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A Guide To Understanding Annuities

If you receive periodic payments over time, chances are you are the owner or recipient of annuity payments. Perhaps you received a structured settlement due to a personal injury claim you or family member were a part of; oftentimes the defendant will purchase an annuity from a life insurance company to defease their obligation and make payments over time. Although you are not technically the owner of the annuity in this instance, you are the beneficiary of the payments and in most instances have the right to assign future structured settlement payment rights. Settlements that arise from workers compensation claims or that involve the federal government as a defendant in the original tort claim are typically not subject to assignment. If you are interested in receiving a quote for cash in exchange for assignable future payments, reach out to the team at Life Contingent Capital at LCpayments.com or (833) 760-7006. For most cases we can provide a quote right over the phone.

In this article, we will cover some of the most common types and variants of annuities.

Nothing in this article should be construed as financial, tax or legal advice. You should consult a professional advisor in connection with any investment in financial securities or transfer of structured settlement payment rights.

Fixed Annuities

An annuity is an insurance contract that pays a specified income at a pre-determined rate in exchange for a premium paid by the buyer. A fixed annuity will provide guaranteed interest rate to the beneficiary – this is typically an investment that someone with a long-term, conservative outlook would be interested in and is a mainstay in many retirement portfolios. Those not interested in being exposed to stock market risk will like the predictability of these returns, although with returns of 1-3% it may not be appropriate for those looking for a high yield either. A financial advisor should discuss the risks and rewards of any investment with you before a decision is made.

However, there are some well-known risks as well. First and foremost, this is a long-term investment that one has to be comfortable with holding. There are often surrender charges for those that wish to withdraw pre-maturely, meaning that a fee will be paid to sell the rights to the annuity. Part of the reason for this is because insurance companies make money by investing the premium received on the annuity: essentially, they are taking the risk that the 1-3% yield they owe to the annuity buyer will be lower than the 5-6% return they make by investing the premium into other securities.

An annuity is an insurance contract that pays a specified income at a pre-determined rate in exchange for a premium paid by the buyer. A fixed annuity will provide guaranteed interest rate to the beneficiary – this is typically an investment that someone with a long-term, conservative outlook would be interested in and is a mainstay in many retirement portfolios. Those not interested in being exposed to stock market risk will like the predictability of these returns, although with returns of 1-3% it may not be appropriate for those looking for a high yield either. A financial advisor should discuss the risks and rewards of any investment with you before a decision is made.

However, there are some well-known risks as well. First and foremost, this is a long-term investment that one has to be comfortable with holding. There are often surrender charges for those that wish to withdraw pre-maturely, meaning that a fee will be paid to sell the rights to the annuity. Part of the reason for this is because insurance companies make money by investing the premium received on the annuity: essentially, they are taking the risk that the 1-3% yield they owe to the annuity buyer will be lower than the 5-6% return they make by investing the premium into other securities.

In fact, many sophisticated global investors with billions of dollars under management have entered the insurance space to obtain long-term, low-cost capital to deploy into their investment strategies. This trend has been particularly prominent in the last decade in the wake of record-low interest rates that influence the yields in the annuity marketplace. Another risk that comes with any time of fixed future payment is that of inflation; when inflation increases, the purchasing power of future fixed payments falls. By way of example, a family spending $200 per week on groceries today may find that, due to rising prices, that $200 doesn’t buy them the same amount of produce a decade from now. Although the $200 hasn’t changed, it now has less purchasing power. 

Finally, there may be fees associated with the purchase of annuities. Not only could fees be charged by the issuing insurance company, but they could also be charged by the financial advisors that market the annuities on behalf of the insurance company. Disclosure requirements make fee information readily accessible for annuities, but nonetheless it is critical to have a good understanding of the costs associated with this investment product.

 

Variable Annuities

These annuities allow the opportunity of some exposure to market risk without the full-blown downside of investing in equities. As with fixed annuities, purchasing a variable annuity provides for tax-deferred growth of income but, also like fixed annuities, there may be fees involved including a surrender fee for those that need to withdraw their money prematurely. Typically, taking some of the annuity proceeds before age fifty-nine (59) would be considered premature and subject to penalties. One of the most popular types of variable annuities are deferred annuities which, as opposed to immediate annuities, don’t begin to pay out for some time (for most annuity buyers, a deferred annuity would begin making payouts around retirement years, to supplement social security income or a pension). This could be an appropriate strategy for those planning for retirement and have a need for steady income in the later years of their life.

