Comprehensive Annuities Basics Cheatsheet

Introduction to Annuities

Annuities are financial products designed to provide a steady stream of income, typically during retirement. They are contracts between individuals and insurance companies where the individual makes a lump sum payment or series of payments, and in return receives regular disbursements beginning either immediately or at some point in the future. Annuities matter because they offer income security and longevity protection by guaranteeing payments for a specified period or lifetime, provide tax-deferred growth potential that can help accumulate retirement savings more efficiently, offer principal protection options that shield against market downturns, complement other retirement income sources like Social Security and pensions, and can be customized to address specific financial needs and risk tolerances. Understanding annuities is essential for comprehensive retirement planning and creating reliable income streams.

Core Annuity Types

Immediate Annuities

• Definition: Annuity that begins payments almost immediately after purchase (typically within 1 year)
• Best for: Retirees seeking immediate income stream
• Features:
  • Typically purchased with lump sum
  • Payments begin 1-12 months after purchase
  • Simple structure with minimal fees
  • Limited/no liquidity once payments begin
• Typical Returns: 3-6% (varies with interest rates and age)

Deferred Annuities

• Definition: Annuity where payouts begin at a future date, allowing for accumulation phase
• Best for: Pre-retirees building retirement assets
• Features:
  • Tax-deferred growth during accumulation phase
  • Can be funded with lump sum or periodic contributions
  • More flexibility than immediate annuities
  • Higher potential for growth
• Accumulation Period: Typically 5-20+ years

Fixed Annuities

• Definition: Provides guaranteed fixed interest rate and payout amount
• Best for: Conservative investors seeking predictability
• Features:
  • Guaranteed principal
  • Guaranteed minimum interest rate
  • Predictable income stream
  • Protection from market volatility
• Typical Returns: 1-5% (depends on current interest rates)

Variable Annuities

• Definition: Returns tied to performance of investment subaccounts (similar to mutual funds)
• Best for: Growth-oriented investors comfortable with market risk
• Features:
  • Investment options across various asset classes
  • Potential for higher returns than fixed annuities
  • Market risk exposure
  • Tax-deferred growth
• Fees: Typically 2-4% annually (higher than other annuity types)

Fixed Indexed Annuities

• Definition: Combines elements of fixed and variable annuities; returns linked to market index
• Best for: Moderate investors seeking upside potential with downside protection
• Features:
  • Principal protection from market losses
  • Potential for higher returns than fixed annuities
  • Returns linked to market index (e.g., S&P 500)
  • Participation rates and caps limit upside
• Typical Return Range: 0-8% annually depending on market performance and contract terms

Annuity Payout Options

Key Annuity Features and Riders

Common Riders (Optional Add-ons)

• Guaranteed Minimum Death Benefit (GMDB)

  • Ensures beneficiaries receive at least initial investment amount
  • Cost: 0.05-0.15% of account value annually
  • Value: Provides legacy protection regardless of market performance

• Guaranteed Minimum Income Benefit (GMIB)

  • Guarantees minimum income payments regardless of account performance
  • Cost: 0.5-1.0% of account value annually
  • Value: Secures floor for future income even in down markets

• Guaranteed Lifetime Withdrawal Benefit (GLWB)

  • Allows withdrawals of specific percentage annually for life
  • Cost: 0.75-1.25% of account value annually
  • Value: Combines access to principal with lifetime income guarantee

• Cost of Living Adjustment (COLA)

  • Increases payouts annually to help offset inflation
  • Cost: Reduces initial payout by 15-25%
  • Value: Maintains purchasing power over time

• Long-Term Care Rider

  • Increases payout if annuitant requires long-term care
  • Cost: 0.3-1.0% of account value annually
  • Value: Provides additional income during high-expense health situations

Other Important Features

• Surrender Period

  • Timeframe when withdrawals incur penalties
  • Typically 3-10 years
  • Penalties usually start at 7-10% and decrease annually

• Free Withdrawal Provisions

  • Ability to withdraw portion of contract value without surrender charges
  • Typically 10% of contract value annually
  • Important for emergency liquidity

• Bailout Provisions

  • Allows penalty-free exit if interest rate falls below specified threshold
  • Provides protection against declining rates
  • Uncommon in current products

Tax Treatment of Annuities

Tax-Deferred Growth

• Qualified Annuities: Purchased with pre-tax dollars (IRA, 401(k))

  • All withdrawals taxed as ordinary income
  • Subject to RMD rules (Required Minimum Distributions) at age 73
  • Early withdrawal penalties before 59½ (10% federal tax penalty)

• Non-Qualified Annuities: Purchased with after-tax dollars

  • Only earnings portion taxed upon withdrawal
  • Exclusion ratio determines taxable portion of payments
  • No RMD requirements
  • Early withdrawal penalties before 59½ (10% federal tax penalty on earnings)

Exclusion Ratio Calculation (Non-Qualified Annuities)

• Formula: (Investment in Contract ÷ Expected Return) = Exclusion Ratio
• Example: $100,000 investment with $150,000 expected lifetime return
  • Exclusion Ratio = $100,000 ÷ $150,000 = 66.7%
  • For $1,000 monthly payment, $667 is tax-free return of principal
  • Remaining $333 is taxable as ordinary income

