Accumulation We’ve talked a little about your options once you’re ready to annuitize; now we’ll talk about how different kinds of annuities accumulate the funds you’ll be annuitizing. As we discussed earlier, annuities began as primarily distribution vehicles, but become more popular as accumulation vehicles, which lead inevitably to a great deal of innovation. Tax Deferral When researching annuities you’re going to come across the words “tax deferral” a great deal. That’s because annuities are tax-deferred, which makes them great accumulation vehicles. As we mentioned earlier, tax deferral is a simple concept: the interest you earn from your annuity principal is not taxed when you earn it, so it stays with your principal and earns you greater returns than a taxed investment. Premium Options There are basically two options in terms of paying premium into an annuity. Most annuities are single premium, i.e., you purchase the annuity contract with a single lump-sum payment. As annuities became designed more for accumulation, however, the flexible premium option came into vogue. Flexible premium serves those people who don’t have a large lump sum with which to purchase their annuity, but would prefer to make periodic small payments to increase the premium. This option applies to deferred annuities only. Death Benefits Deferred annuities offer a feature absent from other investments: the guaranteed death benefit. This means your beneficiaries are guaranteed to receive at least the premium value of your annuity if you should die before the annuity matures. Some variable annuities offer enhanced death benefits as part of an attractive rider package. Another nice feature of the death benefit (and this is true of all annuities) is that annuity funds are not subject to probate. There is no lengthy legal wrangling; annuity funds are paid to the designated beneficiary without the probate hassle. Surrender Charges Most fixed deferred annuities have surrender charges. Put simply, surrender charges are fees charged as penalties for early withdrawal from an annuity. Make no mistake: deferred annuities are vehicles for long-term retirement savings. As such, they are not designed for quick turn-around (immediate annuities would serve that purpose). With this in mind, you can see that surrender charges usually “step down” with each passing year, and eventually disappear completely. In other words, a surrender charge of a high percentage in the first year of an annuity will generally be much lower in the fourth year, and progressively on down to zero. Many fixed annuities carry with them the promise that surrender charges will never invade your principal, i.e., that you can never lose your initial deposit in that annuity. Again, keep in mind that each annuity product is different, and they can be complicated beasts. Make certain that your agent or financial advisor fully explains the surrender charges of an annuity and how they might effect your retirement savings. Some early fixed deferred annuities developed a poor reputation relating to surrender charges, as companies could “trap” consumers in an annuity with a poor rate of return when the surrender charge penalties made withdrawal an unattractive option for the policy holder. As you’ll see when we discuss some of the innovative new products available today, the industry as a whole has improved its image with more consumer-friendly offerings, and surrender charges geared toward offering options to the policy holder if he or she is unhappy with their renewal rate. Fixed Deferred Annuities Below we’ll discuss the more popular types of fixed annuity product, and a little later on we’ll talk about variable annuities. Keep in mind that the advantages of tax deferral, avoidance of probate, and a guaranteed income for life (as we discussed in the Distribution section) are common to all deferred annuities. Indexed Annuities One of the best products offered today, the indexed annuity (whether interest-indexed or equity-indexed), offers a great deal of choice and flexibility to the consumer. Indexed annuities are tied to an interest index (such as Treasury notes or bonds) or to an equity index (such as the NASDAQ or S&P 500). Interest-indexed annuities are attractive in an optimistic market climate. When interest rates are low, but expected to rise, these products can offer substantial rates of return as rates are continually reassessed according to the bond or note index’s performance. The equity-indexed annuity, which has become extremely popular, can offer a share in the profits of a bullish market, while protecting against bearish penalties. This means, in a nutshell, that if the market loses money, you don’t. If the market has a year of negative returns, you not only don’t lose, but you gain at a guaranteed rate. Hands up who thinks 3% is better than -3%? Equity-indexed annuities are annuity products which let you participate in the gains of the stock market, while at the same time offering a guaranteed minimum return, so you don’t risk your stake even when the index goes into negative returns. 