Intermediate Section

Under these circumstances, your only recourse is to ask to surrender the annuity. You may be required to pay a surrender charge if you take this route. A surrender charge is a fee that is generally a percentage of the annuity’s total value and is usually highest during the earliest years of an annuity contract.

If you’re under 59½ years old and the annuity you wish to make an early withdrawal from is tax-qualified, you’ll have to pay an additional fee in the form of an excise tax — 10% of your withdrawal amount.

One possible way to avoid paying the excise tax is to transfer your money to another annuity rather than withdrawing it. This process is called a 1035 exchange, and it still carries the possibility of a surrender charge. However, there are still risks inherent in this process. For instance, you may need to pay another sales commission for the new annuity, and you’ll be starting the time on your surrender clock over again.

There are several features of fixed index annuities that have an effect on the index-linked opportunity. Of these, the two most significant are the method of indexing selected and the rate of participation. Understanding how these and the other main features of an index annuity contract work together is vital to helping you choose the annuity that’s right for you.

Indexing Method

The way an amount of change in the index is measured is the indexing method. Three of the most commonly used indexing methods are high-water mark, point-to-point, and annual reset (also called ratcheting).

Term

The length of time for the index-linked interest to be calculated is an index’s term. Any interest accrued is added to the annuity at the end of this term. The length of a term is anywhere from one to ten years. Terms of a six or seven-year length are most common.

Some annuities have single terms, while others offer multiple terms that are consecutive. Most terms include a window of about 30 days at the end of the term during which the owner of the annuity may withdraw money with no penalty. For holders of installment premium annuities, the start of a new term often coincides with each premium payment.

Participation Rate

The participation rate will be used to determine how much of the growth in the index will apply toward calculating the index-linked interest on the annuity. For instance, if the index has grown by 10% and the rate of participation is 70%, your annuity’s index-linked interest will be set at 7%.

The company you purchased your annuity from may change the participation rate for newly-issued annuities often. Consequently, your specific annuity’s participation rate will depend on when the company sold it to you. Generally, your participation rate will be guaranteed for a specific length of time, which can be anywhere from one year to the entire length of the term.

Once the designated period has ended, the company is free to change the participation rate. However, some annuities carry provisions that prevent companies from lowering or raising the participation rate below or above a certain point.

Cap Rate or Cap

In some cases, annuities will have an upper limit placed on the index-linked interest rate. This limit, called the cap or cap rate, is the highest possible rate of interest the annuity will be allowed to earn.

The Floor on Fixed Index-Linked Interest

The floor is the inverse of the cap, meaning it is the minimum rate of interest you will earn on your annuity. The floor is commonly set at 0%, meaning that even if the index drops lower in value, you won’t earn negative interest. Not all annuities carry caps or floors on their interest rates, but all annuities do have a minimum guaranteed value.

Averaging

Interest may be determined using the average interest value instead of the value of the index on a specific date. This averaging of the index may happen at the beginning, at the end of the term, or at any point during the entire term of the annuity.

Interest Compounding

There are two possible types of interest paid on annuities during an index term: simple and compound. When index-linked interest is added but doesn’t compound during the index term, this is simple interest. Compound interest, on the other hand, means that any index-linked interest added to your premium also accrues its own interest.

In either case, any interest earned in a given term is generally compounded in the next term.

Margin/Spread/Administrative Fee

Some annuities forgo the participation rate entirely in exchange for a different method of calculating interest: subtracting a certain percentage from any measured change in the index. This percentage is referred to as the margin, spread, or administrative fee, and it is only subtracted if the index has a positive interest rate.

Vesting

Some annuity contracts include provisions that grant none or only part of the index-linked interest if the full amount of the annuity is withdrawn before the end of the term. The percentage of the interest that is credited (a process known as “vesting”) usually increases the closer to the end of the term the withdrawal occurs. You can always expect 100% of the interest to be vested if you make your withdrawal at the end of the term.

If index-linked interest is credited to your annuity, it will likely be in one of these four ways.

Annual Reset

The value of the interest that has accrued at the end of the year (if any) is compared with the index value at the start of the year in order to determine the total index-linked interest. Interest is credited to your annuity each year during the term.

High Water Mark

The value of any index-linked interest accrued is determined by examining the index value at various specific points within the term, most often coinciding with the anniversary of the annuity purchase date. The interest value is found by subtracting the index value at the start of the term from the highest index value (or vice versa if the starting value is higher). Interest is credited to your annuity at the end of the term.

Low Water Mark

In this case, the index-linked interest is determined by the difference between the end-of-term index value and the lowest value the index held during the term. At the end of the term, this interest is credited to your annuity.

