Annuities are tools. They are acquired because the purchaser has a particular job to be done and is willing to exchange his money for a tool to do that job. In many ways, this exchange transaction is like the purchase of a hammer. The hammer has certain specifications — type and strength of the metal, length of the handle, size of the hammer head — and when purchased from a quality company, often comes with a guarantee that the product will perform as specified.

The important key to understand about this metaphor is that we generally do not buy a hammer simply because it happens to be cheaper, or lighter, or shinier than any other hand tool in the hardware store. We purchase it because we have a need, for example, to pound a nail into a piece of wood, or anticipate having a need in the future that we want to be prepared for, and we believe that a hammer is the best tool to fulfill that need.

In addition, there are many different situations where we might need a hammer, and each of those situations may call for a different one. Clearly, using a sledgehammer to drive a small nail into your drywall to hang a picture is the wrong tool for the job. Thus, the key in purchasing the right hammer is understanding the need and the job you’re hoping to accomplish with it. Only once you understand the right situation for any particular hammer can you determine whether a hammer is the right tool for the job, and which type you need.

To complete the analogy, the key to decision-making when it comes to annuities is to first understand the problems for which the annuity can represent a solution. Only then can one actually determine whether an annuity is the right tool to solve the problem, and which sort of annuity will best accomplish the task.

We are all familiar with the kinds of problems that hammers solve, such as driving a small nail, pounding a large nail, or forcing a wedge between two pieces of wood to separate them. The problems that the annuity-as-a-tool are meant to solve are quite varied because of the broad number and types of annuity-tools available. That said, the problems that annuities solve — the needs that they meet — can be identified and separated into several general categories to meet several different client needs.

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

income stream

1. Clients who need a known income stream.

For the client who requires a certain income stream commencing within one year, an immediate annuity is an almost intuitive choice. Providing income— certain as to amount, duration, or both—is what an immediate annuity does. But first we need to ask a key question: For how long will the income stream be required?

If the need is for an income for life, an immediate life annuity makes good sense. It is the only financial instrument that can guarantee a specific amount of income for as long as the recipient lives. It allows the purchaser to manage the risk that the asset base that is used to create the payments may not earn an adequate rate of return, or may not be large enough to provide enough payments for life (i.e., the risk of outliving one’s assets). Some immediate annuities can be structured so that annuity payments will increase each year by a specified percentage. This is sometimes known as the COLA (cost-of-living-adjustment) option. Unfortunately, many insurance companies do not offer such an option in their immediate annuity portfolios.

Similarly, if the need is for an income specified for a  period of years, an immediate period certain annuity may be an appropriate choice. It, too, manages the risk of an unknown future rate of return over the time period, and the risk that the asset base, or the dollars used to create the income stream, may not be sufficient to produce the income required.

One risk often cited by critics of immediate annuities is that the buyer has locked in current interest rates. This criticism is generally voiced during periods when prevailing interest rates are unusually low. How valid is this criticism? In the authors’ opinion, it has merit, from an investment perspective. The interest rate used in the calculation of the annuity payout factor — the number of dollars, per thousand dollars of purchase payment that the annuitant will receive each period — is, indeed, locked in. Should prevailing interest rates rise over the period of time during which annuity payments are made, those annuity payments will not reflect that rise. However, the authors feel that from a risk management perspective, this criticism is misdirected. If the goal is to ensure an income level, the relevant risk is whether the dollars invested to produce that income can do so with certainty. A rise in prevailing rates would not present that risk, but a decline would. To transfer that risk from the annuity buyer to the insurance company, the buyer must incur a cost. Locking in the annuity interest rate is part of that cost.

It should be noted, though, that the changes in interest rates used in immediate annuity calculations over the past two decades have been far less dramatic than the changes in interest rates for short-term instruments such as savings accounts and certificates of deposit. While it is true that the purchaser of an immediate annuity in January 2009 is locking in an interest rate lower than would have been used for someone the same age and sex in, say, January 1982, the difference is not nearly as great as one might think. By the same token, if interest rates should trend sharply upward in the next 10 years, the locked in rates 10 years hence will probably not be substantially greater than the current ones.

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

guaranteed return

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.

rate of return

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.

tax

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.

money

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.