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Understanding Annuities

(March 2014)

An annuity is a contract that can increase in value and provide a steady income over a long period of time. People often use annuities to build retirement savings. Annuities can also help you save for a child's education, create a trust fund, or provide for your spouse or children after you die.

Annuities aren't right for everyone. They typically take years to become profitable, so they're usually not a good tool for short-term investments. Talk to an accountant, attorney, or trusted financial adviser before buying an annuity.

An Introduction to Annuities

Insurance companies and agents sell annuities. Banks or investment firms backed by insurance companies may also sell annuities.

When you buy an annuity, you'll begin paying premium payments. The insurance company - or the bank or investment firm - issuing the annuity pays a minimum guaranteed interest on your premium payments. The annuity might also give you additional interest or a bonus over the minimum guaranteed interest rate.

Accumulation Phase and Payout Phase

Annuities have an accumulation phase and a payout phase.

Your premiums and interest grow during the accumulation phase. The company pays you the accumulated value in the payout phase. The value depends on market conditions and interest rates.

The payout phase is also called annuitization. The payout can be a partial withdrawal, complete withdrawal, a death benefit, or a series of guaranteed payments.

Most annuities let you withdraw some of your accumulated value before the payout phase begins. Some contracts provide a free 10 percent annual withdrawal.

If you withdraw money before the payout phase begins, you will probably have to pay a penalty called a surrender charge. Surrender charges are usually high during the first few years of the contract, so you could lose money if you withdraw any of the accumulated value early. Companies may lower or eliminate the penalties in later years.

Withdrawing the entire accumulated value early cancels the annuity.

Regulating Annuities

The Texas Department of Insurance regulates annuities 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 -- an independent nongovernmental agency that regulates security firms -- also licenses agents who sell variable annuities. TDI also works with the Texas State Securities Board on issues involving agents that TDI and the board license.

To verify the license status of an agent or company, call TDI's Consumer Help Line at 1-800-252-3439 or 512-463-6515 in Austin or view company profiles on our website at www.tdi.texas.gov .

Is an Annuity Right for You?

Think about your age, income, financial situation, and debts before buying an annuity. The following guidelines can help you decide whether an annuity is right for you:

  • If you are retired, an annuity is probably not a good option because it can take years for an annuity to become profitable. If you want to use an annuity for retirement income, it's best to buy it at least five to 10 years before you retire.
  • If you don't have any other investments or savings accounts, an annuity is probably not a good place to start. It's a good idea for investors to have some investments that can be converted to cash in case of an emergency or other need. You usually have to pay a penalty - often as high as 25 percent - if you withdraw your money from an annuity early.
  • If you want to have a guaranteed income stream for retirement, annuities that make fixed monthly payments for the remainder of your lifetime might be a good option.
  • If you have the financial discipline to keep an annuity for a long time, it can be a good option. But it's not a good option if you want or need to cancel it after only a few years. You'll not only have to pay a penalty for cashing in early, but it will probably increase your tax obligations too.
  • If you're in a high-income tax bracket now, but expect to be in a lower tax bracket in the future, an annuity can be a good choice because earnings are tax-deferred. This means an annuity's earnings aren't taxed while they grow. They're only taxed when you actually make a withdrawal or receive a payment. If you contribute to an annuity while you're in a high tax bracket and receive payments while you're in a lower one, you will probably pay less in taxes than you would with other investments.

Types of Annuities

There are three types of annuities:

  • fixed
  • variable
  • equity indexed

Each type of annuity earns interest differently and has a different level of financial risk.

Fixed Annuities

Fixed annuities are the least risky because they are invested in conservative, non-stock market investments, such as government and corporate bonds. You usually don't have input into how the money is managed.

Fixed annuities generate earnings at an interest rate that the insurance company sets each year. The rate can change, but will never fall below the guaranteed minimum rate. The guaranteed rate might be lower than the interest rate you would earn in a bank savings account.

Many fixed annuities guarantee a rate that is higher than the minimum rate for a number of years but then lower it later on. Ask your agent for an annuity's rate history to know what kind of rate you can expect over time.

Market value adjusted annuities are a type of fixed annuity that pay more than the guaranteed minimum rate for a period of time. You may withdraw money before the period ends, but you'll have to pay an early surrender charge, and the annuity's surrender value will be based on current market interest rates.