Point-to-Point

Point-to-point involves finding the difference between the index value at the start of the term and the end of the term. As with the previous two methods, interest (if any) will be added to your annuity at the end of the term.

Since the interest you earn annually is guaranteed by the end of the year, and the index value is reset at the end of every year, any future declines in the index value will not impact the interest your annuity has already accrued.

Therefore, your annuity may earn higher interest using this method when the index fluctuates frequently throughout the term. Annual reset has a greater likelihood of earning you interest-linked interest before the term ends than other designs.

Annual Reset (con)

The participation rate attached to your annuity will change each year, and, in general, is likely to be lower than the participation rate of other methods. Additionally, an annual reset design is likely to use a cap rate or some form of averaging to limit the amount of interest you’re able to earn.

High Water Mark (pro)

This method can earn more interest than other methods if the index reaches a high point in the middle of the term and then declines in value at the end.

High Water Mark (con)

No interest is credited to your annuity until the end of the term. In some cases, surrendering your annuity before the end of the term will prevent you from gaining any interest accrued during that term. Contracts that use a high water mark design also tend to have a lower participation rate than other designs, and may also have a cap on the total amount of interest you’re able to earn.

Low Water Mark (pro)

This design will allow the annuity to accrue more interest than other designs if the value drops to a low point early on or somewhere in the middle of the term and then soars up to a high point at the end.

Low Water Mark (con)

Similar to the high water mark, no interest is added to your annuity until the end of the term. If you give up your annuity before the end of the term, you run the risk of losing any interest accrued during that term. It also tends to have a lower participation rate and a cap on the interest your annuity can accrue.

Point-to-Point (pro)

In the point-to-point method, interest cannot be calculated until the term reaches its end, which leads to a higher possible participation rate than is generally found in other designs.

Point-to-Point (con)

No interest is credited to your annuity until the end of the term, which is typically a period of 12-months. You probably won’t be able to draw from the index-linked interest until the end of that period.

Annuitization describes the process of an annuity having its proceeds paid out by an insurance company. Annuitization is irreversible, so the holder of an annuity should plan carefully before proceeding.

In essence, the process of annuitization turns the available cash in your annuity into a guaranteed and fixed income stream, so you won’t be able to make independent withdrawals from your annuity once annuitization has been set in motion.

An annuity’s guaranteed rate is defined by the annuity’s contract and usually denotes the minimum rate you are guaranteed to be paid by the contract. The current rate is the actual rate paid by the company and is generally higher than the guaranteed rate.

Unlike the guaranteed rate, the current rate is not contractual and is set by the insurance company at its discretion.

A fixed annuity’s floor refers to the minimum guaranteed value credited to the annuity.

When you choose a guaranteed income annuity, you should be aware of some of the factors that can influence the level of income you can expect to receive from a given amount of money put into the annuity.

Gender

Guaranteed income annuities often provide higher income payments to men. This is due to the fact that males generally have a lower life expectancy than females (74½ years compared to 80 years).

Age

The younger you are when you first purchase your annuity, the longer your life expectancy, which leads to a lower income.

Annuity Features

Certain features of your annuity contract can affect the amount of income you receive from that annuity. For instance, an annuity that guarantees a certain level of income over a fixed period of time will pay less than an annuity that ceases to pay upon your death.

Interest Rates

An annuity purchased at a time when interest rates are at their highest will pay more than an annuity purchased during a period of lower rates. If you want to increase your chances of buying at an opportune moment, one way to do so is to buy multiple guaranteed income annuities over the course of several years.

No, not all income riders are equal. It’s important to learn to spot the differences to ensure you know what you’re being offered by each carrier.

Income riders are unique and specific to their given insurance carriers, and occasionally the same carrier will offer a different rider for each of its specific annuities.

When you’re shopping around for annuities with income riders, make sure to compare and contrast each offer you get from different insurance carriers to ensure you’re getting the best possible deal. As an example, the interest designated by your rider or by the death benefit associated with your annuity could be either simple or compound depending on the insurance carrier’s discretion. This detail could make a huge difference to you and your beneficiaries in the future.

Most riders offered by insurance carriers come with a premium cost, generally lasting for the duration of the policy. This cost is usually subtracted from the investment value on the anniversary date of the contract. The fee is not deducted from the value of the rider itself, which is one of the reasons why adding a rider to your annuity is considered a good strategy.

You don’t need to report any credited interest on your annuities until the money is withdrawn. As soon as you begin receiving your retirement money, the IRS will send you a 1099 form.

In perusing your options as a retiree with a lump sum distribution, you may decide that an immediate annuity makes the most sense for you. Using an immediate annuity, that lump sum premium can be transformed into a stream of monthly payments that also accrue interest and are guaranteed to last for the rest of your life. Plus, the amount of the regular payout that is a return of the principal value can’t be taxed.

