What Is the Value of My Annuity

Annuities are investment vehicles used primarily in retirement planning for the purpose of creating some certainty in your future financial security.  The degree of certainty you could have can only be based on your understanding of the value of your annuity at any time during both the accumulation stage and the income distribution stage.  Annuities are contracts between an individual and a life insurance company that exchanges capital for a stream of income.  They can also be used for accumulating capital prior to the need for the income. In both instances, the contract contains provisions and formulas that enable annuity owners to determine the value of their annuity at various stages.

Because annuities are based on a series of payments (received or paid in), a known interest rate, and a known amount of payment or deposit, it is generally fairly easy to calculate its value.  But, there are two ways to value an annuity – in its present value or its future value – so you first need to know from which vantage you are looking.

Present Value

Often times a person who is receiving a monthly payment, from a pension plan, a settlement, or an annuity, wants to know what the value of that future stream of income amounts to as a present value, in other words, what the future payments are worth today as an investment.  People who have won a settlement of some sort, in which the reward is paid out in installments, will often seek to exchange the future payments for a lump sum payment.  Sometimes a person who is receiving payments from an annuity may want to do the same because their circumstance have changed to where they would be better off with a lump sum of money instead of the future income.  Present value calculations are also used by investors to determine if an investment in real estate or a business that produces income will meet their criteria for a profitable return of investment.

First, you should know that you can easily calculate the present value or future value of any investment by accessing a calculator online. They allow for the easy input of key variables and will produce a quick calculation. However, it would be important to understand what the variables are and what is entailed in the calculation so you can put it the right context. Also, the use of variables does create the possibility of error or broad extrapolation that can render the calculation meaningless.  It is important to have an understanding and appreciation of the “time value of money” to know that a quarter of a percentage point difference over several years can affect the outcome of the calculation by huge measures.

The common factors used in all present and future value calculations are:

Interest rate:

the interest earned on a lump sum annually, or applied to each payment annually.

Number of payment periods:

the number periods in which a payment is received from an annuity, or paid into an annuity for accumulation.

Payment amount:

the dollar amount of the payment received from or paid into an annuity

To calculate the present value of a future stream of fixed payments, you would discount each payment by the amount of interest credited, multiplied by the payment number.  So, each payment is discounted by the fixed interest rate, based on the period in which it is made or received. Each payment is calculated this way and then added to each other.  The sum of the payments is the amount of lump sum investment required today to produce that stream of fixed payments.  Sound complicated? It’s not really, but it could take a long time.  Let’s look at how a slight change in the variables can impact the calculation:

An annuity is currently making payments at a rate of $2000 a month and is scheduled for another 240 payments (20 years). The current interest rate applied is 3%. The current or discounted value of the annuity is $66,600. By adjusting the interest rate up by just .5% , the result is $57,100, more than a 10% difference in the present value.

Future Value

When calculating the future value of your annuity, the same factors are used except the math formula is reversed.  So, for example, if you wanted to determine how much a lump sum of capital or periodic investments will be worth at some point in the future, either as a lump sum value or as an annuity payment, you would multiply each investment contribution by an interest factor based on the actual period in which it is invested. So, each investment contribution is calculated separately and then they are all added together to arrive at a future sum.  Again, not mathematically complicated, but time consuming.

When you arrive at future lump sum value, you can then calculate the future stream of income by applying the same factors of the number of payment periods, the interest rate and the lump sum of capital.  This will tell you what the amount of the fixed income payment will be over a specific period of time.  If you want to calculate income payments for your lifetime, you would take your life expectancy age, based on current mortality tables, and subtract your current age, then multiply that by 12 to arrive at the number of monthly payments.  Keep in mind, that, while a lifetime income annuity payment is based on the number of monthly payment periods in your life expectancy time frame, the income payments will continue even if you live beyond your life expectancy.

Using a future value calculator you would arrive at the following outcome based on an annual investment of $12,000 at a rate of 5% for 20 years:

Future lump sum amount: $416,600

Future stream of annual income from lump sum (20 year period): $33,400

Bear in mind, that all of these calculations are do not include any taxation. Of course taxes paid on income received would reduce the amount, but the accumulation within an annuity is tax deferred, so the calculations for accumulation would be accurate. The other thing to bear in mind, is that annuity payments are only partially taxable because a portion is actually a return of your principal.  So, it is advisable to consult with a tax professional to determine the impact of taxes on all future values.