50 Years of S&P 500 Annualized Returns In the chart above, we’re using the S&P 500 as an example index, and we’re looking at 50 years of annualized returns. The dark bars indicate years with negative returns. As you can see from the bars for 2000 and 2001, we were moving into the third year of negative returns. What has your retirement savings plan been doing these past few years? Has it been earning you money or earning you headaches? In the late 90s, when the market was doing extremely well, consumers shied away from equity-indexed annuities in favor of more open-ended mutual funds. You see, in order to protect against outrageously high rates of return, insurance companies generally offer equity-indexed products with a rate “range”. As a base, you have a guaranteed rate of return which protects your principal and to-date returns from a market downturn. Often, an equity-indexed annuity will also have a cap or participation rate, which varies from product to product, and represents the maximum rate of return available from the index. As we close out our third straight year of negative returns in the equity indices, the promise of guaranteed returns is making equity-indexed annuities the preferred product for retirement savings. Bonus Annuities Some fixed deferred annuities offer a bonus rate during the first year of the contract. Here’s where a little investigation can save you hassle in the long run. Some consumers can purchase an annuity product with a first-year 8% rate of return, and then find themselves earning a disappointingly lower rate for the remaining years of the contract (when surrender charges may make it unappealing to withdraw). Again, discussing any annuity purchase with your agent or financial planner is paramount to your satisfaction. Make certain you understand how rates may change, and what the bonus offer entails. Some bonus annuities are offering premium bonuses in the first-year instead of a bonus rate; in other words, you’ll begin with a little larger premium. Both of these bonus plans are designed to attract consumers, just as the promise of 0% financing for one year might induce you to buy a car or furniture. Understanding up front all the details of your annuity contract can help you take advantage of all the products out there (and the product calculators on AnnuiWeb can let you compare and contrast competing products). Variable Deferred Annuities Don’t let the name confuse you: a variable deferred annuity is one where the rate of return varies. You might be thinking but indexed annuities have variable rates, and you talked about those under the fixed deferred annuity heading. Well, while it’s true that rates of return can vary in an indexed annuity, the minimum rate is guaranteed, representing a “fixed” rate, and placing indexed annuity in the fixed annuity category. Variable deferred annuities are where the fun starts, because they are extremely complicated. We’ll try to lay out the basics and build on that base of knowledge, and then we’ll talk a little bit about the differences between variable annuities and mutual funds (the two are often compared). Separate and General Accounts Although there are many different kinds of variable annuity, there are some features they all have in common. Most importantly, each variable annuity is divided into a “general” account and a “separate” account. Typically, the general account behaves like a fixed annuity and can earn returns from fixed-rate options, while the separate account behaves like a mutual fund, where the contract holder allocates capital from the separate account to that account’s options (often these options are divided into levels based on risk). There are two “pools” at work here: the general account which earns guaranteed returns, and the separate account which is not guaranteed, but is still tax-deferred, and offers extremely broad options for allocation. These two accounts allow for greater protection from falling interest rates, and hedge against inflation. Here’s how: suppose interest rates are relatively high, so you invest your variable annuity funds more heavily in the general account, which gives fixed rates of return. If interest rates should drop over the years, you can allocate more funds into the separate account to take advantage of the favorable investment climate. Normally, you can transfer funds between the two accounts without charge or penalty. Prospectus and Profile Variable annuities are considered securities, and must therefore be registered with the SEC, which requires that all variable annuity marketing materials contain a prospectus. This prospectus can be invaluable to you as a consumer, because it will reveal any hidden costs or charges. The prospectus, however, can be a very daunting document; it’s lengthy, and very complicated. To offset the consumer’s difficulty in understanding the prospectus, many companies include a profile with the prospectus. The profile summarizes key aspects of the prospectus and uses more simplified language. The insurance companies which offer annuities are extremely concerned about consumers and their knowledge of the annuity contracts they purchase. Think of the profile as a customer service tool; the insurance company wants you to understand the terms of your annuity contract, because they want you to be a satisfied customer. Costs and