A fixed annuity will probably earn more than the current interest rate, but the insurance company keeps the profit. Insurance companies have an incentive to keep the current interest rate high because high interest rates attract new buyers.

Variable Annuities

Variable annuities can provide greater returns than fixed annuities, but they also have greater risk and require you to be more involved. These annuities are dependent on the stock market and generally don't make guarantees about earnings. If the annuity performs poorly, you could lose some or all of your original investment.

A variable annuity typically invests in a range of financial instruments, such as government securities, equity indexes, money market funds, and mutual funds of stocks and bonds. Unlike fixed annuities, variable annuities typically allow you to decide how the accumulated value is allocated among the selected investments. Your agent or broker can also decide for you.

For example, you could choose to put 40 percent of your accumulated value into the annuity's bond fund, 40 percent into its mutual fund, and 20 percent into its money market account. Meanwhile, other people could allocate their accumulated value differently. This means that people who buy the same variable annuity will have different rates of return, depending on the performance of the investments they choose.

Most variable annuities will allow you to change your allocation for free a certain number of times per year. The company will charge you for any changes beyond those.

Some variable annuities offer a fixed interest account within their investment options. The account essentially acts like a fixed annuity within the variable annuity and guarantees a minimum rate of return. A fixed interest account can be a valuable feature during an economic downturn.

Unlike fixed annuities, variable annuities are classified as securities by the SEC because performance is heavily dependent on the stock market. An agent selling variable annuities must maintain a Financial Industry Regulatory Authority license and a Texas insurance license.

Equity-indexed Annuities

Equity-indexed annuities (EIAs) combine features of both fixed and variable annuities. They are riskier but offer higher potential returns than fixed annuities. They are usually less risky and offer lower returns than variable annuities.

EIAs base returns on changes in stock, bond, and money markets, but also have a guaranteed minimum interest rate. The value of your annuity won't drop below the guaranteed minimum. Some EIAs place a cap on the maximum rate of interest the annuity can earn.

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

The indexing method is how the amount of change in the index is measured. An index is a statistical measure of a change in a market. The following are some of the most common indexing methods:

  • Annual reset is determined by comparing the index value at the beginning and end of the contract year. Since the interest earned is locked in annually and the index value is reset at the end of each year, future decreases in the index won't affect the interest you already earned. Your annuity may credit more interest than annuities using other methods when the index fluctuates up and down during the term. This method is more likely to give you access to index-linked interest before the term ends.
  • High-water mark is decided by looking at the index value at different times during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the highest index value and the index value at the start of the term. Since interest is calculated using the highest index value during the term, this method may credit higher interest than other methods if the index reaches a high point early or in the middle of the term, then drops off at the end of the term.
  • Low-water mark is determined by looking at the index value at different times during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the index value at the end of the term and the lowest overall index value. This indexing method may credit higher interest than some other methods if the index reaches a low point early or in the middle of the term and then rises at the end of the term.
  • Point-to-point is based on the difference between the index value at the end of the term and the index value at the start of the term. Since interest can't be calculated before the end of the term, this method might have a higher participation rate than annuities using other methods.

The index term refers to when the company calculates the index-linked interest and credits the interest to your annuity at the end of a term. Terms are generally from one to 10 years, but six or seven years are the most common. Some annuities offer single terms while others offer multiple, consecutive terms. If your annuity has multiple terms, there will usually be a 30-day window at the end of each term during which you may withdraw your money without penalty. For installment premium annuities, the payment of each premium may begin a new term for that premium.

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 multiplied by 70 percent equals 6.3 percent).

A company may change participation rates daily, so your initial rate is determined by when the company issued the annuity. The company guarantees participation rates for a specific period, from one year to the entire term. When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee a minimum and maximum participation rate.

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.

EIAs are long-term financial options. Withdrawing your money early may result in a loss because many EIAs have surrender charges. In addition to surrender charges, an EIA may also include a negative adjustment in the event of early termination. For example, an EIA with a 20 percent surrender charge and a 9 percent negative EIA adjustment produces an effective early withdrawal penalty of 29 percent.