What Are Deferred Fixed Annuities

In the time since deferred fixed annuities were introduced more than 75 years ago, the annuity marketplace has ballooned with several different types of products offered in multiple variations, produced by dozens of different providers, resulting in hundreds of products lining the shelves today. In the deafening noise of the vast annuity marketplace, the deferred fixed annuity has become somewhat muted, but for many investors, it remains the best way to inject some certainty into their financial futures.

What Exactly is a Deferred Fixed Annuity?

In the simplest terms, it is contract between an individual and a life insurance company in which funds are exchanged for a promise to provide a competitive rate of interest, with a guarantee to credit a minimum rate if interest rates decline, while protecting the principal investment. And because annuities are classified as non-qualified retirement instruments, they receive favorable tax treatment from the Internal Revenue Code. Any taxes owed on the earnings within an annuity are deferred until they are withdrawn. Beyond this simple definition, there are a few other things to know about deferred fixed annuities in order to gain a full understanding of their role in your investment portfolio.

How did they Originate?

Annuities rates originated centuries ago as a financial instrument that generated a lifetime income stream for people. Roman citizens and soldiers turned their savings over to the government of Rome in exchange for a promise to pay them an annual stipend for the rest of their lives. The annuity concept was formalized by life insurance companies in the 1800s as a contract, much like a life insurance policy, in which the insurer guarantees the payments. Later, insurers began issuing “deferred” annuity contracts that enabled the contract owner to delay income payments while funds were allowed to accumulate in an account. By deferring the income, annuity owners would be able to build up the lump sum of capital over time that would be used to “annuitize” or convert their annuity to income.

How do they Work?

Within an annuity contract, there are two different stages. The first is the accumulation stage which is the period of time in which funds are invested and interest is credited for the purpose of building capital. The second is the distribution stage which is when the annuity owner decides to convert his lump sum of capital into a stream of income.

Accumulation Stage

When funds are deposited with a life insurer they are credited to an accumulation account in the name of the annuity owner. The life insurer then credits the account balance with a fixed rate of interest. In most cases, the fixed interest rate is guaranteed for a certain period of time, from one year to ten years. When that period expires, the interest rate is reset by the insurer, typically for one year periods. In some cases it could renew for a longer period of time. Most annuity contracts include a minimum rate guarantee which ensures that, if interest rates fall too low, the rate credited to the account will not fall below the minimum.

Withdrawals are allowed in most contracts; however there are certain limitations. In a typical contract, the withdrawal provisions allow for one annual withdrawal. If any withdrawal exceeds 10% of the value of the account, the insurer will charge a surrender fee on the excess. The fee can range from 7% to 15% on a declining schedule. So, each year, the fee percentage will drop by one percentage point until it reaches zero. At that point the “surrender period” is over and there would be no more fees applied to withdrawals. So, conceivably, in a contract with a first year surrender fee of 10%, the annuity owner would be able to access all of his funds, without a charge, after 10 years.

Because annuities enjoy favorable tax treatment, the IRS has established rules designed to circumvent their abuse. The funds in annuity accounts are allowed to grow tax deferred until they are withdrawn, at which point they are taxed as ordinary income. But, if a withdrawal is taken prior to age 59 ½, the IRS could levy a penalty tax of 10% on the withdrawal unless certain conditions are met.

Deferred annuities also offer a layer of protection for the family of the annuity owner in the event he dies prematurely. The death benefit component of annuities ensures that the beneficiary will receive no less than the principal investment plus any gains in the account. The death benefit proceeds are taxable to the beneficiary as ordinary income.

Distribution Stage

When an annuity owner decides that he wants to convert his account balance into a stream of income, he can have the insurer annuitize his contract which becomes the distribution stage. The insurer will take the lump sum that has accumulated and calculate the amount of income that can be paid for a specified period of time. This process is irrevocable, meaning that, once the income payments begin, the annuity owner cannot have access to the account balance.

The payout rate is the rate at which the insurer will make payments from the annuity balance and is determined by dividing the balance by number of pay periods – either a specified number of periods or the number of periods based on the life expectancy of the annuitant – and factoring in an interest rate that is credited to the balance over that period of time. Because the calculation leads to a depletion of both principal and interest over the time period, the payments consist of portions of both.

The “insurance” aspect of annuities is the guarantee by the insurer that the income payments will continue even if the annuitant lives beyond his life expectancy – in other words, he is assured of not outliving his income.


Deferred fixed annuities were originally introduced as a way for people to accumulate a lump sum of capital that could then be converted into a guaranteed stream of income. Today, there use is widespread by investors for achieving any number of long term objectives. Investors have many choices in their selection of annuity products that best match their investment profile. Deferred fixed annuities still remain the annuity product of choice for investors who are concerned with uncertainty and they need to know that their funds will absolutely be there when they need it the most.

