Deferred Annuities for Dummies

When it comes to deferred annuities, most people might classify themselves as “dummies” if only for the fact that they are fairly unique in the realm of investment products.  While the basic concept of a deferred annuity is simple – In exchange for a deposit of funds from an investor, a life insurer promises to credit a competitive rate of interest over the phase period and then guarantee a lifetime income payout during the distribution phase – there are a lot of moving parts within an annuity contract to make sure that all of that happens.  Herewith is an explanation of deferred annuities for dummies.

The Basic Premise of Deferred Annuities

An annuity is a legal contract issued by a life insurance company because it is a form of insurance protection.  Instead of insuring against the risk of dying too soon, and annuity insures against the risk of living too long. In other words, by contract, a life insurance company will guarantee that you cannot outlive your principal.

Annuities have existed for thousands of years as binding contracts between a private or government entity and individuals wherein a promise to pay the individual annual payments for a specified period of time, or a lifetime, was made in exchange for lump sum deposit of money. The purpose of the modern annuity, a product of life insurance companies originally offered in the 19th century, evolved so that it could also be used to accumulate funds prior to the need for income.  These became known as “deferred” annuities because the income was to be deferred until a later time.

How a Deferred Annuity Works

A deferred annuity is comprised of two distinct phases: An accumulation phase which begins once the annuity owner’s funds are on deposit with the insurer; and a distribution phase which begins once the owner annuitizes, or converts a lump sum of money to an income stream.

Accumulation Phase

The key components of the accumulation phase are the accumulation account, a credited interest rate, a minimum rate guarantee, withdrawal provisions, and the death benefit.

Accumulation account:

Each annuity contract creates an account in which an investor makes a deposit and the funds accumulate.  Although the account is established in the name of the annuity owner, the funds become a part of the life insurer’s general account which is invested in secure vehicles such as long term government bonds.

Credited interest rate:

In return for the lump sum deposit, the life insurer credits the account with a fixed rate of interest.  In some deferred annuities, the rate of interest is guaranteed for a certain period of time, after which it is adjusted to the prevailing rates at the time or a minimum rate whichever is higher. The insurer generally credits a rate of interest that is based on the yield it generates from its own investment portfolio and the rates are typically higher than those found in bank CDs and other short term fixed vehicles.

Minimum rate guarantee:

After the initial or guaranteed rate period, the insurer will adjust the rates according to a formula. Most deferred annuity contracts include a minimum rate guarantee which prevents the adjusted rate from falling below it.

Withdrawal provisions:

Deferred annuity contracts allow for an annual withdrawal of funds up to 10 percent of the account balance without incurring a charge.  The charge, known as a surrender fee, is based on a percent of the funds withdrawn that are in excess of 10 percent of the balance, and can range from 5 percent to 10 percent in the first year of the contract. Each year the fee declines by 1% until it eventually disappears, after which there are no more withdrawal fees.

Death benefit:

Because annuities are an insurance contract, they include a death benefit which pays a lump sum of the accumulated values or the principal whichever is greater to a designated beneficiary.

Distribution Phase:

The key components of the distribution phase are the lump sum of principal, the payout rate, and the refund option.

Lump sum of principal:

During the accumulation phase, the funds are left to accumulate until the owner has a need for income. The accumulated balance then becomes the principal amount that is annuitized for income. Once the principal amount is annuitized, converted to income, the annuity owner no longer has access to the principal and can only receive it back through the annuity payments.

Payout rate:

This is the rate at which the insurer will determine how much income can be generated from the principal amount. The insurer factors in the amount of principal that is repaid as part of the income payments, the length of the payout period – either a specified period of time or the life expectancy of the annuitant, a minimum interest rate, and the income ownership (single or joint life) to arrive at the rate which is then fixed for the life of the annuitant. The shorter the annuity period the higher the payout rate and the higher the amount of principal that is paid as part of the monthly payment.

Refund option:

A refund option can be selected that will pay a designated beneficiary all or a part of the remaining principal balance in installments over a specified period of time.

Tax Issues

Deferred annuities qualify under the Internal Revenue Code as retirement plans, and as such, they are afforded some of the same tax advantages as qualified plans such as IRAs.  Primarily, the funds that accumulate inside an annuity are not currently taxed.  They are taxed upon withdrawal as ordinary income. Contributions to deferred annuities are made with after-tax dollars unless the annuity resides inside of a qualified retirement plan.