How Interest Rates are Set for Fixed Deferred Annuities

During the accumulation period, your money -- minus any charges -- earns interest at rates that change over time. Usually, the rates are entirely up to the insurance company.

  • The current rate is the rate the company decides to credit to your contract at a particular time. The company will guarantee that rate won't change for a certain period.
  • The initial rate is an interest rate the insurance company may credit for a certain time after you buy your annuity. The initial rate in some contracts may be higher than it will be later. This is often called a bonus rate.
  • The renewal rate is the rate credited by the company after the end of the set time period. The contract tells how the company will set the renewal rate, which may be tied to an external reference or index.
  • The minimum guaranteed interest rate is the lowest rate your annuity will earn. This rate is stated in the contract.

Some annuity contracts apply different interest rates to each premium you pay or to premiums you pay during different time periods.

Other annuity contracts might have two or more accumulated values that fund different benefit options. These accumulated values may use different interest rates. You get only one of the accumulated values depending on which benefit you choose.

Paying Premiums

If you have a single premium annuity, you will probably pay the entire premium payment up front. An advantage of a single premium annuity is that the full amount of your premium begins earning interest from the first day.

Installment premium annuities allow you to make premium payments. This can be a good option for people who want to buy an annuity but have limited money. There are two main types of installment premium annuities:

  • Scheduled premium annuities specify the amount of each premium payment and when you'll make them.
  • Flexible premium annuities allow you to pay as much as you want when you want, within certain limits.

Earnings for a flexible premium annuity aren't solely determined by the contract's performance, but also by the amount you pay in. Most flexible premiums will require certain minimum premium payments, at least in the early years. In some cases, companies might also have a maximum amount you can contribute.

An advantage of a flexible premium contract is that it allows you to decide the amount you pay according to the annuity's performance. Flexible premium annuities generally charge higher administrative fees than scheduled premium annuities.

Receiving Payouts

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 one to 13 months after purchase. You will typically pay for an immediate annuity in a single premium payment because the entire premium amount must accumulate before the payout phase begins.

People typically buy immediate annuities to convert a large sum of cash into a steady stream of income. Immediate annuities are commonly used to create trust funds.

Deferred annuities begin the payout phase about seven to 10 years after you buy them, although some contracts can defer payout for 20 years or longer. The most common type of annuity is the deferred annuity with an installment premium, although single premium deferred annuities are also common.

How Annuities Pay

An annuity may pay the full amount of your accumulated value in a lump sum or in a series of payments.

You will usually be asked to set up the amount and duration of payments when the payout phase begins - not when you initially buy the annuity. Talk to an accountant, attorney, or trusted financial adviser before you decide how you want your annuity to pay. Companies generally don't let you change your mind once payments begin.

The following are some of the most common payout structures. Not all annuities offer these options, and some might offer others.

  • Fixed amount. The insurance pays the value of the annuity in fixed amounts for the time period stated in the contract. If you die before the payouts end, your estate or heirs might continue to receive payments.
  • Life only. The company makes payments for as long as you live. If you don't live as long as expected, you might not receive the entire accumulated amount. But, if you live longer than expected, you could receive more than the accumulated value of the annuity. Life only payments are primarily determined by life expectancy; the longer you are expected to live, the smaller the payment amount will be.
  • Fixed period. You receive a payment for as long as you live or for a specific number of years, whichever is longer. A designated beneficiary may receive payments after you die. The amount of the payments for this option will likely be smaller than for life only because the insurance company is guaranteed to pay a specific amount and could pay more if you live for a long time.
  • Life with period certain. Payments end when you die, but your designated beneficiary will inherit the balance if you didn't receive the stated amount based on the value of the annuity. The main difference between life with period certain and fixed period is that the beneficiary receives the amount in a lump sum with the former option.
  • Joint and survivor life. The company pays you or a survivor for as long as either is alive. The amount of the regular payments will typically be smaller than with the life only option since the company is now paying for the longer of two lifetimes.
  • Death benefit. In some annuity contracts, the company might pay a death benefit to your beneficiary if you die before the income payments start. The most common death benefit is the contract value or the premiums paid, whichever is greater.