More About Annuities

Annuities have long played an important role in people’s retirement planning. As far back as the Roman Empire, people have relied upon annuities to secure an income they can count on. But, as with other types of investments, they have had their ups and downs as far as popularity. If you trace their history, it seems as though their appeal increases during times of economic distress or uncertainty. For instance, during the Great Depression, annuities were the savings vehicle of choice, largely because the life insurance companies proved to be the financial stalwarts as the rest of the financial system was crumbling around them. Now, in the aftermath of the Great Recession, annuities are once again seeing resurgence as investors peer into the uncertain economy that lies ahead. People, as well as financial planners, are rediscovering, or, for the younger ones, discovering for the first time the important role of annuities in securing their financial future.

Annuity products have come a long way since the Great Depression. Their basic, time-tested structure remains the same – a contractual obligation of life insurers to provide principal protection, minimum rates of growth and a guaranteed income, in return for a capital investment – but, due to the proliferation of annuity products and increased competition among the providers, these are no longer your grandfather’s annuity.

The Uncertainty of Certainty

As annuities explained gained in popularity over the years, the number of products increased and the race was on for providers to make their products more attractive and more competitive. Each product iteration introduced new features, new options, more guarantees and more reasons to invest in annuities. But, these wonderful innovations are sometimes overshadowed by the added complexity they create. And, today, investors are faced with a near impossible choice of hundreds of annuity products and deciphering all of the features, options and expenses. So, for people looking to instill more certainty in their portfolio, they’re facing more uncertainty in searching for the right annuity for them.

Matching an Annuity to Your Investment Profile

Knowing how much you need to invest, your time line, the level of risk you can take, the advantage of tax savings, and your overall investment preferences will enable you to narrow down the choice of annuity products by matching them with your overall investment profile. Here is a brief guide for evaluating different types of annuities in light of different investment profiles:

Fixed Annuities

If you are absolutely adverse to market risk, where you can’t tolerate the possibility of a loss of your principal, or if you are trying to counter the volatility of your stock portfolio, a fixed annuity offers the greatest amount of certainty with guaranteed returns and safety of principal. It is important to consider all forms of risk when selecting your investments because a portfolio weighted towards low or zero market risk will be vulnerable to inflation risk which could keep you from achieving your long term objectives. Fixed annuities are the easiest to understand and have the least amount of expenses; however, it is important to know understand the rate guarantee and how rates are determined when they are reset.

Indexed Annuities

Indexed annuities offer nearly the same degree of safety as fixed annuities but are a bit more complex which, for some investors, may be a concern. They are, essentially, a fixed yield product as well; however, the yield is determined each year based on the movement of the stock index to which it is linked. If there is a gain in the stock index, the yield that is credited will be based on some portion of the gain. The yields are capped so that you will never earn more than the stated cap. For instance, if the stock index gains 20%, and your annuity contract allows you to participate in 70% of the gain, the annuity yield could be 14%. However, if the stated cap is 8%, your account is credited only 8%. On the flip side, the contract will also have a minimum rate guarantee that ensures your account will always have a gain.

If your investment profile is such that you want to seek higher fixed yields, without additional risk, an indexed annuity may be right for you. However, if you are adverse to investment products that are more difficult to understand, you may find an indexed annuity unsuitable.

Variable Annuities

If you understand how the markets work, and you have some experience investing in mutual funds, perhaps in your 401(k) plan, variable annuities can be a great complement to the growth portion of your portfolio. The advantage of a variable annuity that appeals to some investor profiles is the tax deferral of earnings. If your income places you in the higher income tax brackets you could benefit from keeping more of your earning working for you before they are taxed at withdrawal. Some variable annuity products now offer additional guarantee options that can substantially reduce your downside risk, but they also add to the expenses of the product. Variable annuity expenses can run as high as 2.5% when they include any of the additional guarantees, but, for some investors, the potential to earn market returns with minimal risk is worth the additional cost.

Narrowing Your Selection

Once you have decided on the type of annuity product, it becomes easier to compare between the different providers. Expenses, rate guarantees, caps and participation rates (indexed annuities), withdrawal provisions and surrender fees, and can be compared in an apples-to-apples fashion. One of the quickest ways to narrow your list is to establish a criteria for the quality of the provider. For instance, if you decide that you only want to work with providers who have the highest ratings from the ratings agencies, you can narrow your list to about 35 out of more than a hundred. The higher your ratings criteria, the more narrow your list. For instance, if you decide to only work with providers who have earned an A+ rating from A.M. Best, your list could be reduced to 20. Not only will this reduce your time and effort, it will increase your confidence in your annuity selection.