Fees You’ll occasionally come across bad press regarding variable annuities, most of which focuses on costs and fees which are unique to variable annuities and therefore seem pejorative in a facile comparison to mutual funds (we’ll discuss such comparisons below). Let’s take a look at the way variable annuities work in order to see where costs and fees are necessary, and who carries most of the burden of those charges. Keep in mind that these charges are levied against the separate account(s), not the general account, in a variable annuity. Variable annuities have surrender charges which are similar to those used for fixed annuities. In addition, variable annuities usually have a contract maintenance charge, which is a charge for issuing the policy and covering its administration. This charge is usually applied at a contract’s anniversary (annually), and can sometimes be waived by the insurance company if the policy is valued above a specific level (just as banks may sometimes waive checking account maintenance fees if you maintain a certain balance in your account). An administrative charge wears a few more hats, covering the costs of transferring funds between separate accounts and the general account, the issuing of scheduled reports and statements, and the costs of any loans or deductions. Because variable annuities provide a guaranteed death benefit, the insurance company is obligated to cover its risk should the policy holder die before the account balance is sufficient to cover that benefit. This risk is translated into the “mortality” portion of the mortality and expense charge. The “expense” portion covers the insurance company’s risk in case administrative costs should exceed the amount guaranteed in the contract. These costs generally range from .40 to 1.75 percent per year (with 1.25 being about average). There are also some costs associated with the management of individual separate account investments. These costs vary depending on the fund and its level of complication, i.e., money market funds are simple to manage and thus their fees are usually lower than the fees to manage international funds. As a side note, some newer products being developed are called “no-load” variable annuities. These annuities have no surrender charges and generally have very low mortality and expense charges. The trade-off here is in the general account: Because of the increased risk to the insurance company of early withdrawal by policy holders, the fixed, guaranteed rate investment options for the general account are sometimes not offered. Liquidity Options, Death Benefits, & Guarantees Variable deferred annuities offer similar liquidity options to fixed annuities, with some differences. Usually, a portion of the fund is available for free withdrawal, as with fixed annuities, and the usual annuitization options are valid for variable annuities, as well. Variable annuities can also provide systematic withdrawals, and some variable annuities are looking into the liquidity options of long-term care and illness (a little more on that later). There are different death benefit options with variable annuities, mostly concerned with the specific account valuation used to calculate the benefit. The fact that variable annuities provide a death benefit is one of their strongest marketing aspects when compared with other investment vehicles. You may have noticed that one thing is missing from our discussion of variable annuities to this point: a guarantee. Unlike fixed annuities, variable annuities aren’t known for guarantees beyond some contract terms that may guarantee maximum rates for costs and fees. More recently, however, some guarantees have been offered to newer products, giving contract holders even more options. The three most popular guarantees are a minimum account value, which protects a percentage of your premium from market risk; a guaranteed minimum income benefit, which ensures that a guaranteed percentage of premium will be available for annuitization; and a guaranteed minimum income payment, which ensures that your annuitized payments will be over a certain amount. Keep in mind that adding one or more of these guarantees to a variable annuity contract will raise the fees and costs associated with that policy. The insurance company has to have some way to minimize its risk. Variable Bonus Annuities Unlike bonus fixed annuities, which generally provide a first-year bonus rate, variable bonus annuities almost always take the form of a one-time bonus to premium. Think of variable bonus annuities as having a “jump-start” toward accumulation. If you deposit, for example, $50,000 in an annuity with a 3% first-year premium bonus, your annuity premium will be $51,500. As with the guarantees we discussed above, keep in mind that any extra “perk” attached to an annuity contract will have a corresponding increase in fees and/or costs. As with any annuity, make sure you clearly understand its terms and trade-offs before purchase. With a variable bonus annuity, mitigating factors such as length of contract can make the initial premium bonus so valuable as to balance out any increased fees, but it is important to be as informed as possible about potential impacts