Here are some basic features of the different types of annuities and life insurance plans to consider before investing:
Term Life Insurance
- Purchased to provide income for dependent in the event of death.
- Usually purchased from individuals 25-50 years old.
- It does not accumulate money tax deferred.
- Pays out when you die typically in one lump sum.
Whole Life Insurance
- Purchased to provide income for dependents in the event of death as well as to provide financial planning needs.
- Usually purchased from individuals 30-60 years old.
- Accumulates tax deferred.
- Pays out in three different ways depending on circumstances: death, borrow against the policy, or surrender the policy.
Deferred Annuities
- Purchased to invest and contribute tax deferred.
- Buyers typically 40-65 years old.
- Accumulates tax deferred.
- Death benefit pay out can be a single sum or monthly withdrawals to give a steady cash flow.
Immediate Annuities
- Purchased to give coverage against outliving retirement income.
- Buyers typically 55-80.
- Accumulates tax deferred but only if you have early payout.
- Pay out is for a period of time but it stops when the annuitant expires, however payments will continue at death if the annuity has an option of "guaranteed period" and it hasn't expired when the annuitant expires.
Annuity Payment Frequency
Most Insurance companies will allow you to choose how often your income is paid: monthly, quarterly, half-yearly or yearly and you can choose whether you want this to be paid up front or at the end of the first year. For example, annuities paid at the end of the year will be higher then annuities paid yearly in advance (payment starting immediately), and annuities paid monthly in advance, over the course of a year will pay more than a yearly in advance.
Level Annuities
If you select an income that does not increase, you will generally receive a much higher initial income than an annuity that does increase. However you should bear in mind that, as time goes by, the real value of your income will be eroded by the effects of inflation.
Increasing Annuities
If you are worried about the effect inflation may have on your retirement income, you can choose to have your income increased each year. If you opt for an inflation proofed annuity you will receive a smaller starting income compared with a level annuity. However, you will have the peace of mind knowing the real value of your income is protected. You can choose for your income to increase in line with inflation and therefore maintain its buying power or you can choose a fixed percentage increase each year such as 3% or 5%.
At the time you purchase a contract you may be able to choose when benefit payments begin. You'll select between an immediate or deferred annuity.
Immediate Annuities
Immediate annuity contracts require a single premium payment. Benefit payments normally must begin within one year after the annuity is purchased.
Let's say you've decided you want benefit payments from your immediate annuity every month. You can usually get your first payment one month after you pay the premium.
If you want annual payments, your benefits generally will start one year after you pay the single premium.
You might buy an immediate annuity just before retiring if you want to guarantee a stream of payments over your lifetime.
This type of annuity is simply a way to convert a sum of money into a steady flow of income over a period of time.
Deferred Annuities
When you choose to start the payout phase at some future date, you have a deferred annuity.
You might buy a deferred annuity during your working years to provide retirement income. You could schedule benefits to begin on the date you anticipate retiring.
You can usually alter the date when benefit payments begin. The contract will specify what you must do to make such a change, but any change in the date will likely also change each benefit payment amount.
Deferred fixed annuities specify that you will earn interest on funds held by the company during the deferral period.
The contract will usually guarantee a minimum interest rate, but the actual credited interest rate will vary and be declared by the company from time to time. Declared rates can never be lower than the guaranteed minimum rate specified in the contract.
Accumulation phase - The period of time prior to annuitization.
Annuitant - A person who receives benefit payments from an annuity.
Annuitize - A method of receiving annuity benefits through a series of income payments for life or some other defined period of time.
Annuity - A contract with a life insurance company which guarantees an income for life or some other defined period in exchange for premiums you pay.
Back-end load - Company expenses that are charged at the time benefits begin.
Beneficiary - When provided in a contract, the person who receives benefit payments if the annuitant dies.
Contractholder - A person who pays premiums for an annuity. Often the same person as the annuitant.
Death benefit - A provision in certain annuity contracts that pays the beneficiary when the annuitant dies before the payout phase begins.
Deferred annuity - A contract that begins the payout phase at some future date.
Equity-indexed annuity - A contract that combines a guaranteed minimum interest rate with earnings linked to the performance of an external stock or bond index.
Fixed rate annuity - A contract that specifies your funds will earn a specified interest rate and guarantees a return on your premium.
Flexible premium annuity - A contract in which the amount of each premium payment you make can vary.
Front-end load - Company expenses that are charged at the beginning of a premium payment period.
Free look - A period specified in the contract (such as 10 days) during which you can decide whether to keep an annuity or return it for a full refund of your premium. Your free-look period is 20 days when you buy an annuity contract to replace one you already had.