Are Annuities Taxable

It’s difficult to address a topic such this and avoid the tired, old cliché, “the only certainties in life are death and taxes.”  So, we won’t try. The fact of the matter is that there is no investment vehicle that is completely tax free. Even with tax exempt bonds, the income received can increase the amount of taxes paid on your Social Security payments.  You can pretty much count on the fact that the IRS always wants to collect its share and annuities are no different. The earnings from annuities, while not currently taxable, are taxed as ordinary income when they actually received.  A primer on annuity taxation is helpful for understanding both the tax advantages and the tax consequences.

Annuity Tax Essentials

The tax treatment of annuities can be viewed through their two distinct stages of accumulation and distribution.  Both stages provide for tax advantages and tax consequences, and, with some fundamental knowledge, investors can maximize the advantages and minimize the consequences.

Accumulation: Tax Deferral

Deferred annuities, so named because the income or distribution stage is deferred until some point in the future, allow your funds to accumulate over time without having to pay current taxes on the earnings.  Whether the funds grow at a fixed rate (as in a fixed deferred annuity) or at variable returns (as in a variable annuity), their earnings are not reportable as income.  For people whose income falls within the higher income tax brackets, this can be quite an advantage in achieving faster accumulation. For someone in a 50% combined federal and state tax bracket, that means that half of the earnings that would otherwise have to be paid to the IRS are left in the account to grow.  The compounding of tax deferred earnings over time can have a significant impact on the growth of your funds.

Because they are only deferred, the taxes will come due eventually when the earnings are actually received. At that point, they are taxed as ordinary income.  Because you are able to control how much of the earnings are withdrawn, you are then able to control how much in taxes you will pay in any given year.  If you need to access your funds before you turn 59 ½, you can expect to pay an extra 10% on top of the tax as a penalty. A penalty is not applied if your withdrawal meets certain conditions, such as funding a disability.


Income Distribution: Partially Tax-Exempt

When a deferred annuity is converted into an income annuity, or if an immediate annuity is purchased for the purpose of generating immediate income, your lump sum of capital is committed to a life insurer that then commits to an income payment schedule.  Essentially, the insurer calculates the amount of income your lump sum of capital will generate for a specified period of time. If your income need is for your lifetime, the number of payment periods is based on your life expectancy.  The income payment is calculated by dividing the capital amount by the number of periods factoring in interest paid on the balance.  The calculation will result in an income amount that will deplete both the capital and the earnings in the specified time frame.  The insurance guarantee of a lifetime annuity provides that the income will continue even if you surpass your life expectancy age.

Because your income payment is a combination of your original capital and your earnings, only the portion that is earnings will be taxed. Your principal is not taxed. The shorter the distribution stage, or the fewer the number of payment periods, then the larger the principal portion of your income payment and the less tax you will owe.  This is why it is often recommended that you delay annuitization as long as you can, to shorten the payout period.  Because you are only paying taxes as the earnings portion of your income payment is received, you are, in effect, deferring taxes further into the future.

The good news is that income received from annuities is not included in the Social Security income tax calculation which can be an advantage over tax exempt bonds. That would depend on your tax situation at retirement.

Annuity Taxation at Death

One of the distinct features of annuities is their guaranteed death benefit.  Your beneficiaries are assured of receiving your principal investment at a minimum and, most annuities, your gains are also guaranteed to be passed along.  But, again, the IRS is waiting patiently to collect its share, so when the death benefit is paid, the earnings are taxed as ordinary income to the beneficiary.  If the annuitant dies while receiving income, and an installment refund option was selected, the beneficiary owes taxes as the earnings are received.

Additionally, the full value of the annuity is included in the estate of the annuity owner which may result in estate taxes if the total value of the estate exceeds the exemption level.  The good news is that annuity proceeds are excluded from probate proceedings, so at least they can be quickly transferred without adding to the legal costs.


Annuities are popular largely due to the deferral of taxes on earnings.  Unquestionably that can put people in higher tax brackets further ahead in the accumulation of retirement savings.  But, the tax man will eventually call, so it is important to weight the tax consequences at the time of withdrawal or income. And, it is also important to alert your beneficiaries of the tax consequence at death so there are no surprises. Because annuities do involve tax issues, it is always recommended that you consult with a qualified tax professional when considering an investment.

