Help Line at 1-800-252-3439 or by visiting the TDI website at www.tdi.texas.gov.
  • Don’t rush into a purchase. It’s probably not a good idea to buy an annuity on the first visit with an agent. Take the time you need to decide. If you feel you are being pressured to make a decision quickly, go elsewhere. Consider bringing a trusted family member or friend with you when you meet with the agent.
  • Remember the free look period. Annuities sold in Texas are required to provide a 20-day free look period. Replacement annuities provide a 30-day free look provision. During this period, you may cancel the contract for any reason and get a full refund. Use this time to reread the contract and make sure it meets your needs.
  • Be careful when buying an annuity on the Internet, over the phone, or from a door-to-door sales agent. Protect yourself by knowing the location of the company, financial rating, and license status
  • Talk to an accountant, financial planner, a trusted family member, or a friend. Be sure you fully understand the annuity you are considering. A financial professional can help you understand the annuity and evaluate it in comparison to other investment products.
  • Review the annuity you’re considering and ask the agent or company the following questions:
    • What is the guaranteed minimum interest rate?
    • What is the current interest rate?
    • Is there a bonus interest rate
    • If yes, what are the requirements for you to see or receive the bonus interest rate?
    • What are the surrender period and charges?
    • Is there a free withdrawal option and if yes, what are the terms?
    • How does the annuity earn excess (non-guaranteed) credits?
    • Can the annuity lose value?
    • Is there a death benefit?
    • What is the maturity or annuitization date?
    • What are the fees?

Replacing an Existing Annuity with a New One   

It’s against the law in Texas for agents to recommend a replacement because they want to earn commissions. If anyone asks if you want to replace an annuity you own, or if you are considering other annuities, be sure to ask and understand the following:

  • What is the accumulated value in your annuity prior to the replacement?
  • What is the surrender charge?
  • Is there a loss of bonus interest or other feature that is provided only if you keep or annuitize your current annuity?
  • How much money do you need to start the new annuity?
  • What loads or commissions will you pay to start the new annuity?
  • What are the surrender penalties in the new annuity?
  • What are the new fees and charges in the new annuity?
  • Does the new annuity meet your needs better than your current annuity?

For More Information or Assistance  

For answers to general insurance questions, for information about filing an insurance-related complaint, or to report suspected insurance fraud, call the Consumer Help Line 1-800-252-3439 between 8 a.m. and 5 p.m., Central time, Monday-Friday, or visit our website at www.tdi.texas.gov.

You can also visit HelpInsure.com to help you shop for automobile, homeowners, condo, and renters insurance, and TexasHealthOptions.com to learn more about health care coverage and your options.

For printed copies of consumer publications, call the Consumer Help Line.

To report suspected arson or suspicious activity involving fires, call the State Fire Marshal’s 24-hour Arson Hotline at 1-877-4FIRE45 (434-7345).

The information in this publication is current as of the revision date. Changes in laws and agency administrative rules made after the revision date may affect the content. View current information on our website. TDI distributes this publication for educational purposes only. This publication is not an endorsement by TDI of any service, product, or company.

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Last updated: 12/09/2014

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