Tax Efficiency Strategies

• 1035 Exchange: Tax-free exchange between annuity contracts

  • Preserves cost basis and deferred status
  • Allows upgrading to better terms without tax consequences
  • Must be direct transfer between insurance companies

• Partial Annuitization: Convert portion of contract to income stream

  • Spreads tax liability over time
  • Maintains some liquidity in original contract
  • Available under Tax Code Section 72(a)(2)

Comparison: Annuities vs. Other Retirement Products

Common Annuity Fees and Charges

Variable Annuity Fees

• Mortality & Expense (M&E): 1.0-1.5% annually

  • Covers insurance company risk and death benefit
  • Largest ongoing fee component

• Administrative Fees: 0.1-0.3% annually

  • Covers record keeping and customer service
  • May be flat fee instead of percentage

• Subaccount Management Fees: 0.5-2.0% annually

  • Similar to mutual fund expense ratios
  • Varies by investment option

• Rider Charges: 0.25-1.5% annually each

  • Optional features for added benefits
  • Multiple riders can significantly increase costs

Fixed and Fixed Indexed Annuity Indirect Costs

• Spread/Margin: Insurance company keeps portion of investment returns

  • Not directly visible to consumer
  • Typically 1-3% of investment yield

• Participation Rates: Percentage of index return credited to account

  • Example: 60% participation rate means 60% of index gain
  • Higher participation = lower implicit fees

• Caps: Maximum return credited regardless of actual index performance

  • Example: 6% cap means maximum 6% credit even if index returns 20%
  • Lower caps = higher implicit fees

Surrender Charges

• Declining Schedule: Typically starts 7-10%, decreases annually
• Duration: Usually 3-10 years depending on product
• Market Value Adjustment (MVA): May increase or decrease surrender value based on interest rate changes

Selecting the Right Annuity

Assessment Questions

1. When do you need income to begin?

   • Immediate need → Immediate annuity
   • Future need → Deferred annuity

2. What is your risk tolerance?

   • Conservative → Fixed annuity
   • Moderate → Fixed indexed annuity
   • Aggressive → Variable annuity

3. How important is liquidity?

   • High importance → Consider alternatives or short surrender period
   • Low importance → Longer surrender period for higher rates

4. What is your life expectancy and health status?

   • Longer life expectancy → Lifetime income options more valuable
   • Health concerns → Consider period certain or refund options

Suitability Considerations

• Age: Generally more suitable as retirement approaches (50+)
• Income Needs: Should fill specific income gap in retirement plan
• Net Worth: Typically no more than 25-40% of retirement assets
• Tax Situation: More valuable in higher tax brackets
• Legacy Goals: May impact payout option selection

Common Annuity Pitfalls to Avoid

1. Surrender Period Mismatch

   • Problem: Locking funds for longer than needed
   • Solution: Match surrender period to income timeframe

2. Excessive Fees

   • Problem: High fees eroding returns, especially in variable annuities
   • Solution: Compare all-in costs across products and companies

3. Insufficient Inflation Protection

   • Problem: Fixed payments losing purchasing power over time
   • Solution: Consider COLA riders or partial allocation to growth options

4. Overconcentration

   • Problem: Too much wealth in annuities limiting flexibility
   • Solution: Diversify retirement income sources

5. Insurer Financial Strength Concerns

   • Problem: Risk of insurer inability to meet obligations
   • Solution: Choose carriers with strong ratings (A+ or better)

Annuity Purchase Decision Framework

Step 1: Define Income Needs

• Calculate retirement income gap
• Determine amount needed from annuity sources
• Consider timing of income needs

Step 2: Select Appropriate Type

• Immediate vs. Deferred based on timeline
• Fixed vs. Variable based on risk tolerance
• Consider hybrid options for balanced approach

Step 3: Compare Specific Products

• Obtain quotes from multiple carriers (at least 3)
• Compare guaranteed rates/features and contract terms
• Review insurer financial strength ratings

Step 4: Optimize Purchase Strategy

• Consider laddering (purchasing multiple annuities over time)
• Evaluate partial annuitization vs. lump sum
• Review tax implications of funding source

Step 5: Implement with Safeguards

• Review contract details before signing
• Utilize free-look period (typically 10-30 days)
• Document conversations with agent/advisor

Resources for Further Learning

Regulatory and Educational Organizations

• FINRA: Financial Industry Regulatory Authority (finra.org)
• SEC: Securities and Exchange Commission (sec.gov)
• NAIC: National Association of Insurance Commissioners (naic.org)
• Insurance Information Institute (iii.org)

Consumer Protection Resources

• State Insurance Commissioner’s Office
• Consumer Financial Protection Bureau (consumerfinance.gov)
• Society of Actuaries Annuity Research (soa.org)

Professional Guidance

• Certified Financial Planner (CFP)
• Chartered Life Underwriter (CLU)
• Retirement Income Certified Professional (RICP)

This comprehensive cheatsheet provides an overview of annuity basics, from fundamental concepts to practical selection guidelines. As with any financial product, consider consulting with a qualified financial advisor to determine if and how annuities fit into your overall retirement strategy.