30 April 2014 0 Comments

Potential Pitfalls of Deferred Annuities – Part One


In my previous entry “The Truth About Annuities” I provided an overview of the two types of annuities, Immediate and Deferred, touching on the strengths and weaknesses of Immediate Annuities as well as the major strength of Deferred Annuities—tax deferral.  Now it’s time to cover the downside of Deferred Annuities.  But, first it’s important to define the three basic types of Deferred Annuities: Fixed, Indexed and Variable.

Fixed Annuities provide guaranteed and current interest crediting.  Policies being issued today might have a minimum guaranteed interest of about 2%, but are currently crediting slightly more than that.  The annuity owner has no investment decisions to make.  These types of annuities have historically been competitive with bank CD rates.

Indexed Annuities have a fixed account similar to the fixed annuity, but they also provide accounts that track the returns of published indexes such as the Standard and Poors 500.  The annuity owner can move assets between the fixed account and accounts tracking one or more outside index.  If the index selected has a negative return, typically the value of the account does not drop below the previous year’s value or the total premium paid. In order to provide this downside protection, the maximum amount credited in any year will be capped and there may be a participation percentage of less than 100% of the index’s return.  Funds are not invested directly in indexed accounts; rather the insurance company employs options to accomplish the contractual tracking provided.

Variable Annuities are similar to indexed annuities inasmuch as there is a fixed account option as well as the potential for growth in a managed fund.  But, here the funds invested outside of the fixed account are place directly into investment accounts similar to mutual funds (perhaps even managed by mutual fund companies) and their value will rise or fall in direct proportion to the underlying fund value without the protection of any minimum guarantee.  The annuity owner determines what funds are to be used and can move from one investment option to another.  In order to sell Variable Annuities an agent must hold a license with the National Association of Security Dealers (NASD) as well as a state insurance license.

Surrender Charges

One of the important things to understand with any type of Deferred Annuity is that they are not intended as short term investment vehicles.  There will be penalties, referred to as surrender charges, if you decide to cash out in the early years.  At the very least do not plan to withdraw funds for 5 years or to the end of the surrender charge period if longer.  There may be a way to withdraw a small amount in the early years without incurring a surrender charge, but if you do you have lost the advantage of tax deferral since any withdrawal assumes earnings are received first, followed by principle, resulting in ordinary income.

Part Two of this entry reveals some additional concerns about Deferred Annuities…but it’s not all bad.

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