Understanding annuities with respect to Term Life insurance

Question

I am financially well to do. I have Term Life insurance (along with high 6 digits in savings) that will protect my kids. I am considering protecting myself and guarding against outliving my assets with the help of annuities.

When I thought about my kids and looked at various life insurances in market about 12 years ago (without reading StackExchange), I concluded that Term Life is best.

Now, when I look at annuities, I am totally confused. I want a simple product that is "honestly written". I understand that insurance companies are in business to make money but what I dislike most is that contracts are written in confusing language.

I am avid investor and sometimes I feel that annuities are not for me. But for my spouse who is not an investor, I want to have an annuity that provides a steady return and that my kids can inherit.

What annuity will come close in simplicity to "Term Life insurance", some inflation protection, is tax efficient and is protected from the issuer going bankrupt? I know that all of these cannot be achieved but I hope to to a reasonable extent.

Answer 1

Annuities are complex products and therefore the description in the prospectus is complex. I'd question whether some of the indexed annuities are a good investment but I don't think that the problem is that the description isn't "honestly written" (they're regulated).

I don't think that you can make a direct comparison of annuities with term insurance because there are different kinds of annuities and they have different duration, risk/reward spectrum, payouts , benefits, etc.

All of the US annuities that I have come across are tax efficient. The growth is sheltered until withdrawn with no penalty if after 59-1/2.

When people comment about annuities, the initial knee jerk reaction is to mention high commissions. In most cases, that's true but not always. For example, Vanguard offers some very low cost variable annuities (circa 0.50 %). But they're not going to come with "not going to outlive my income" protection. If you want that rider, you pay for it. If you want income step up to lock in gains or a better death benefit, you pay for those riders. The more that you want, the more that you pay. All of these fees are a large drag on market performance. You are accepting drag in return for certain guarantees.

Fixed income annuities are another category. Pay a lump sum and receive a defined benefit for life, some with spousal inheritance features.

Structured index products have become very popular in recent years. For example, you could choose an ETF such as the SPY, IWM, GLD, etc. and with a 5-6 year annuity, the annual limit would be an upside participation with an 8% cap along with protection from the first 10% of index drop. These are sheltered but IMO, they are a rip off because the insurance company is keeping the dividends. That means that the index must gain the dollar amount of the dividend annually before you begin to profit. This product can be duplicated with options, resulting in a much higher annual amount of protection (~ 17 to 18%) but unfortunately, if done yourself, there's no tax sheltering.

This cursory answer is by no means comprehensive since there are many, many variations out there. If you feel that some specific type of annuity meets your needs, you're going to have to learn about it in depth in order to make a financially literate decision. And no, I'm not in the business :->)

Answer 2

I want to have an annuity that provides a steady return and that my kids can inherit. What annuity will come close in simplicity to "Term Life insurance", some inflation protection, is tax efficient and is protected from the issuer going bankrupt?

A fixed deferred annuity typically offers a stable return and is among the simplest of annuities. It may be tax efficient in terms of the income being deferred but as discussed below that may not be a net advantage. It does offer some inflation protection but it may not be as much as investments outside of an annuity. No annuity is protected from issuer insolvency. That’s what an insurance contract is, a contract that the issuer will pay the contracted benefits. If they go bankrupt you may lose some of your investment. To reduce the risk of that you have to carefully check the insurers ratings and financial stability.

The below is background to help understand what options you have with annuities.

It’s important to understand that annuities in the US can have two different parts.

1. The deferral stage. Also called the accumulation stage or period.
2. The annuitization stage.

In the deferral stage you can make one or more contributions or even monthly contributions.

In the annuitization stage the money is converted into a stream of income and but can involve balloon payments. This stage is typically irrevocable.

The complication is you can have deferred annuities that are never annuitized and you can have immediate annuities that have no accumulation phase.

Within deferred annuities you can have variable annuities that contain separate accounts that act a lot like mutual funds and are regulated as investment products or you can have fixed annuities that are regulated as pure insurance products. Within fixed annuities there are what are called FIA or fixed index annuities that used to be called equity index annuities. These can be anything from a simple percentage of the return of a given index over a longer time period to complex strategies that have repeated shorter participation periods and various percentages of the index. FIAs are regulated as fixed annuities because they have a certain minimum guaranteed returns that are typically not very good. They can be marketed in ways that make the potential returns look very good but the actual returns are typically much less than the returns are made to look like. To complicate matters, variable annuities can have guarantees of certain kinds against losses because they are insurance products.

Tax treatment As long as the annuity qualifies as an annuity for IRS purposes the income and capital gains from the investment are tax deferred until withdrawn. Withdrawals made before the year the owner turns 59-1/2 generally have a tax penalty. When the money is withdrawn the portion that is attributable to growth is taxable as ordinary income. Deferred annuities are typically touted as benefiting from tax deferral but it may or may not be a benefit since ordinary income rates are typically higher than capital gains rates on investments.

**Benefits and expenses ** Deferred annuities typically have a death benefit where even if the variable annuity value declines the beneficiary receives at least the original contribution. It can be more depending on various riders that can increase the death benefit at various based on growth in the separate accounts.

To obtain these benefits there is a cost which for the basic death benefit is the M&E or mortality and expense charge. Other riders for various guarantees have additional costs. M&E charges range from 0.45% or so to 1.5% or more and are typically 1% or above. That can be a very expensive charge to get a relatively minimal death benefit. For example if you invest $100k and it grows to anything over that such as $110k after 10 or 20 years then you get the $110k account value but gain nothing from the 1% M&E that was paid every year.

Fixed annuities don’t have M&E expenses their expenses are just built into the interest rate they pay.