Guaranteed interest rate - A minimum rate of interest specified in a fixed annuity. The actual rate the insurance company credits your contract at any given time may be higher but can never be lower.
Immediate annuity - A contract that begins the payout phase within one year after you pay the single premium.
Level premium annuity - A contract in which the amount of each premium payment you make stays the same.
Loan provision - A feature in certain annuity contracts that allows you to borrow up to a specified percentage of the value. Contract loans are usually subject to taxes.
Morality Tables - Statistics that project ones life expectancy based on many variables.
Payout phase (also called the annuity phase) - The period of time when benefit payments are being made to the annuitant.
Premium - The money you pay to fund an annuity contract.
Refund Annuity - Refunds part or all of the premiums paid if the insured dies before the start of the liquidation period.
Surrender charge - A fee the insurance company will charge you if you cash in (surrender) an annuity before the payout phase begins, or if you make a withdrawal larger than specified in the contract.
Variable annuity - Traditionally, a contract with no minimum guarantee (some newer products do include guarantees). Because the benefit amount depends on the insurance company's investment gains or losses, you share some part of the investment risk with the insurer.
Withdrawal privilege - A provision in many annuity contracts that allows you to withdraw an amount less than the surrender value, without paying a surrender charge. Any withdrawal may be subject to taxes and penalties.
When you buy a deferred annuity, the interest credited to your contract builds up free of current income tax.
Once you start to receive a monthly payment, however, the government begins to tax the accumulated interest. Part of each payment will be interest and will be taxed as ordinary income. The other part is principal and is not taxable. This is true of both deferred and immediate annuities.
If you withdraw money from your annuity before age 59 1/2, the interest you have earned on your contributions must be withdrawn before the principal and is subject to personal income tax. In addition, there is a ten percent penalty tax on such premature withdrawals, except in certain circumstances, such as disability or death.
You may want to consult a tax advisor well in advance of retirement for more information about the taxation of retirement income. Also, the Internal Revenue Service has helpful booklets on the subject.
Most states require insurance companies to pay a tax, commonly at two percent, on the annuity premiums they receive. A company will either charge you for the tax separately or include it in the premium amount.
Annuity sales to senior citizens have significantly increased in recent years. However, as annuity sales have risen, so has a sense of confusion among consumers. This is due, in part, to questionable or deceptive sales practices employed by companies and agents looking to take advantage of uninformed consumers. It is extremely important, when considering whether or not to buy an annuity, to take the necessary precautions in order to make an informed decision that is best for you.
What is an Annuity? An annuity is a contract in which an insurance company makes a series of income payments at regular intervals in return for a premium or premiums you have paid. Annuities are most often bought for future retirement income, and can pay an income that can be guaranteed to last as long as you live.What are the Different Kinds of Annuities? There are several types of annuities, all of which carry varying levels of risk and guarantees. To get the most out of an annuity, it is imperative that you know the different options available to you, as well as the benefits each type provides.
Single Premium Annuity: An annuity in which you pay the insurance company only one premium payment.
Multiple Premium Annuity: An annuity in which you pay the insurance company multiple premium payments.
Immediate Annuity: An annuity in which you begin to receive income payments no later than one year after you pay the premium.
Deferred Annuity: An annuity in which you begin to receive income payments many years later.
Fixed Annuity: An annuity in which your money, less any applicable charges, earns interest at rates set by the insurance company or in a way specified in the annuity contract.
Variable Annuity: An annuity in which the insurance company invests your money, less any applicable charges, into a separate account based upon the risk you want to take. The money can be invested in stocks, bonds or other investments. If the fund does not do well, you may lose some or all of your investment.
Equity-Indexed Annuity: A variation of a fixed annuity in which the interest rate is based on an outside index, such as a stock market index. The annuity pays a base return, but it may be higher if the index increases.
Is an Annuity Right for You?To find out if an annuity is right for you, think about what your financial goals are for the future. Analyze the amount of money you are willing to invest in an annuity, as well as how much of a monetary risk you are willing to take. You shouldn’t buy an annuity to reach short-term financial goals. When determining whether an annuity would benefit you, ask yourself the following questions:
How much retirement income will I need in addition to what I will get from Social Security and my pension plan?
Will I need supplementary income for others in addition to myself?
How long do I plan on leaving money in the annuity?
When do I plan on needing income payments?
Will the annuity allow me to gain access to the money when I need it?
Do I want a fixed annuity with a guaranteed interest rate and little or no risk of losing the principal?
Do I want a variable annuity with the potential for higher earnings that aren’t guaranteed and the possibility that I may risk losing principal?
