Annuities: What Investors Should Know

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Investors are pouring billions of dollars into annuities, as worries about stagflation and a U.S. recession whipsaw the stock and bond markets.

These complex financial tools, a mix of insurance and investment, come in a variety of product types and are sold as a way to safeguard retirement assets until they can be tapped for a stream of income.

Limra, a research firm funded by the insurance industry, reported that annuity sales have hit the highest levels since 2008. Last year, $255 billion of annuities were sold in the U.S., up 16% from 2020. In the first quarter of 2022, U.S. annuity sales totaled nearly $64 billion, a 4% increase over the year-earlier period.

“Annuities fill the void for people who are more risk-averse in today’s marketplace,” says

Derek Delaney,

a registered investment adviser and certified financial planner in Minnesota who runs PharmD Financial Planning LLC. “The bear bond market has made these products a fixed-income alternative.”

Some people, however, buy annuities without really understanding how they work, how much they cost and the risks they carry.

Here are answers to some common questions about annuities:

What is an annuity exactly?

An annuity is a contract with an insurance company that allows an investor to convert premiums or an upfront lump-sum payment into a guaranteed income stream either for life or for a fixed period. As private pensions in the U.S. have virtually disappeared, many consumers have turned to annuities to protect themselves from the risk of outliving their income.

These products appeal to people looking to supplement their retirement income, preserve their principal and diversify their portfolios. They also can be tailored to fit your financial needs. For example, you can add riders to guarantee income for life with or without inflation protection and to ensure your heirs receive something from the annuity should you die.

Insurance companies sell annuities; so do some banks, brokerage firms and mutual-fund companies. Investors can buy them using cash, or through pretax dollars in a 401(k) or an individual retirement account.

How do they work?

Once you invest in an annuity, the income you receive from it can be distributed monthly, quarterly, annually or in a lump-sum payment. The size of the payments is determined by factors such as interest rates, your age and life expectancy, and the length of the payment period.

You pay no taxes on the income and investment gains until you start withdrawing the money.

Depending on your financial needs you can set an annuity for immediate payments, or you can defer payments to some point in the future. These options are called immediate annuities, or deferred annuities, respectively.

Annuities have what is known as an accumulation period (the time between purchase and when it makes payments to you), and the draw period (when you begin taking payments).

What types of annuities are there?

There are three basic types of annuities: fixed, variable and indexed, as well as variations on those themes. Here’s how the basic types work:

Fixed annuity: The insurance company promises you a minimum rate of interest and a fixed amount of periodic payments. These products provide a guaranteed payout and are regulated by state insurance commissions.

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Variable annuity: This product allows you to direct annuity payments to different investment options such as mutual funds and exchange-traded funds. The payout you get depends on many factors, including how much you put in, the rate of return on the investments you choose and the expenses you incur on the contract. The Securities and Exchange Commission regulates variable annuities.

Indexed annuity: The insurance company credits you with a return that is based on the performance of a stock-market index such as the S&P 500, typically over a 12-month period, though it can vary. Dividends are usually excluded from the return, and accounts usually are credited with only a portion of the index’s gain. These products are regulated by state insurance commissioners. (The SEC only regulates indexed annuities that are securities.)

What annuity variations have become popular?

Fixed-index annuities and registered index-linked annuities represented about 40% of total annuity sales from Jan. 1, 2021, through March 30, 2022, according to Limra’s Secure Retirement Institute. Here’s how they work:

Fixed-indexed annuity: This is a cross between a fixed-income annuity and a variable annuity. It offers some degree of principal protection against market downturns by promising a fixed rate of return over a certain period, as well as a link to an index. If the index is positive, the investor is credited with a percentage of its return, based on his or her participation rate (or the percentage of the index’s return the insurance company credits to the annuity.) If the index is negative, the investor loses no money.

