A Deferred Annuity is an insurance contract that delays payments of income, installments or a lump sum until the investor elects to receive them. This type of annuity has two main phases, the savings phase in which you invest money into the account, and the income phase in which the plan is converted into an annuity and payments are received. A deferred annuity can be either variable or fixed. Earnings within the contract are tax deferred, and are taxed upon withdrawal at income tax rates (similar to qualified retirement plans) and share with these plans the 10% early penalty tax for withdrawals made prior to age 59 and 1/2.
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I have put together this primer on annuities. (Source is attributed at the end.)
Types of Annuities
Deferred Annuities are used to accumulate assets. Funds will grow at a rate that can be either fixed or variable.
The money you put in a fixed annuity earns interest at a rate that is guaranteed for a specific period of time—ranging from one to five years or more, depending on the terms of the contract. When that period ends, a new rate may take effect—or the old rate may be offered again.
With a variable annuity, your money is put in subaccounts that are invested in stock and bond funds. The return on your investments is subject to the risk of market fluctuation. Your total account value depends on how much risk you take, the performance of the subaccounts, and what charges and fees are deducted.
Immediate (Income) Annuities [note:see the Reference Library Topic Immediate Annuities] are used to convert a lump sum into an income stream (regular payments). If the income stream is fixed, it is considered a fixed immediate annuity. Some fixed immediate annuities are offered with inflation-adjusted payments or graded payments that rise at a fixed rate, of for example, 3% annually. However, these options reduce the initial payment received but with the anticipation that payments will grow steadily over time.
If the income stream is variable, it is considered a variable immediate annuity. Like deferred variable annuities, your money is put into subaccounts. These subaccounts can be invested in stock or bond funds. Payments will fluctuate based on the underlying subaccounts. With funds invested in stocks, it is possible that payments could grow at a rate higher than can be achieved by fixed immediate annuities.
Source: The Individual Annuity: A Resource in Your Retirement (pdf)
The following definitions can help explain the technical terminology associated with Annuities.
Assumed Interest Rate (AIR)
Guaranteed Minimum Accumulation Benefit (GMAB)
Guaranteed Minimum Income Benefit (GMIB)
Guaranteed Lifetime Withdrawal Benefit (GLWB)
Guaranteed Minimum Withdrawal Benefit (GMWB)
Inflation Protected Annuity (IPA)
Joint and Survivor Annuity
Life With Guaranteed Term
Mortality and Expense Risk Charge
Straight Life Annuity
Systematic Withdrawal Schedule
Sales practices associated with Variable Deferred Annuities are often clouded with conflicts of interest as much of the product is sold through commissioned agents. Insurance benefit charges make annuities a higher cost investment medium than other investment vehicles. No-load, lower cost Variable Annuities are available from Vanguard, TIAA-CREF, and Fidelity.
SEC: Variable Annuities: What You Should Know
NASD : Variable Annuities: Beyond The Hard Sell
Tax free exchanges of non-qualified Annuity contracts are permitted through what is known as a Section 1035 Exchange.
Transfers are quantifiable decisions. The following paper provides guidance for determining the suitability of a transfer.
1. Exchanging Variable Annuities: An Optional Test For Suitability by Moshe Milevsky and K. Panyagometh (2003)
In this paper we offer a novel method of assessing whether exchanging one variable annuity (VA) policy for another, destroys or adds value from a purely economic perspective. We do this by decomposing the policy into a portfolio of financial options and then use an option pricing model to compute the difference in aggregate value between the embedded options in the new and old VA. Our paper illustrates this
approach with a variety of case studies using a software implementation that is available on the journal’s website. We also draw some general conclusions about the conditions under which a VA exchange is likely to be suitable. Overall, we believe that our methodology is a non-biased and objective technique for mitigating some of the long-standing concerns about excessive churning of VAs.
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