5 prime annuity prospects

2. Clients who need a guaranteed rate of return.

When a specific minimum return on investment and preservation of principal is required to accomplish a particular goal, an immediate annuity makes no sense because it does not preserve principal. The income payments from an immediate annuity, while they may be larger than might be achievable from alternatives, are not just a return on investment, but a combination of return on and return of investment. However, a deferred annuity offering a multi-year interest rate guarantee may well provide a solution. The risk of getting an inadequate rate of return is managed by transferring it to the insurance company issuing the annuity. This provides a total or minimum rate of return guaranteed to equal or exceed the return required. However, it is important to note that there is a lack of liquidity cost associated with these annuities. This is because the insurance company makes its guarantees assuming it will have use of the money used to purchase the annuity. Typically, a deferred annuity contract does not become profitable for an insurer until after it has been in force for several years due to commissions, other issuing charges, administrative costs, deferred acquisition costs, taxes, and reserve requirements. If the annuity owner elects to surrender or take withdrawals from the annuity in the early contract years, he will usually be required to pay a surrender charge. The amount and terms of this vary considerably from contract to contract.

Recently, many variable deferred annuities have been marketed with guaranteed living benefits. The structure and provisions of these policies vary greatly, but it should be noted that the guarantees provided are typically not equivalent to the guaranteed minimum rate of return of fixed annuities, and usually require annuitization, minimum holding periods, or other conditions for the guarantees to be effective. For an extensive discussion of the various living benefits available with variable annuities, see Chapter 6.

Gain access to the full Advisor’s Guide to Annuities content here.

3. Clients who need a better nonguaranteed rate of return.

With the exception of fixed annuities with multi-year current rate guarantees, or so-called CD annuities, no deferred annuity guarantees the current rate of return for more than a year at most. Although, all fixed annuities offer a guaranteed minimum rate of return. Variable deferred annuities generally do not offer any guarantees of return or of principal, except where the fixed investment account is used or as provided by optional riders. That said, we should bear in mind that most other long-term investments do not offer such guarantees either. For clients who require a guarantee of principal and are willing to accept a current rate that may change, deferred fixed annuities may offer better returns than certificates of deposit or individual bonds. The interest rate history of many fixed annuities has exceeded that of CDs, although there can be no assurance that this will hold true in the future.

When comparing the interest crediting rate of a deferred annuity with that of an alternative, the diligent advisor will point out not only any applicable surrender charges, but also the early distribution penalty which applies to withdrawals taken prior to age 59½, unless an exception is available. Those are essential elements in any sound risk management decision. So, too, is the fact that earnings in deferred annuities are not taxed until distributed.

Gain access to the full Advisor’s Guide to Annuities content here.

4. Clients who want and needs income tax deferral.

Tax deferral is perhaps the most advertised and promoted advantage of deferred annuities. Earnings are not taxed until distributed, either to living contract owners or beneficiaries. The advantages of such deferral are well-recognized. However, the cost of such tax deferral, granted by Section 72 of the Internal Revenue Code, is a requirement in the same section that all distributions from annuities be taxed at ordinary income rates. No capital gains treatment is ever available under current law. Whether this trade-off is favorable, or appropriate, is a matter of considerable controversy. In the authors’ view, it is always a matter of individual facts and circumstances.

Gain access to the full Advisor’s Guide to Annuities content here.

5. Clients who needs a guaranteed payment in the event of death.

An often overlooked feature of deferred annuities is the right of the beneficiary to receive a guaranteed payment, or a payment determined by a guaranteed formula, in the event of death. This payment may not occur until the distant future, but upon purchase of the contract the owner knows exactly what the payment will be or how it will be determined.

When is this important? When the client requires that a certain amount be available upon death, regardless of investment performance in the meantime. This guarantee allows an annuity owner to manage the risk that inadequate investment performance will cause a smaller amount to pass to her beneficiaries than desired, regardless of actual investment performance over the time period until death. The authors strongly believe, however, that, when the need for such guaranteed death benefit is a primary concern, life insurance generally represents a far more efficient solution, if available.

Gain access to the full Advisor’s Guide to Annuities content here.

The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.