Decode Annuities to Find the Best Fit

A stream of guaranteed income from an annuity can provide peace of mind that essential expenses will be covered if you live well into your eighties or nineties.

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Do your eyes glaze over when you heard the word annuity? When you imagine handing over a large chunk of money to an insurance company in exchange for promised income, do those glazed eyes turn into a death stare?

Accumulation Phase Annuities

Consider three types of accumulation annuities: fixed deferred, indexed and variable annuities. In comparing them, you can “look at a scale of how much exposure you want to the equity market,” says Ray Caucci, senior vice president of product management, underwriting and advanced sales at Penn Mutual.

Fixed deferred annuities are one of the simpler products to understand. These offer a guaranteed interest rate for a certain term, such as five or 10 years. The rate is set by the insurer, based on market rates. Craig Simms, senior vice president of Vantis Life Insurance Co., says “2.6% is the best rate now for five-year contracts,” which he says are popular now.

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These products tend to sell well when there is a gap between certificate of deposit rates and fixed annuity rates. As with a CD, if you hold the money in the contract to maturity, you will receive a scheduled amount of interest. Unlike a CD, the annuity’s interest isn’t taxed along the way. Tax is deferred until the earnings are withdrawn.

If you pull your money out before the term ends, you could incur a surrender charge. At the end of the term, says Simms, the insurer will offer a renewal rate with no new surrender charges. For example, he says the company might offer a one-year rate with no surrender charges, or you could buy a new product with a higher rate and a new surrender period.

Indexed annuities are a type of fixed deferred annuities with a growth rate pegged to the performance of an equity index over a certain term. But the money isn’t invested directly into the market, and you won’t get the full market gain. The key with these annuities is understanding the formula behind your return, says Golden.

For instance, you might have a “participation rate” of 50% of Standard & Poor’s 500-stock index gains during the contract term. If the market rises 10%, you’re only going to get 5%. But if the contract also has a “cap rate,” which limits the credited return, perhaps to 4%, you’d only get 4%.

If the market falls, “it has a floor, which is generally zero,” says Caucci. That limits the downside.

Ask how earnings are credited, because the method can vary. Usually, earnings are credited on an annual basis, says Ken Nuss, founder of AnnuityAdvantage.

While some indexed annuities are tied to the performance of a well-known index, others are tied to one of the company’s making. If you are unfamiliar with the index being used, ask what investments comprise the index. When shopping, “you have to compare the underlying indices,” says Dylan Huang, senior vice president and head of retail annuities at New York Life.

Check the surrender period, which most commonly is seven or 10 years for indexed annuities. And read the Financial Industry Regulatory Authority’s investor alert on indexed annuities at (opens in new tab) to learn more about how these complex products work.

Then, there are variable annuities. “With a traditional variable annuity, you have unlimited upside but also unlimited downside,” says Caucci. You participate fully in the market by investing your money in mutual-fund-like subaccounts within the annuity.

You can buy some downside protection by paying extra for a rider that offers a guaranteed minimum withdrawal benefit. Generally, with this kind of contract, your account has a cash value and a market value. The cash value would increase, say, annually, giving you a certain amount of guaranteed income if you follow the rules of the contract. The market value would be what your actual assets are worth, and that value could fall if the market drops even though your cash value is rising. Be aware of the rules for maintaining the guarantee; for instance, if you withdraw too much from the account in one year, you may lose the guarantee.

You defer paying tax on earnings while your money is invested. “A VA has traditionally been used for the benefit of tax deferral and growth potential,” says Sadowsky. Ask about surrender periods; you may have to keep your money in the account for perhaps five or 10 years to avoid incurring a withdrawal penalty.

Variable annuities can bridge the accumulation and payout phases. Generally, you can tap variable annuities for cash after the surrender period and without IRS penalties after age 59½, but the earnings would be taxable at your ordinary income rate. You can choose to “annuitize” the money—that is, turn the account into guaranteed income for life. Part of the payouts would then be considered a return of capital and not taxable.

