An annuity is a financial tool for saving money that might increase in value over time. Annuities can be used to build savings for retirement or to provide an income stream. They can also be used to provide income for your heirs after you die.
Annuities might not be the best financial investment option for some people. Talk with a financial adviser or financial planner about your needs and goals before buying an annuity.
You can buy an annuity from a licensed life insurance agent, insurance company, financial planner, or broker.
TDI licenses agents and companies that sell annuities in Texas. TDI and the U.S. Securities and Exchange Commission jointly regulate variable annuities. The Financial Industry Regulatory Authority (FINRA) 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.
Make sure any company you’re considering investing with is licensed and financially stable. To verify the license status of an agent or company, call TDI’s Consumer Help Line at 1-800-252-3439 or use the Agent and Company Lookup features on our website at www.tdi.texas.gov. You can also use the Company Lookup feature to learn a company’s financial rating from an independent rating organization.
Types of Annuities
There are two broad categories of 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. 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. For example, if you get money from an inheritance, the sale of property, or life insurance proceeds, you can use the money to set up an immediate annuity to provide you with monthly income payments for the rest of your life.
Both deferred and immediate annuities offer several types of products:
- Fixed annuities are guaranteed to earn at least a minimum interest rate. They are the lowest financial risk and offer conservative returns.
- Equity-indexed annuities have 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. Your earnings potential is higher but there isn’t a guaranteed return. Variable annuities are higher risk because there’s a chance you could lose some or all of your money.
Fixed annuities are the least risky because they guarantee a minimum interest rate, generally between 1 and 3 percent. The company might pay a higher interest rate than the guaranteed 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. Be sure you understand how and when the interest rate changes.
Equity-indexed annuities 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 choose to follow is negative, then you get no earnings. They also differ in the fees that are charged.
Equity-based annuities base returns on changes in indexes, such as the S&P 500, Russell 2000, or the European, Australian, or Far Eastern Indexes. Equity-based annuities can be more complex than a fixed deferred annuity. This makes it critical that you understand the type of indexed annuity you’re considering and the different elements and what they mean.
The two features that have the greatest effect on the amount of interest credited to an equity-based annuity are the indexing method and the participation rate.
- The indexing method is how the amount of change in the value of an index is measured. Some of the most common indexing methods are:
- annual reset,
- high-water mark,
- low-water mark, and
Each of these methods relies on the index term, which is when the company calculates the interest and credits it to your annuity.
- The participation rate decides how much of the increase in the index will be used to calculate the index-linked interest.
The following are some other important features of indexed annuities:
- Rate cap. Some annuities cap the index-linked interest rate. This is the maximum rate of interest the annuity will earn.
- Floor on equity index-linked interest. The floor is the minimum index-linked interest rate you will earn. Not all annuities have a floor. 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. The index-linked interest is added to your original premium amount but doesn’t compound during the term. Other annuities pay compound interest during a term. This means that 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.
- Vesting. If you take out all your money before the end of the term, some annuities won’t credit the index-linked interest. Some annuities might credit only part of the 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.
Variable annuities provide the potential for greater returns than fixed and index annuities, but they also have greater risk. The performance of these annuities depends on returns from sub accounts that are similar to mutual funds. 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 can help you decide whether a variable annuity is suitable for you and, if it is, how you should diversify your money in sub accounts.
Some companies limit the number of times you can reallocate your money in sub accounts. The company may charge you if you exceed the amount of changes allowed.
Some variable annuities offer a fixed sub account. 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 investments. An agent selling variable annuities must have a state license and a license from FINRA.
Phases of an Annuity
There are two phases in a deferred annuity: an accumulation phase and a payout phase. During the accumulation phase, you’re contributing money to the annuity. During the payout phase, you’re withdrawing money from the annuity.
During the accumulation phase your annuity earns interest.
You may have several options on how you contribute to an annuity, depending on the type of annuity you buy:
- 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.
The Internal Revenue Service (IRS) regulates the taxation of annuities. The IRS allows you to defer the tax on earnings until you withdraw them. If you withdraw your earnings before age 59½, you will probably have to pay a 10 percent early withdrawal penalty in addition to the taxes you owe on the interest earned. There are a few exceptions to this rule, however.
If the annuity is used as a traditional IRA, the money you contribute and the earnings are usually tax-deferred. If the annuity is used as a Roth IRA, the money and earnings are usually 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 tax professional to understand the taxation of the IRA you’re considering.
After the accumulation phase ends, an annuity enters its payout phase. This is sometimes called the annuitization phase. During this phase, you’ll start getting payouts on your annuity. There are several options for getting payments from your annuity:
- A fixed amount option. Your company pays you a fixed dollar amount for the time period stated in the contract.
- A life-only option. The company makes payments to you for as long as you live, but there aren’t any payments to your heirs after you die.
- A life option with a period certain. You get payments for as long as you live. If you die before the end of a certain period of time (usually 10, 15, or 20 years), the person you name as your beneficiary will get payments until the period ends.
- A joint and survivor life option. The company makes payments to you or your beneficiary 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 make sure your selection meets your needs.
Many annuities charge a penalty if you withdraw money 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. If you withdraw money before the age of 59½, the IRS usually charges a 10 percent penalty.
Your contract might include a free withdrawal option. This means you can withdraw money each year without the company charging a surrender penalty. Typically, the free withdrawal amount is 10 percent of the accumulated value. You might owe taxes on the money you withdraw, and you might have to pay the IRS’ early withdrawal penalty.
The Load or Commission
Annuities have other fees called loads or commissions. In some cases, these fees can be as much as 2 percent of an annuity’s value. Be sure to 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 is a good option for you, use these tips to help you shop:
- Shop around. Premiums and benefits vary from company to company, so it’s useful to talk to more than one company and compare.
- Decide before shopping how much financial risk you’re willing and able to take. Remember, fixed annuities have a lower risk and guarantee a minimum rate of return. Variable annuities, on the other hand, have the potential for higher earnings, but there’s more risk that you’ll lose money. Be careful 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 in the state.
- 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. Take the time you need to decide.
- Consider bringing a trusted family member or friend with you when you meet with an agent.
- Remember the free-look period. Annuities sold in Texas must have a 20-day free-look period. Replacement annuities have a 30-day free-look period. During the free-look period, you may cancel the contract for any reason and get a full refund. Use this time to review the contract and make sure it meets your needs.
- Make sure you fully understand the annuity you’re considering. A financial adviser can help you understand the annuity and evaluate it in comparison to other investments. A financial adviser or tax professional can also help you understand the tax consequences of the annuity you’re considering.
- 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? If there is, what are the terms?
- Can the annuity lose value?
- Will the annuity pay my beneficiaries after I die?
- 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 annuity in order to earn commissions. If someone suggests that you replace an annuity you own, or if you’re considering replacing an annuity, make sure you know these things:
- the accumulated value in your annuity before replacement,
- the amount of any surrender charges,
- whether you’ll lose any bonus interest or other feature if you give up your current annuity,
- the guaranteed interest rates of both your current annuity and the one you’re considering replacing it with,
- how much money you’ll need to start the new annuity,
- the loads or commissions for the new annuity, and
- whether the new annuity will meet your needs better than your current one.
For More Information or Help
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.
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.
For more information contact:
Last updated: 01/19/2016