Retiring With Annuities

With the “new normal” economy ushered in after the financial crisis comes the new rules for retirement that now guide the plans for anyone intent on retiring securely and comfortably.  The financial crisis was merely the final straw for a whole generation of people who had, at one time, had their sights set on a timely retirement. For at least three decades the savings rate had plummeted. People were more interested in consuming than saving. Then the tech implosion of 2000 burst the bubble of pre-retirees by wiping out a quarter of their retirement accounts. Hoping to ride the home equity gravy train to retirement, people were then hit with a double whammy of a housing crash and a stock market crash that wiped out as much as 60% of their net worth.  The new bottom line is that retirement is no longer such a sure thing for most people, which is why annuities are suddenly making such a strong comeback.

Going back as far as the Great Depression, when savers had to abandon the failing banking industry, annuities have been the “go-to” vehicle in times of uncertainty. Now, as life spans are expanding and economic uncertainties become the norm, people are again turning to them to inject stability and predictability in their financial futures.  The new rules for retirement dictate that, in order to meet your savings and income goals, you may need to take on more risk than you would normally tolerate to keep your assets growing throughout your lifetime. In a retirement portfolio, annuities can serves several purposes to help ensure better returns while building an essential safety net.

Using Annuities to Shore up Your Retirement

Annuities as a Low-Risk Growth Vehicle

Studies clearly show that people will need to achieve higher growth rates on their assets both before and during retirement. The old rules implied that one had to be able to tolerate more risk in order to achieve higher returns. The new rules, adopted in light of some new investment product options, say that doesn’t have to be the case.  Some of the new options available in variable annuity products can provide both growth potential with a layer of protection.

For six decades, variable annuities have provided long term investors with a tax advantaged alternative to mutual fund investing. Offering the same type of diversified, professionally managed stock and bond accounts, variable annuities have enabled investors to achieve market returns while providing security for their family with a guaranteed death benefit. Some of the newer options available will also provide protection against market declines by guaranteeing a minimum rate of return or a minimum income upon annuitization. You pay an extra half to three quarters percent for these added guarantees, but with so much at stake, they can be priceless.

Indexed annuities also offer opportunities for market-like returns with no downside risk.  The rate of return is linked to a stock index which gives it upside potential, yet they provide a floor below which your rate cannot drop.  Your funds will always be growing. The caveat is that the investors can only participate in a portion of the gain in the index (i.e. 70% participation rate) and then the actual credited rate is capped at some level (i.e. 8%). So, the best case is that you will earn a maximum of 8%, and the worst case is that you will only earn 8%, even if the index increases by 20%. But, you will never earn less than the minimum guaranteed rate.

With both variable and indexed annuities, there are costs that you wouldn’t pay in alternative investment vehicles, as much as 2.5% in a variable annuity and the cost of a capped rate in the indexed annuity. But, for people taking the long view of achieving consistent, positive returns year after year, there are no other investment vehicles that can match them.

Annuities as an Income Safety Net

Arguably, the greatest concern among pre-retirees and retirees is the possibility that they will outlive their income. People are starting to get it that they are living much longer than past generations. And they also get it that their primary source for income is going to be their own retirement assets that they accumulate. The new rules of retirement state that, “if it is to be, it is up to thee,” which means that we can really only count on ourselves to make sure we have a secure and sustainable income for the rest of our lives. As has been the case for centuries, annuities are the only retirement vehicle that can guarantee you don’t outlive your income.  When a lump sum of capital is annuitized, a life insurer establishes a fixed payout that is calculated to last until your life expectancy. And if you live beyond your life expectancy, as an increasing number of people are doing, the insurer is still obligated to continue your payments.

Options available with today’s annuities can also ensure that your income keeps pace with inflation. Income from variable or indexed annuities can rise as the markets rise, and while it can also drop in declining markets, there are options available that will guarantee a minimum level of income.  Again, any options that enhance your protections and guarantees will add to the cost of the annuity, but, in essence, what you are really paying for is added peace-of-mind.

Don’t Forget the First Rule of Retirement Planning

The first, very critical rule of retirement planning, no matter your stage of life, is to have a plan with well-defined, quantifiable targets.  That hasn’t changed. Nor has the rule that states the need for a well-balanced and diversified approach to asset allocation – just ask those who had 80% of their retirement assets invested in the stock market in 2008.  Your goals should be based on an actual budget for a realistic standard of living that may not be the “dream” retirement, but one in which you are comfortable.  One of the new rules of retirement is that it is no longer a sin to work while “retired”. Most people today not only expect to earn a living after 65, they look forward to it. Retirement today is becoming a whole new cycle of life for people where quality of life is much more important the life style.