Every annuity contract has a table of guaranteed benefit rates, and most companies have current benefit rates as well. The company can change the current rates at any time, but the current rates can never be less than the guaranteed benefit rates. When income payments start, the insurance company generally uses the benefit rate in effect at the time to figure the amount of your income payment.

While all deferred annuities offer a choice of benefits, some use different accumulated values to pay different benefits. For example, an annuity might use one value if annuity payments are for retirement benefits and a different value if the annuity is surrendered. As another example, an annuity might use one value for long-term care benefits and a different value if the annuity is surrendered. You can't receive more than one benefit at the same time.

Tax Treatment of Annuities

Income tax on annuities is deferred, which means you aren't taxed on the interest your money earns while it stays in the annuity. Tax-deferred accumulation isn't the same as tax-free accumulation.

An advantage of tax deferral is that the tax bracket you're in when you start getting annuity income payments might be lower than the one you're in during the accumulation period. You'll also be earning interest on the amount you would have paid in taxes during the accumulation period.

Part of the payments you get from an annuity is considered a return of the premium you've paid. You won't have to pay taxes on that part. Another part of the payments is considered interest you've earned. You must pay taxes on the part that is considered interest when you withdraw the money. You might also have to pay a 10 percent tax penalty if you withdraw the accumulation before age 59 ½. Federal law also regulates distributions after your death

Annuities that are used to fund some employee pension benefit plans defer taxes on plan contributions as well as on interest or investment income. Within the limits set by the law, you can use pretax dollars to make payments to the annuity. When you take money out, it will be taxed.

You can also use annuities to fund traditional and Roth IRAs. If you buy an annuity to fund an IRA, you'll receive a disclosure statement describing the tax treatment.

Talk to a professional tax advisor to discuss your tax situation.

Administrative Fees and Charges

Surrender Charges

Most annuities will charge you a penalty if you withdraw 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. Surrender charges commonly range from 5 to 25 percent of the amount withdrawn.

Early withdrawal from an annuity can penalize you in another way. Annuities are tax-deferred to encourage you to use them for retirement savings. To discourage people from buying annuities to avoid paying taxes, the tax code includes a 10 percent penalty for withdrawing under age 59 ½. For example, if you are under 59 1/2 and want to withdraw $1,000 with a 20 percent surrender fee, you will have to pay a $200 penalty to the annuity, a $100 penalty to the Internal Revenue Service, and the normal tax rate you would pay on the money as income.

The Load

Annuities commonly have other charges and fees - called the load -- to pay for the cost of marketing and managing the fund. In some cases, the load can be as much as 2 percent of an annuity's value. It is important that you calculate the amount of the load when you're estimating earnings. For example, if an annuity is projected to earn 7 percent annually and charges a 2 percent load, your earnings should be 5 percent.

A typical annuity might charge one or more of the following types of fees:

  • Percentage of premium. A charge that's automatically deducted from your annuity's value for each premium paid. The company might reduce the percentage after the annuity has been in force for a certain number of years or after you've paid a certain amount of premium.
  • Percentage of net assets. A regular charge that is deducted from your annuity contract's current accumulated value. Variable annuity contracts most often charge this fee.
  • Contract fee. A flat dollar amount that is charged either annually or when you buy the annuity. Agent commissions often come out of the contract fee.
  • Transaction fee. This fee, which is usually associated with variable annuities, may be charged for each premium payment or when you move your money from one investment to another. Typically, a variable annuity will allow you to make a certain number of free transactions each year.

Some companies don't have a load, but you will probably pay higher surrender charges and transaction fees, or the company might take a share of the earnings before counting it as income. The load - or some substitute mechanism - is how the insurance company makes a profit.

Free Withdrawal

Your annuity might have a free withdrawal feature. The size of the free withdrawal is often limited to a set percentage of your contract value. If you make a larger withdrawal, you might pay withdrawal charges, and you lose any interest above the minimum guaranteed rate on the amount you withdraw. Some annuities waive withdrawal charges in certain situations, such as death, moving to a nursing home, or terminal illness.

Premium Tax

Some states charge a premium tax on annuities. Insurance companies collect the tax by adding it to your premium or by subtracting it when you withdraw your contract value or start receiving payments. Texas doesn't currently charge a premium tax on annuities.

Texas charges insurance companies a maintenance tax based on premiums, including annuity premiums. The company, not the contract holder, pays this tax.