Understand the Product You are Buying: When it comes to annuities, inappropriate sales practices can occur in many ways and come from a variety of sources. Anyone can be a victim, but senior citizens remain a prime target. Here are a few ways to protect yourself: Always review the contract before you decide to buy an annuity. Terms and conditions of each
annuity contract will vary. You should understand the long-term nature of your purchase. Be sure you plan to keep an annuity long enough so the charges don’t take too much of the money you invest. Compare information for similar contracts from several companies. Comparing products may help you make a better decision. Ask your agent and/or the company for an explanation of anything you don’t understand. Remember that the quality of service you can expect from the company and the agent should be an important factor in your decision.
Verify that the company and agent are licensed. In order to sell life insurance in your state, companies and agents must be licensed. To confirm the credibility of a company or agent, contact your state insurance department. Check the company’s credit rating. Legitimate insurers have their “creditworthiness” rated by independent agencies rating is a sign of a company’s strong financial stability. You can check a company’s rating online or at your local library.
The proof is in the paperwork. As you complete your research and decide to purchase a particular policy, it’s important to keep detailed records. Get all rate quotes and key information in writing. Once you’ve made a purchase, keep a copy of all paperwork you complete and sign, as well as any correspondence, special offers and payment receipts.
Avoid Being Fooled by Deceptive Sales Practices Watch for the following red flags, which serve as warnings of possible deceptive sales practices:
High-pressure sales pitch. If a particular group or agent has contacted you repeatedly, offering a “limited-time” deal that makes you uncomfortable or aggravated, trust your instincts and steer clear.
Quick-change tactics. Skilled scam artists will try to prey on your “time fears.” They may try to convince you to change coverage quickly without giving you the opportunity to do adequate research.
Unwilling or unable to prove credibility. A licensed agent will be more than willing to show adequate credentials.
Remember, if it seems too good to be true, it probably is!
Immediate
annuities have always been a reliable source of lifetime income for retirees.
But that guaranteed paycheck has its downsides: The fixed payouts don't rise
with inflation, and you can't gain access to the principal once you hand it
over to the life insurance company.
Now dozens of insurers are offering a new
way to get lifetime income, but with opportunities to cash out and for payouts
to increase. These products with "living benefits" are actually
variable annuities with income guarantees. You can diversify among stock and
bond funds, and you can withdraw 5% to 6% of your initial investment every
year.
There are two major types of living
benefits. With a guaranteed minimum-withdrawal benefit, you can withdraw money
at 5% or 6% annually for the rest of your life, no matter how your investments
perform. If your investments do well, you can cash out your balance, although
you may have to pay a surrender charge.
A guaranteed minimum-income benefit also
allows you to withdraw 5% or 6% annually, but only until you convert your
account to a lifetime stream of payments. Once you annuitize, your payments are
based on no less than the value of your original investment, regardless of
market performance.
David Schechter, 71, a retired computer
consultant in Wilmette, Ill., is a convert to living benefits. He
and his wife, Irene, 67, first bought immediate annuities, but worried that
fixed payouts wouldn't keep up with inflation. They then turned to
living-benefit products. "When the stock market is like a roller coaster,
I'm comforted by the fact that not one cent of my deposited funds is actually
at risk," he says.
How to Shop
Choosing a living-benefit product can be tough because each insurer offers its
own twist. Also, these products are pricey -- you pay extra for the income
guarantees, along with the costly, standard variable annuity fees. Seek expert
advice to decide whether one of these products is right for you. Mark Cortazzo,
a certified financial planner with Macro Consulting, in Parsippany, N.J.,
recommends that you:
Compare fees. The products Cortazzo likes charge about
0.55% of the account balance per year for the guaranteed income benefit, plus
1.4% for the standard fee. Some companies tack on death benefits, which you
don't need if your goal is to maximize lifetime income.
Shorten the surrender period. These annuities generally let you
withdraw at least 5% of your account balance every year without paying a
surrender charge. But many companies will try to sell products that levy up to
7% of your balance if you cash out within seven years. Instead, ask for the
same annuity with a four-year surrender period or no period. These products may
charge just 0.1% extra for a four-year period, or 0.15% to eliminate the
period.
Study the withdrawal amount. Depending on how the insurer calculates
your benefits, a product that lets you take withdrawals of 6% a year may be
better than one that lets you receive 7%. Some base your withdrawal on your
original investment, while others let you increase withdrawals if your
investment value rises -- letting you take 6% of a balance that has grown to
$120,000, rather than 7% of an original investment of $100,000.
