Although I haven’t sold insurance or investments for almost a decade in my role as a financial educator, my happiest client from those days is my dad, who purchased a deferred variable annuity from me. There is quite a bit of negative press about the high fees and long surrender charges with some annuities, but what makes my dad a satisfied investor are the safety nets provided from the benefits riders that can amount to an alphabet soup of abbreviations. So what is an annuity, and how does it help my dad sleep at night without worrying about his money?
An annuity is a contract between you and an insurance company that is ultimately designed to pay you out a steady stream of income for life. You can purchase an immediate annuity with a lump sum of money and the insurance company immediately converts the amount you invested into a guaranteed monthly income you can never outlive. This is typically referred to as a SPIA (single premium immediate annuity). Or, you can invest in a deferred annuity by contributing with a lump sum (SPDA) or flexible installment payments (FPDA) with the intent of perhaps converting the annuity some time later down the road to pay you a monthly income for life. This is what is referred to as “annuitization.”
With annuities, you also have to decide how you want your money to be invested within the contract. A fixed annuity’s growth is based on a stated interest rate so there is no market risk but the rates are pretty low right now. A variable annuity allows you to select from a variety of “sub-accounts” (which are similar to mutual funds) that represent different investments, such as bonds, stocks, and real estate investment trusts.
My dad purchased a SPVDA (single premium variable deferred annuity) using some of his retirement funds from a 457 plan he had as a state worker. This type of annuity is considered “qualified,” meaning the money came from a tax-advantaged retirement account. When he eventually starts to take withdrawals, the entire amount would be considered taxable as ordinary income.
However, you can also use after-tax funds to invest in an annuity. This would be considered a non-qualified annuity that provides tax-deferred growth and an interesting mix of nontaxable and taxable income after annuitizing the contract. The portion of the annuity payments that’s tax-free is called the exclusion ratio.
One of the main concerns my dad had was in regards to any loss on his initial investment. His SPVDA was invested in a moderate portfolio with a balanced mix of stock and bond exposure, but he wanted to know that no matter what happened to the stock market, he’d get back what he invested. So, he selected riders that offered a guaranteed minimum income benefit (GMIB) based on a 6% interest rate if he annuitized, a guaranteed minimum withdrawal benefit (GMWB) at 5% of his base investment if he didn’t decide to annuitize but wanted to take out some funds for annual income, and a guaranteed minimum death benefit (GMDB) that would provide my mother with a minimum death benefit based on a 5% annual increase of his initial deposit if he dies before ever taking anything out of the contract.
Whenever I visit my parents around the mailing time of his quarterly statement, he has it out on the kitchen counter and points out how happy he is with his annuity, even when his actual account value has dropped. When the market is doing well, he likes to brag about how well his account is doing, but when the market takes a hit, he points out how relieved he is that my mom has a guaranteed value if he dies that she can rely on. So although I am no longer his official “broker of record” (the agent’s name who is assigned to his account), I am always glad to chat with my favorite client.