Registered index-linked annuity: This is a deferred annuity that also allows you to limit losses during a down market, though gains are capped at the same percentage when the market rises. Investors decide the exposures they want by setting a floor (the maximum percentage loss they are willing to absorb in a down market) or a buffer (percentage loss they don’t want to accept).

What are the costs?

Annuities—90% of which are sold by insurance agents and brokers who earn commissions—can be expensive, and costs go up with customization. That is why you should review an annuity’s prospectus and analyze annuity offerings with a trusted financial expert. There are also marketplaces such as DPLFP.com, Cannex.com and Immediateannuities.com that have tools to compare annuity products.

In addition to the annual management and administrative fee, you will be charged for every rider added to the contract which can range from 0.25% to 1.5% a year or more.

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There also are fees, which may be hidden in the fine print, such as underwriting fees and penalties for withdrawals before age 59½. In addition, withdrawing funds before the annuity contract term ends can result in a surrender charge. This penalty—represented as a percentage of the annuity balance—can be as high as 10% the first year and decline to 0% at the end of a surrender-charge period.

“I won’t recommend annuities with long surrender periods that lock in your money for 10 years,” advises

John Piershale,

a fee-only CFP who runs John Piershale Wealth Management in Crystal Lake, Ill. “It can be a costly mistake if you change your mind or need your money sooner than intended.”

What are the tax considerations?

For qualified annuities, or those funded with pretax dollars, the IRS charges income tax on withdrawals taken from the account. For nonqualified annuities, or those funded with after-tax dollars, you pay tax only on the interest earned. If you make partial withdrawals before age 59½, the money is subject to last-in-last-out tax rules. There also is the 10% early withdrawal penalty.

Mr. Delaney points out another tax consideration to keep in mind: “Many seniors hold annuities until they die and all money in the contract is taxable to the person who inherits it,” he says.

Are there other negatives?

“There are downsides and they differ depending on the product,” says

Wade Pfau,

co-director of the American College Center for Retirement Income. Some annuities are illiquid; once you invest in one your money is locked in. Thorough rare, annuities also carry the risk of default. If an insurer goes bankrupt, annuity owners can lose some of the promised payments. That is why it is important to review the financial strength of the insurer by reviewing its rating with credit-rating firm AM Best.

“If you are going to buy an annuity, opt for one sold by a strong counterparty that can guarantee income for 50 years or more,” says

Eric Nelson,

a certified financial planner at Altfest Personal Wealth Management.

Glossary

Annuitant: The person whose life expectancy is used to determine annuity income benefits.

Bailout provision: Allows the annuity owner to surrender the annuity contract if cap rates—the maximum interest rate an annuity will earn during a certain time period—or renewal rates on a fixed annuity fall below a certain level.

Bonus rate: A higher-than-average interest rate provided at the beginning of the annuity contract.

Buffer: A set percentage of loss that the insurance company is willing to absorb before deducting value from the indexed annuity.

Cash value: The account value of an annuity.

Distributions: Income payments from an annuity.

Guaranteed minimum income benefit: A rider on an annuity contract that allows an annuitant to receive a minimum monthly payment regardless of market volatility.

Interest-rate floor: The minimum interest rate that is credited to an annuity’s underlying portfolio.

Joint and survivor annuity: This contract guarantees payments for the remainder of two people’s lives so a spouse will continue to receive payments after the contract holder’s death.

Laddering: Buying several annuities of lower value over a period of years.

Nonqualified annuity: An annuity funded with after-tax dollars.

Proceeds: The net amount of money the company that issued the annuity pays at the death of the insured, or at the maturity of a contract.

Qualified annuity: An annuity funded with pretax dollars.

Renewal rate interest: Rate at time of annuity contract anniversary set at the end of each policy year.

Surrender period: The amount of time investors must wait until they can withdraw funds from an annuity without facing a penalty.

Source: Insured Retirement Institute

Ms. Ioannou is a writer in New York. She can be reached at reports@wsj.com.

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