Cortazzo prefers the guaranteed
minimum-income benefit over the withdrawal products. You can't cash out once
you annuitize, but your payouts at that point tend to be higher. The guarantee can be worthwhile because their retirement
savings would suffer if they started withdrawing in a down market. Those in
their seventies and older might do better with an immediate annuity.
To spot the problems, you have to know the basics of how annuities work. For
starters, they come in two varieties: Immediate annuities provide income
right away; deferred annuities allow investors to save for retirement while
deferring taxes.
With an immediate-income annuity, you give an insurance company a chunk of
money in exchange for the insurer's promise to send you regular payments for
the rest of your life, or for a certain period of time. Immediate annuities can
be an appropriate and simple way to invest some of your nest egg while you're
in retirement.
Deferred annuities, on the other hand, are complex investment products.
Besides surrender charges, some charge annual fees that can top 2%, plus the
management charges of the underlying investments.
The most common type of deferred annuity is the variable annuity, which lets
you choose from among several mutual funds like accounts. The value of your
accounts rises or falls with the performance of those funds. An equity-indexed
annuity is an exotic variation of deferred annuity that ties returns to
stock-market indexes.
A deferred annuity offers tax benefits similar to those of a traditional
nondeductible IRA. You don't owe taxes until you begin making withdrawals,
which are then taxed as ordinary income. Deferred annuities became much less
appealing when the tax rate on capital gains dropped to 15% (or lower) in 2003,
making it more attractive, tax-wise, to simply invest in stocks and mutual
funds.
Shift
in tactics
As a result, annuities salespeople switched tactics, focusing on guarantees
instead of tax savings. For example, a guarantee in an annuity contract might
promise that your account balance will never fall below a certain level, no
matter how poorly the stock market performs, or it might promise to give you a
minimum annual payout.
But figuring out which guarantees are worthwhile is extremely complicated.
Mark Cortazzo, a certified financial planner in Parsippany, N.J.,
specializes in clients who are nearing retirement or are recently retired. He
avoids most of the deferred annuities on the market, and rarely recommends them
to people in their seventies or eighties. "Out of 100 annuity contracts,
fewer than a dozen work well," says Cortazzo, who says his staff spends
thousands of hours each year poring over contracts to find the few that provide
good value.
The ideal candidate for a deferred annuity, says Cortazzo, is someone
between the ages of 55 and 65 who needs to have immediate access to the
investment but still wants the option of a guaranteed income later. Cortazzo
likes contracts that, for example, let you withdraw 6% of your original
investment every year until you decide to convert the investment to a lifetime
string of payments. Regardless of market performance, those payments will be
based on no less than the value of your original investment.
But most contracts aren't that generous. They may guarantee nothing more
than a death benefit rather than a certain amount of lifetime income -- a fact
many buyers don't realize.
Equity-indexed annuities can be even more complex. "They're sold as the
best of both worlds, with no risk on the downside and all the profit on the
upside," says Barry Lanier, chief of the Bureau of Investigation for the
Florida Department of Financial Services. "But the upside is never that
good."
Most equity-indexed annuities don't count dividends, and annual returns are
either limited to a percentage of the stock market's gain -- for example, 80%
-- or capped at, say, 8% per year. To compound the problem, equity-indexed
annuities fall into a gray area and are not regulated as securities.
Salespeople who push them don't have to be licensed to sell securities and may
not know about other investing options.
And here's the best-kept secret in the annuities business: There's no reason
for you to pay high up-front commissions or get stuck with a long surrender
period. Most companies offer identical annuities with lower commissions and
shorter surrender periods -- if you're savvy enough to ask. The ones Cortazzo recommends
are those that carry a commission of 1.5% to 2% the first year, followed by 1%
annually, and have a relatively short surrender period of three years or less.
Outrageous
returns
But even a good deferred annuity isn't suitable for most people. Younger
individuals should invest first in 401(k)s and IRAs, and then in taxable
accounts; older people like Alice Bouchard should stick with immediate-income
annuities.
To persuade seniors to buy deferred annuities, "salespeople use any
argument that appears to be effective," says Galvin. Sometimes agents
pitch annuities as estate-planning tools, even if the death benefit is paltry.
And some agents promise outrageous returns.
In one extreme case, an agent persuaded 32 Exxon employees from Louisiana to retire early,
take their retirement money in a lump sum and invest it in deferred variable
annuities. The agent promised they could replace all of their monthly income by
earning up to 18% a year. If he couldn't produce returns of 10% to 14% a year,
the agent said, his clients could fire him.
Most of the employees didn't understand that they were investing in
annuities, says their lawyer, James Swanson. Nor did they realize they were
paying close to 3% per year in expenses and that the agent was investing their
money in ultra-risky mutual funds with no guarantees to protect them. His
clients were "slaughtered," says Swanson. "These people started
with $600,000 or $700,000 in 2000, and by 2002 they had $200,000."
