An annuity is a life insurance product that promises payments to a beneficiary throughout his or her lifetime (or a set number of years, known as “period certain”) in exchange for prior payments to the life insurance company. An annuity has two stages during its lifetime: an accumulation phase in which funds are deposited into the product either at regular intervals or as a single lump sum, and a distribution phase when the insurance company pays regularly to the beneficiary. The primary difference between an annuity and a traditional life insurance contract is that an annuity is designed to be payable to the policyholder during his or her lifetime.
These products are also regulated in various degrees by the IRS depending on the product’s structure. While annuities are commonly used as retirement funds similar to pensions, they can be useful for just about any purpose in which a guaranteed income is desirable at a later date.
Who Can Sell an Annuity?
By law in the United States, only life insurance companies can sell annuity products. Therefore, only a properly licensed insurance professional with an appointment from a life insurance company can sell an annuity. In the United States, the terms “annuity broker” and “annuity advisor” are somewhat synonymous. In general, annuity brokers are the professionals of record licensed to sell annuity products by a state insurance commission. In addition, annuity brokers who sell variable products must also hold the relevant FINRA securities licenses (usually Series 6 and 63 depending on the state). “Annuity advisor” may refer to someone qualified to service the annuity product after the sale, but not necessarily the agent of record who sold the product.
What Kinds of Annuities Are Out There?
Fundamentally there are three varieties of annuities contracts. Fixed annuities, or annuities with a contractual, predetermined return on investment, and variable annuities, or annuities in which the return of investment is determined by market conditions. Fixed annuities are somewhat analogous to savings accounts, with a low but stated interest rate. Variable annuities are akin to mutual funds, utilizing funds based on stocks, bonds and other financial vehicles called “separate accounts” which are in practice very similar to mutual fund subaccounts. While variable annuities traditionally outperform fixed annuities over the long term, they are subject to risk. It is possible to lose money on a variable annuity, something any potential investor should be keenly aware of.
Conceived in the mid 1990s, the third type of annuity contract is a fixed indexed annuity (FIA), or simply an indexed annuity, which is a hybrid of the fixed and variable annuity. Like the fixed annuity, rate of return is based on a stated formula and it does not use special accounts. Like the variable annuity, the rate of return is based on market performance. Rate of return on a fixed annuity is based on the performance of a stock index (commonly the S&P 500, although others can be used). Many indexed annuity products employ caps and floors on their products, which means that the annuity can never make more than a certain amount (say 9 percent) or less than a certain amount (say 2.5 percent) in any given year regardless of the stock index’s performance. The indexed annuity is often a good fit for an individual who wants better performance than a fixed annuity can provide but is hesitant to assume the risk required with a variable annuity.
What Annuity Brokers Will Ask You
First and foremost, annuity brokers will ask what the annuity is intended to be used for. While retirement funding may be the most common answer, it isn’t the only one. Annuity brokers will also ask you questions on your retirement timeline, your investment tolerance (i.e. how much experience and comfort you have in various investment vehicles), and of course how much you expect to invest over time. If looking at a variable product with an annuity broker, these questions are required by government and industry regulation.
Annuity brokers may also ask you how you would like to pay into your annuity. Some annuity products can be started up with as little as $25. Others, such as a single premium option, require substantial amounts. Single premium is what it implies; pay a large lump sum into the annuity once then let it accumulate until it’s time to annuitize, or switch from the accumulation phase to the distribution phase.
What To Ask Your Annuity Broker
Ask your annuity broker about the surrender charge schedule on any annuity product. A surrender charge is the percentage of a annuity’s value the life insurance company will hold if the product is liquidated in the first years after its creation. This is in addition to any government withholding that may apply. For example, the company may charge a surrender charge of 10 percent in the first year, 9 percent in the second year, and so on. Surrender charges are typically in force for five to seven years; however surrender charge schedules lasting longer than 15 years are not unheard of.
One should also consider what whether to invest in a qualified annuity – usually in the form of a regular or Roth IRA – or in a non-qualified annuity. With qualified annuities, yearly contributions and disbursements are limited (currently $5,000 per year across all IRAs you own, but increasing to $6,000 in 2011 if one is age 50 or over, with disbursements without penalty allowed only after age 59 ½), but one enjoys tax free or tax deferred status. Usually non-qualified annuities have fewer restrictions regarding contributions and disbursements, but are not as favorable from a tax standpoint. A qualified annuity is designed to serve as a retirement fund and should be used accordingly. Non-qualified annuities may be a better fit for other situations. Both qualified and non-qualified annuities are generally available as fixed, variable or indexed products.
If looking at an indexed product, ask the annuity broker how often the cap and floor changes, when was the last time it changed, and if he expects it to change again in the near future.