The risk and return characteristics of fixed and variable annuities are so fundamentally different that each type is more or less suitable for various purposes.
However, some form of annuity would be indicated in the following circumstances:
- When investors want a retirement income that they can never outlive.
- When investors (often retired) want a monthly income equal to or higher than could be generated by other conservative investments and are willing (or especially if they want) to liquidate principal.
- When persons would like to avoid probate and pass a large sum of money by contract to heirs to reduce the possibility of a will contest. (Note that this only applies to annuities purchased outside a retirement plan; investments purchased inside a retirement plan already pass by beneficiary designation and are not subject to probate. Annuities provide no additional probate avoidance benefits inside a retirement plan that are not already provided by the underlying plan.)
- When investors desire a tax deferred accumulation of interest. The interest earned inside an annuity owned by an individual grows income tax-free and is not taxed until it is withdrawn. (This only applies to annuities purchased outside a retirement plan; investments purchased inside a retirement plan are already tax-deferred by virtue of the retirement plan. Annuities provide no additional tax-deferral benefits inside a retirement plan, and thus should be purchased for other reasons, such as risk management.)
- When investors want to be free of the responsibility of investing and managing assets (in the case of a fixed annuity or an annuity payout; this is not applicable to a variable deferred annuity, as the owner still retains the burden of making all investment selections).
- As a supplement to an IRA. With limited opportunity for pre-tax contributions to IRAs, many clients are seeking opportunities of making regular after-tax contributions to an investment vehicle after reaching the IRA contribution limits. The annuity may be a good choice because contributions are not limited.
- Fixed annuities, in particular, would be indicated: (a) when safety of principal is a paramount consideration (this can be particularly important in some retirement planning scenarios); (b) when investors want a guarantee that a given level of interest will be credited to their investment for a long period of time; or (c) when investors desire a conservative complement to other investment vehicles.
- Variable annuities, in particular, would be indicated: (a) when investors want more control over their investment and are willing to bear the risk associated with their investment selections; or (b) when investors are looking to increase their potential retirement income.
- When investors would like to invest their money in the types of vehicles available in variable subaccounts, but desire some aspect of risk management, such as the guaranteed death benefits or living benefits offered by most insurance companies.
Continue reading for a more complete look at the advantages and disadvantages of fixed and variable annuities.
Annuities are available with a host of features to meet a wide variety of investor needs. (Photo: iStock)
The advantages of fixed and variable annuities
- The guarantees of safety, interest rates, and particularly lifelong income (if selected) give the purchaser peace of mind and psychological security.
- An annuity protects and builds a person’s cash reserve. The insurer guarantees principal and interest (in the case of a fixed annuity; a variable annuity is subject to the performance of the underlying selected subaccounts), and the promise (if purchased) that the annuitant can never outlive the income stream. This makes annuities particularly attractive to those who have retired and desire, or require, fixed monthly income and lifetime guarantees.
- An annuity allows a client to invest in the market while moderating risk. The insurer may provide guarantees of death proceeds or a certain annuitization amount (if purchased) within a variable annuity, thus providing clients with guarantees that otherwise would be unavailable to those clients who purchased the underlying investments directly. This makes a variable annuity particularly attractive to those clients who have retired or are nearing retirement and need (or want) to hold riskier investments while trying to moderate risk.
- A client can time the receipt of income and shift it into lower bracket years. This ability to decide when to be taxed allows the annuitant to compound the advantage of deferral.
- Because the interest on an annuity is tax deferred, an annuity paying the same rate of interest (after expenses) as a taxable investment will result in a higher effective yield.
- Because of the risk management factors available, especially in variable annuities, clients may be able to take on greater risk in the underlying investment options (e.g., equities, smaller capitalization equities, high yield bonds, etc.) while still maintaining a reasonable overall risk exposure due to the underlying guarantees.
- Adjusted Gross Income (AGI) may be reduced in years where the annuity is held with no withdrawals (thanks to the tax deferral features of the accumulation phase). In addition, annuitants may recognize less taxable income during the payout phase, due to the partial recovery of basis associated with each payment. A reduced AGI can bring tax savings, as many other income tax rules are calculated based upon AGI and, generally, a lower AGI results in lower taxation (and vice versa). A reduced AGI can create tax savings by lowering the amount of Social Security includable in income, reducing the floor threshold for deduction of medical expenses (10 percent of AGI) or miscellaneous itemized deductions (2 percent of AGI), and avoiding the threshold for phase out of exemptions and itemized deductions.
Possible disadvantages of fixed and indexed annuities
- Receipt of a lump sum (either at retirement, or to a beneficiary at death) could result in a significant tax burden because income averaging is not available (however, planning can moderate this if the proceeds are annuitized).
- The cash flow stream of a fixed payout may not keep pace with inflation, particularly for longer-term payout phases such as a life annuitization.
- Annuity owners generally incur a 10 percent penalty tax on withdrawals of accumulated interest during the accumulation phase prior to age 59½, unless the annuity owner is disabled. This may also apply to the annuitization phase if the annuity was not an immediate annuity and the owner selected certain short payout terms. (Annuitization of a deferred annuity during the accumulation phase will be subject to the pre-59½ penalty unless the I.R.C. §72(q)(2)(D) requirements for substantially equal periodic payments are met.)
- With a few limited exceptions, annuity contracts held by corporations or other entities that are not natural persons, are not treated as annuity contracts for federal income tax purposes. This means that income on the contracts for any taxable year are treated as current taxable ordinary income to the owner of the contract regardless of whether or not the owners make any withdrawals.
- If the client is forced to liquidate the investment in the early years of an annuity, management and maintenance fees and sales costs could prove expensive. Total management fees and mortality charges can run from 1 percent to 2.5 percent of the value of the contract (occasionally as high as 3 percent in the case of variable annuities with a number of underlying guarantees). Most insurers charge a back-end surrender charge if the owners terminate contracts within the first few years after purchase to compensate the insurers for the sales charges that they typically do not levy up front.
- Owners are taxed on investment earnings at the owners’ ordinary income tax rates when the owners receive payments, regardless of the source or nature of the returns. Consequently, investment earnings attributable to long-term capital appreciation (typically in variable annuities) do not enjoy the more favorable long-term capital gain tax rate that otherwise generally would apply. This has become even more disadvantageous in recent years with the reduction of the maximum long-term capital gain rate. Furthermore, investment earnings attributable to dividends on stocks that would qualify for the 15 percent maximum tax rate if the stocks were held outside an annuity also are taxed at the owner’s ordinary income tax rate (although owners/annuitants will not be taxed on these dividends until they receive payments). Consequently, variable annuities — where the annuity owners, generally, are more inclined to invest in equities under a tax regime of lower capital gains and dividend tax rates — have been much less attractive than previously.