NASD charged the broker with securities fraud and last fall fined his
broker-dealer, Securities America, $2.5 million for inadequate supervision. The
company has also paid investors $13.8 million in restitution. However, it is
appealing $9 million in punitive damages and lawyers' fees, according to a
spokesman.
No
free lunch
Seniors are particularly vulnerable at "free lunch" seminars where
agents feed them the hard sell. Michael Huggs, a senior examiner for the
Mississippi Secretary of State's office of business regulation and enforcement,
recently interviewed an agent who referred to seniors attending these
free-lunch seminars as "plate lickers" -- a phrase that even appears
in some agent-training materials. "If you have that much disdain for your
clients, you shouldn't be in this business," says Huggs.
And disdainful is one way to describe the treatment of Alice Bouchard, now
92, and others like her. Florida
investigators identified three other individuals allegedly ripped off by the
same agent, Bijan Razdar. Razdar was permanently banned from the insurance business
in Florida,
but was arrested last October for conducting business without a license and is
awaiting trial.
Razdar denies doing anything wrong. He says surrender charges were
irrelevant because his clients wanted the annuities for their death benefit.
But Bouchard says she told Razdar repeatedly that she didn't want to lock up
her money for more than five years. And Lanier, the Florida official, points out that her
beneficiaries would have inherited about as much if she had simply put the
money in a CD.
Razdar says he was advised to settle the cases by his insurance company, and
that he couldn't afford to continue fighting the state. He also says he is
contesting the charge that he was conducting insurance business without a
license.
Bouchard settled with Razdar in September for an undisclosed amount. Most of
those to whom he sold annuities have gotten part of their money back from him
through civil suits or by working with the insurance companies to cancel any
penalties. Some of the victims are suing the insurers to get back more of their
money.
If you're retired and barely have
enough money to meet your annual expenses or fear that you will outlive your
capital, then consider purchasing an immediate annuity. You'll get a guaranteed income stream, even if you outlive
your annuity's principal. Of course, if you die tomorrow, the remaining balance
of the annuity goes to the insurance company, explains annuity analyst Patrick
Reinkemeyer of Morningstar.
For some, that risk is worth the
price. "You're buying peace of mind," says Mark Mackey, president and
CEO of the National Associatio for Variable Annuities.
"No one would question you if you bought homeowners insurance to protect
against a fire, even though a fire is unlikely."
If you are under 40, trade mutual funds several times a year
and have maxed out your 401(k) and IRA, a variable annuity might make sense.
Why under 40? You may need more than 20 years for the benefit of a
tax deferral annuity to exceed the benefit of the 15% long-term capital gains rate on
profits from selling your mutual funds. (Remember, annuities are taxed at ordinary income tax
rates , which run as high as 35% at the federal level.) Of
course, the lower your tax bracket in retirement, the better the case for
annuities becomes.
Traders too should want an annuity because if you did that
kind of trading in a taxable account, you'd get hit with short-term capital
gains taxes at rates of up to 35%. In an annuity, your money can continue to compound
until you withdraw it. "Switching and asset rebalancing are one of the
great advantages of a variable
annuity," notes Reinkemeyer. "Most annuities allow you
to switch investments up to 12 times a year for free, and after that it's about
$10 a switch." Of course, if this description fits you, make sure you pick
an annuity with plenty of attractive subaccounts. Or, better yet, one with no surrender charges.
Otherwise, you are likely to be hit with a fee as high as 9% if you try to move
your money to another annuity provider (a so-called 1035 transfer) before your
surrender charges expire.
Other suitable annuity investors: potential targets of
lawsuits. "Assets in life
insurance policies and annuities are credit protected in many
states," says financial planner Ben Baldwin. "As long as the money
wasn't put there in defraud of creditors, it's safe from malpractice suits.
Anyone in the personal services business today who's likely to be sued —
doctors, lawyers, CPAs, architects, financial planners — might want to take a
second look at these products."
If you own an underwater universal life insurance policy,
you may want to transfer the assets to an annuity. Typically, life insurance
losses are not tax deductible. But, if you move the money into an annuity, the
losses can be used to offset the annuity's gains.
A deferred annuity receives premiums
and investment changes for payout at a later time. The payout might be a very
long time; deferred annuities for retirement can remain in the deferred stage
for decades.
An immediate annuity is designed to
pay an income one time-period after the immediate annuity is bought. The time
period depends on how often the income is to be paid. For example, if the
income is monthly, the first payment comes one month after the immediate
annuity is bought.