Shopping Smart for Annuities

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

  • Shop around. Premiums and benefits can vary from company to company, so it's useful to talk to more than one and compare benefits.
  • Make sure the time frame for payout is right for your needs. Remember that annuities aren't short-term financial tools. They might take a decade or longer to become profitable.
  • Know how much risk you can take on. Weigh the amount of risk you're willing to take against the risk of the type of annuity you're considering. Fixed annuities guarantee a minimum rate of return. Variable annuities have the potential to earn significantly more, but you could also lose money. Remember, annuities are investments and could lose value.
  • Check the company's earnings history. An agent will probably give you materials that project an annuity's growth over time. But remember projections aren't guarantees. An agent might show you a high rate of return for a fixed annuity, but you might only earn the guaranteed minimum rate. Also, if financial conditions change for the worse, your earnings could decline. Ask the agent how well earnings have met projected rates in the past. If earnings are consistently below target, consider shopping for another company.
  • 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. You can verify licensing status by calling our Consumer Help Line at 1-800-252-3439 or 512-463-6515 in Austin or by viewing company profiles on our website at www.tdi.texas.gov .
  • Check the company's complaint index. The complaint index is an indication of a company's customer service record. You can check complaint records by calling the Consumer Help Line or by visiting the website.
  • Consider the company's financial condition. Annuities are a long-term financial option. A company that is in solid financial shape is more likely to be around when it is time for you to collect on your contributions. You can learn a company's financial rating from an independent rating organization by calling TDI's Consumer Help Line.
  • Take your time to consider. It's probably not a good idea to buy an annuity on the first visit with an agent. Take all 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.
  • Use the free look period. Almost all annuities sold in Texas come with a 20-day free look period, and 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. If the annuity doesn't offer a free look period, be especially cautious.
  • Be wary of annuities sold door-to-door or over the telephone. While most annuities sold door-to-door or over the telephone are legitimate, these sales techniques can lend themselves to fraudulent operations. If you buy an annuity this way, ask for the company's physical address and make sure you have a way to contact the agent or company.
  • Talk to an accountant, financial adviser, or a trusted family member or friend. Be sure you fully understand any annuity you buy. A finance professional can help you understand the annuity and evaluate it in comparison to other investment products.
  • Research the annuity you're considering. Ask the agent or company the following questions:
    • What is the projected interest rate? Is there a guaranteed interest rate or bonus?
    • What is the length of time until annuitization or payout?
    • How does the annuity earn excess (non-guaranteed) credits?
    • Can the annuity lose value without surrender?
    • Are there early withdrawal penalties, such as surrender charges or negative adjustments?
    • What is the percentage or duration of surrender charges?
    • Is there a free withdrawal provision? If so, what are the terms?
    • What is the death benefit?
    • What is the earliest maturity or annuitization date?
    • How much are the fees?
    • How does the annuity compare to the projected return with other types of investments, such as index funds, mutual funds, and government bonds? Even with an annuity's tax advantages, these other investments might provide an equal or better return while providing more access to your money.

Replacing an Existing Annuity with a New One

Many annuity sales pitches encourage you to withdraw from the accumulated value of an annuity you already have to purchase a new annuity that might provide a better rate of return or offer more features and benefits. If you are considering this option, remember that many annuities have early withdrawal penalties. It might take many years for the replacement annuity to return to the value of the annuity that it replaced. When you buy a new annuity, you will start over at year zero and will lose any time you built up under the old annuity.

For a deferred annuity, you will lose time earned toward the payout period. Even if the new annuity pays a higher interest rate, the difference likely won't be higher than the value of getting your payout sooner rather than later, once you account for inflation and the normal interest rate you'd earn by putting the money in a bank.

Also, keep in mind that your agent will earn a new commission if you switch annuities. Advising a client to change annuities for the sole purpose of earning a commission, without regard to the client's best financial interest, is called churning. It's illegal in Texas. If you believe you've become a target of churning, call the Consumer Help Line.

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 at 1-800-252-3439 or 512-463-6515 in Austin 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 24-hour Publications Order Line at 1-800-599-SHOP (7467) or 512-305-7211 in Austin.

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: 09/08/2014

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