If you have held a variable annuity for a while, don’t be quick to get rid of it. “Before the financial crisis, some VA features were fairly liberal,” says Caucci. The guaranteed minimum withdrawal benefit on old variable annuities could be as high as 6%, he says, while today’s guarantees are more likely just 4%.

As for costs, Caucci says there’s a basic insurance charge that comes out of the variable annuity’s net asset value. The subaccount funds will have their own fees. Riders for guaranteed income and death benefits for beneficiaries come at an extra cost, and if you run afoul of the surrender period, you’ll incur a penalty.

“If there are no bells and whistles, the cost comparison is relatively easy,” says Mark Cortazzo, founder and senior partner of Macro Consulting Group, in Parsippany, N.J. “When you add guaranteed riders, the provisions of that guarantee are not easy to compare—the devil is in the details.” Like a car, if you load the annuity up, it’s going to be a lot more expensive, he says.

Cortazzo offers a service to help determine if an annuity owner should switch out or keep an existing variable annuity. “There might be gold hiding in that contract,” he says. For $299, his firm will review up to two contracts; for more details, go to (opens in new tab).

Payout Phase Products

When entering your retirement spending years, additional annuity products come into the picture to provide guaranteed income. You can choose between an immediate annuity or a deferred income annuity.

With immediate annuities, you turn over a lump sum to the insurer, who agrees to give you guaranteed payouts over a certain term, say 10 to 20 years, or as long as you live. “Once you buy a payout annuity, it’s set for life,” says Caucci. The guarantees won’t change. Payouts start anytime within 13 months.

A 72-year-old man in Washington, D.C., who invests $100,000 will receive $672 in immediate lifetime monthly income, according to a recent quote on (opens in new tab). Interest rates affect payouts, so if you think rates will rise, you might break up an immediate annuity purchase to hedge your bets. Age affects payouts, too: The older you are when you buy, the bigger the payout you’ll get, all else being equal.

When shopping, look for the highest payouts by the highest-rated insurers. The insurer’s creditworthiness is critical. “It’s very important because you are planning to get income for 20 to 30 years, and you want to make sure the insurer will be around,” says Huang.

Shopping for a deferred income annuity, for which you pay a smaller lump sum now for bigger payouts to start years later, is similar. Look at the payout amounts and the insurer’s rating.

A special kind of deferred income annuity, the qualified longevity annuity contract (QLAC), is only a few years old. It’s designed to be bought inside an IRA or employer retirement plan, such as a 401(k), to provide income for old-old age. You can invest up to $125,000 or one-fourth of your total retirement account assets, whichever is less. The amount is ignored when figuring required minimum distributions that start at age 70½, and you can postpone payouts as late as age 85. Invest $100,000 in a QLAC at 65 and you get monthly payouts of about $2,300 starting at age 85, according to a recent estimate at Golden’s website (opens in new tab).

Of course, many people aren’t fans of the idea of handing over a large lump sum to an insurer when the threat of an early death could shortchange them. After all, payouts generally stop when you die. But the market has evolved to offer more flexibility, such as inflation adjustments or death benefits. For example, you could buy a rider that provides five years of income to you or your beneficiaries, or lets you or your heirs receive at least your full investment.

These features can make income annuities “more palatable and less scary,” Sadowsky says. But there’s a cost: “When you take some risk off the table, the payout will be reduced.” The immediate annuity payout of that D.C. 72-year-old, for instance, would be cut to $579 a month if he opted for an heir to receive a lump sum of any premium balance at his death.

Even if you’re an ardent fan of annuities, don’t lock up your entire portfolio. Generally, experts say no more than 30% of your net worth should be in annuities.

A smart strategy: Add up your guaranteed income sources, including Social Security. Then add up your basic expenses, such as housing costs and food. If there’s a gap between your steady income and essential costs, buy an income annuity to fill it. “If all your other investments don’t perform, you’ve got those needs covered,” says Simms. And if your investments do well, you’ll have the means for more fun things, such as traveling or spoiling the grandkids.

Rachel L. Sheedy
Editor, Kiplinger's Retirement Report