to your investment. Types of Subaccount The separate account in a variable deferred annuity is made up of subaccounts which represent individual allocations of the separate account. These subaccounts can take many forms, but the most popular are: Growth Accounts Invests primarily in the common stock of organizations. Risk varies. Bond Accounts Invests in debt securities. Risk varies. Money Market Accounts Short-term, secure investments, usually CDs, Treasury bills, commercial paper from large financial institutions. Lower risk. Global and International Accounts Debt and equity issues from developing nations (can include U.S.). Higher risk and fees. Precious Metals Accounts Gold and precious metals. Risk varies. Index Accounts Similar to index annuities, matches to an index fund (e.g., S&P 500). Risk varies. Life Cycle Funds Almost a “meta-fund”, the life cycle fund bases its investment strategy on the age of the contract holder, focusing on accumulation at a young age, preservation at middle age, and distribution after retirement. Social and Environmental Accounts Screens for socially and environmentally responsible companies with which to invest. Risk varies. Variable Annuities vs. Mutual Funds We didn’t invent this comparison; variable annuities are constantly compared to mutual funds. Without going into an in-depth description of mutual funds, we’ll discuss the differences between variable annuities and mutual funds when dealing with a mutual fund which is geared toward accumulation retirement savings in the long-term. The problem with most variable annuity/mutual fund comparisons is that they focus irrationally on short-term results and costs, rather than end-of-term performance. As you can guess from our discussion of variable annuities thus far, a mutual fund — which generally has fewer fees and costs associated with its maintenance, and which has no mortality and expense charge because it doesn’t offer a guaranteed death benefit — would stand up against a variable annuity quite well in a comparison of first-year returns, or a comparison of costs and fees. This is the kind of facile “test” which can be extremely misleading. Remember that variable annuities are designed to accumulate money for retirement; they are geared toward long-term growth. Mutual funds, on the other hand, can be short- or long-term, and are not designed for retirement savings. The truth is that variable annuities regularly outperform mutual funds even with higher fees. Considering that tax deferral is an annuity benefit which costs nothing, and the mortality and expense fee is present to cover the costs of providing a guaranteed death benefit — something a mutual fund does not provide — how do variable annuities consistently trump mutual funds? Firstly, annuities are designed around long-term savings. With an investment horizon that far in the distance, the power of tax deferral has time to do its work, producing greater returns, on average, than a comparable investment in a mutual fund. A longer-term investment horizon can also significantly influence the levels of risk a variable annuity is able to weather; patience can definitely be a virtue here. Trades in a variable annuity have no tax consequences. In mutual funds, care must be taken not to incur capital gains penalties, so an investment with real potential might be passed over in order to minimize tax liabilities. Variable annuities are not hampered in their choices due to tax concerns. Advisory costs and transfer fees for a variable annuity are generally much lower than in a mutual fund. Think of it this way: mutual funds might have thousands of shareholders, while a variable annuity has only one: the policy holder. Sure there are a lot of policy holders to service, but they’re serviced by the insurer, not the fund, which lowers costs. Mutual funds can suffer from consumer investment trends, from panic and short-timers who jump in and out of funds in an effort to predict its movement. Variable annuities take the slow-and-steady path, remaining invested and weathering the ups and downs of the market, knowing that it evens out eventually. The strength of variable annuities in this area has proven more and more effective these past few years. These advantages combined give variable annuities a significant edge over mutual funds in the retirement planning arena. Variable annuities are tax deferred, geared toward long-term savings, avoid probate, have a guaranteed death benefit, often provide fixed annuity options for the general account, and can be converted to a lifelong income. When you compare variable annuities to mutual funds and keep your goal of retirement savings in mind, well, it’s not just about fees, is it?  Investment in the Contract   Expected Return  Your paid premium (or “basis”) represents your investment in the contract for the formula. The amount of income you expect to receive based on the annuitization strategy you’re following is the expected return. The ratio returned by the formula tells you what percentage of your payments will be non-taxable. The way in which your expected return is calculated can vary by annuity product, but everything should be made clear to you during the annuitization process.