A Q&A To Help You Understand How Annuities Could Play A Role in Your Financial Plan

By Ashli Suprise, Certified Annuity Specialist® (CAS®) 

Annuities have been in existence for centuries, but in recent times often receive a bad reputation, primarily due to their complexity. However, they are a useful tool when used properly and can have advantages when considered in the context of a comprehensive financial plan. This Q&A addresses the essence of annuities and how they could play a role in your portfolio, as well as things to be cautious of and questions to ask when considering if an annuity is right for you.  

What is an annuity? 

An annuity is a contractual financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual later. There are many different annuity contract types to accommodate various scenarios of needs, and most products offer a wide range of supplemental provisions for further personalization. In short, an annuity is a retirement vehicle that features additional characteristics compared to traditional investments.  

 When deciding if an annuity is a desirable choice, its advantages must be weighed against the contract requirements to determine if the pros outweigh the cons. Some inherent benefits of annuities include tax deferred growth, guaranteed death benefit, and guaranteed income stream. A few disadvantages associated with annuity contracts include fees and other stipulations, such as surrender periods.  

What are some of the terms used when discussing an annuity? 

Death Benefit: Most annuity contracts offer a death benefit, which is a guarantee that provides your listed beneficiary(ies) a return of your deposit — adjusted for withdrawals — plus any account growth. For an added fee, you can also purchase death benefit riders that also offer some guaranteed growth of your investment, or the opportunity to lock in growth over time due to performance.   

Market Value Adjustment (MVA): MVA is used in fixed annuities to protect an insurance company from large losses if a contract is surrendered prior to the surrender-free date. The value of the account is decreased to offset the loss, and the remaining balance is distributed to the owner. MVA can benefit the contract owner if interest rates are lower at the time of surrender than they were when the contract was purchased. 

Riders: Riders are optional enhancements that are available on an annuity contract for an additional cost when the basic version of a product’s contract does not fully meet your needs. A common example is the desire to obtain income from the contract while maintaining access to contract value and potential growth. The guaranteed income inherent to annuities is set income and once annuitized, the contract does not retain the accumulation features it had prior. The owner loses access to the lump sum account value once the contract is annuitized. With an income rider, the accumulation features are retained, as well as access to contract value and the future option for annuitization. 

Surrender Period: Annuity contracts always have a surrender period, or a length of time within a contract where if one were to withdraw their deposit before the maturation date there would be a penalty charge. Because of this penalty, annuities are often seen as less liquid compared to other investments. A surrender period typically ranges from 3-10 years, although it can be longer, and the penalty charge amount is typically a percentage of the account value. Many companies offer an annual 10% surrender–free withdrawal during this period without incurring a penalty. 

What types of annuities are there? 

There are two main types of annuities: fixed and variable.  

A fixed annuity is a contract in which one can invest funds for a certain period, usually at least 2-10 years, to receive a death benefit, a guaranteed rate of growth, and/or guaranteed future income. Within a fixed annuity contract, your deposit is guaranteed and therefore cannot incur a loss. 

 There are two types of fixed annuities:   

• Traditional Fixed Annuities:  These annuities provide you with a guaranteed rate of return. 
  • Single Premium Immediate Annuities (SPIA) – guarantee a stream of income right away based on mortality expectations and current fixed rates. 
  • Multi Year Guaranteed Annuities (MYGA) – can be funded with one or more premiums over time and will offer a fixed guaranteed rate of return for a certain period of time as the assets grow tax deferred.  

• Fixed Indexed Annuities (FIAs): FIAs are fixed annuities in which the rate of growth is determined by the performance of a specified market index, such as the S&P 500, with a cap on performance which tends to be low overall. Some may have higher caps in the first year but will drop thereafter.  

Variable annuities are the second type of annuity contract available. Like fixed annuities, variable annuities also allow for one to invest for a certain period, receive a death benefit, and guaranteed future income through annuitization or with a living benefit rider. The difference with variable annuities is that  rate of growth of account value is not guaranteed. Growth within a variable annuity depends upon underlying investments, therefore the value of an account can go up and down. Losses can be incurred with this type of annuity. 

What questions should you ask when buying an annuity? 

When you are buying an annuity, it is important to understand the features of the products being considered. Some key questions that you should ask include:  

• Needs: 
  • How does the proposed product fit my needs?    
  • Why was this product selected for me rather than another?  
  • Are you able to offer me product options for both fixed and variable annuities? 