An indexed annuity would be pegged to a certain benchmark, like the S&P 500, and provide a rate of return commensurate with the return of that index. Fortunately, these annuities will often provide a minimum return so that there is downside protection even when the market is experiencing volatility. However, such annuities can have provisions in the contract that limit their growth through something called a “participation rate.” For some indexed annuities, the participation rate could be 100%, meaning that all of the gain in that index would be reflected in the annuity growth, or it could be significantly lower: a 30% participation rate meaning that if an index gains 20% in a particular year, only the annuity would see only a 6% yield.

Life Contingent Payments

Also keep in mind that certain types of annuities, unless otherwise specified with a secondary beneficiary, cease payout if the underlying beneficiary passes away. This is certainly something to consider: an individual paying a $100,000 premium for a deferred annuity with no other beneficiary may risk losing his or her entire investment if that person passes away before the payout period begins. Recipients of life contingent structured settlement payments face a similar mortality risk in that payouts will end upon their passing. For most structured settlement policies, such payments will be disbursed monthly although in some situations there are lump sums as well (this information can always be found in the “benefits letter” that can be obtained from the issuing insurance company). As a method of estate planning, recipients of such life contingent payments may choose to receive the present value of their future payments by transferring them instead of assuming this kind of mortality risk. Spousal coverage can be obtained if the original beneficiary is married and would like for his or her spouse to continue to receive monthly income after their passing.

Annuities can be “fixed period,” meaning that the time period for which they will make payments is specified in the contract and is not dependent on the age or the continued life of the beneficiary. A “lifetime” annuity is different in that it does depend on the continued life of the beneficiary and will stop paying out when the beneficiary passes away. A common setup is to combine the fixed-period and lifetime features into a single annuity that provides some guaranteed benefits but also the stability of lifetime income. Qualified annuities have a special status under the law and are not considered taxable income, as opposed to non-qualified annuities which are taxable like most investments.

Premiums

With single-premium annuities, one payment is made by the annuity buyer up-front in order to purchase the policy. Alternatively, in some scenarios it is also possible to pay the full amount of the premium over time in a series of payments (this is most common with deferred annuities). This type of payments over time feature can be particularly helpful for those interested in having an annuity as part of their portfolio but are unwilling or unable to pay the full premium up-front.

Withdrawals

You can be paid from your investment in an annuity in several different ways. Complete withdrawals are basically the single payment of the present value of your annuity – this lump sum will have grown from the original premium you invested a long time ago and will have compounded at a pre-determined interest rate over the years. The compounding is especially potent as interest has accumulated on a tax-deferred basis, although taxes may be payable upon withdrawal. By way of example, $100,000 invested today at a 7% annual return assuming a 20% annual capital gains tax rate would yield $297,357 over a 20-year period. Without taxes, that amount would have grown to $386,968, meaning that 31.2% of hypothetical tax-free growth is consumed by taxes. This number is higher than the stated 20% tax rate because annual payment of taxes deprives the investment from compounding its growth. Now, in a deferred tax scenario (as is typical with most annuities) where taxes are only paid upon withdrawal, that same $100,000 would yield $329,575 on an after-tax basis after 20 years. This example shows the power of the compounding effect.

You can also elect to receive a set schedule of withdrawals through an arranged agreement with the insurance company. This might be an ideal situation for those concerned with “dissipation risk,” or the risk of spending all the money too soon. The set schedule could provide much-needed fiscal discipline. For many types of annuities, there will be a provision in the contract that stipulates the maximum amount that can be withdrawn on an annual basis without having to pay extra fees and penalties.

This article was meant to be a short and topical overview of the different types of annuities and some of their features. For a more exhaustive and comprehensive understanding of annuities, and to determine whether they are right for your investment portfolio, consult with a trusted financial advisor who can assess your overall financial situation and objectives.

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