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 Any taxes owed on the earnings within an annuity are deferred until they are withdrawn.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.
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.
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.