• Taxes/Fees: 
  • What fees are associated, and how do they compare?  
    • If it is a no-fee product, then how is the annuity company making money?  
  • What amount will I be taxed on and at what rate? When will I be taxed?  
  • If the annuity offers a bonus, is it vested fully right away, or do I have to wait to get it? If there is a wait, how long? 

• Other Considerations: 
  • How long is the surrender period, and what access options are there during that time?  
  • In the case of fixed annuities, is the product subject to market value adjustment? 
  • For fixed indexed annuities, can the caps change annually and what drives that change? Will I earn a return every year?  
    • It is important to understand what indexes are being invested in if they are  proprietary instead of the most common ones such as the S&P 500, Nasdaq, etc. 
    • FIAs only earn returns when the index is up. When it is down, you do not lose nor gain anything. In contrast, a MYGA offers a guaranteed return each year. 
  • Are there any riders? Why do you need them? What is the additional cost?  
    • If you are being offered a living benefit and a death benefit, does the use of one impact the way the other works? If so, why have both and pay added fees? 

How could an annuity benefit me in retirement? 

As a retirement product, annuities allow funds to grow tax deferred, which is an attractive feature as it allows individuals to save for retirement in a tax advantageous way even if they’ve already maxed out their 401k and IRA contributions. Given this benefit, annuity withdrawals are subject to a 10% IRS penalty and ordinary income tax on gains, which come out first if a withdrawal is made prior to age 59-1/2. The out-of-pocket investment made into an annuity constitutes the cost basis of the product and will be paid to you tax free once all gains have been withdrawn. 

It is important to note that investing IRA funds in an annuity does not provide any additional tax benefits and should only be done if one needs additional death benefit or income benefit protection.  

What cautions should you take? 

Many annuities are sold through sales representatives who promote specific products and try to make them fit everyone’s needs. These sales representatives may not necessarily be fiduciaries, which would mean that they’re not required by law to act in the best interest of their clients. Sales representatives could potentially be putting their financial interests ahead of their clients’ best interests in order to make a sale.  

A common sales setting is a blanket pitch, where you are invited as a group to hear why one annuity product may be suitable for all attending. This scenario does not consider an individual’s specific financial goals and needs, other assets within the individual’s portfolio, or any other annuity products available. 

Some other sales practices to be aware of include high initial rates and extra-long surrender periods. Another thing to look out for is the use of upfront bonuses as a way to make up for surrender penalties you may incur from getting out of your current annuity product too soon. Bonuses are not vested right away, and it is often unwise to pay surrender penalty fees. It is also important to be mindful of any comparisons made to investment products if the agent is not registered to discuss investments. You should also be wary of pitches that encourage you to sign up on the spot, as these “quick sales” lack any sort of needs-based analysis or due diligence.   

How can Cassaday help? 

At Cassaday, we have an Advanced Strategies department that is specially trained in the annuities field and is held to a fiduciary standard. This team is responsible for assessing if there is a need for annuities in your financial plan, selecting appropriate product types, and monitoring and managing the assets in your portfolio on an ongoing basis.  

Annuities can be a desirable choice when they are carefully considered for each individual client based on their unique goals and needs. It is important to consider an individual’s financial situation and circumstances as a whole to determine whether an annuity could make sense.  

If you have an annuity that you would like the Cassaday team to review, or if you would like to learn more about how an annuity might be advantageous to your overall financial plan, please reach out to your advisor. If you are not a Cassaday client, we welcome you to contact us for a complimentary, no-pressure evaluation of your current financial plan by emailing info@cassaday.com or calling our office at (703) 506-8200.  

Want to learn more about annuities? 
Additional educational information about annuities can be found on our website. 

Disclosures: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual. The material has been gathered from sources believed to be reliable, however  Cassaday & Co. cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source.  Cassaday & Co. does not provide legal or accounting advice, and nothing contained in these materials should be taken as such.  Advisory services are only offered to clients or prospective clients where Cassaday & Co. and its representatives are properly licensed or exempt from licensure.  No advice may be rendered by Cassaday & Co. unless a client service agreement is in place. 

Annuity guarantees, including guarantees associated with benefit riders, are subject to the claims-paying ability of the insurance company.