On the other hand, there are certain risks associated with immediate annuities. For one thing, once you’ve locked yourself into guaranteed payments for life, it’s impossible to make any allowances or plans for inflation. You’re also betting on the fact that you’ll live long enough to get your money back with interest; if you die without naming a beneficiary before receiving all of your money, the insurance carrier will get to keep whatever is left over.

If you’re determined to buy an immediate annuity, you can opt for a “certain period” to be included in your contract. This provision guarantees payouts for a certain number of years to your designated beneficiaries. Two other optional provisions include “joint-and-survivor,” which will send payouts to your spouse after you die, or “refund,” which means a portion of whatever money is left in your annuity will be paid to your beneficiaries as a lump sum.

You’ll find that some immediate plans offer payments that are adjusted to anticipate inflation. These plans usually offer an increase of about 10 percent in payments over three-year intervals, with an additional cost of living adjustment set annually at a maximum of 3 percent. The downside of this type of plan is that the monthly payments you receive will usually be much lower, especially for the first several years.

Some companies have an alternative strategy for those willing to tolerate a higher level of risk. These “variable, immediate” plans can potentially earn you higher returns in the form of an income for life, but your monthly payments will be linked to the returns on a collection of mutual funds.

The safest strategy for a comfortable retirement is to accrue a balanced portfolio of mutual funds. If it’s important to you to guarantee that you don’t outlive your money, you can choose to plan out your withdrawals over a longer period of time.

Your age, health, and life expectancy (including any family history of disease or longevity) should all be taken under advisement as you consider whether or not to purchase a retirement income annuity. Consider that many insurance companies refuse to offer annuities to anyone over the age of 80, and the ones that do require beneficiary protection.

In contrast to life insurance policies, annuity applications don’t require any proof or underwriting related to your health. If you have any reason to suspect your health or life expectancy might be an issue, you should consider a plan that includes beneficiary protection even if you aren’t 80 yet.

As you consider your retirement options, consider these important points before you purchase any plan.

The money you put into your non-qualified annuity might be in after-tax dollars. When you add after-tax savings to your annuity, you can do so in any amount you want. Before adding after-tax savings to your annuity, consider first adding the greatest possible pre-tax amount to a qualified retirement plan, such as an IRA, SEP, 401(k), or 403(b).

The aforementioned retirement plans can also be funded using annuities, though such methods of funding are subject to certain contribution limits. Additionally, you’ll be required under federal tax laws to start taking minimum distributions from your retirement account by April 1 of the year after you turn 72. If you fail to comply with these required distributions, you’ll receive a tax penalty amounting to 50% of the amount you failed to withdraw.

Once you’ve put money in a 401(k) or 403(b), you can’t make withdrawals except under extreme circumstances, including unemployment, death, or disability. Any withdrawals you do make of taxable amounts from these accounts will be subject to regular income tax, as well as a possible 10% excise tax if the withdrawals are made before you turn 59½.

Before you sign any contracts, make sure their costs are competitive. Use independent rating services like Lipper Analytical Services or Morningstar to determine whether you’re being offered a fee that is comparable to the insurance carrier’s competitors. While it’s not always best to go with the cheapest possible contract, you don’t want to spend so much on your contract that it offsets the gains from that annuity.

All distributed earnings from annuities will be taxed as regular income. While you might end up paying higher taxes than you’re used to, your earnings from the annuity will also gain a tax deferral. With other types of investments, you might be subject to annual capital gains taxes as well as regular income taxes, which will reduce the value of your earnings in the long run.

If you’ve considered all of these factors and come to the conclusion that an annuity is the right retirement investment for you, ask yourself these key questions before signing a contract:

1. Have you shopped around at different insurance carriers and compared all of your options? These plans are long-term vehicles for generating savings, so you want to choose a company that’s guaranteed not to shut down while you’re still alive. As mentioned in previous sections, you’ll find that different companies offer wildly varying prices, features, and flexibility with their annuity contracts.
2. Does the rate you’re being offered on a fixed annuity seem too good to be true? You want to make sure you’ll have a competitive rate when it comes time to renew your annuity. If a company is offering a bonus rate (a higher interest rate over a designated period of time, for example), check to make sure the base-level interest rate is still competitive, and be sure to factor in any added costs or surrender fees outlined in the contract. As soon as the bonus rate’s term is up, you’ll be stuck with whatever the regular rate is going forward.
3. What are the surrender fees outlined in the contract, and how long will they be in place? Surrender fees are usually set at 10 percent or so and decline over 5 to 7 years until they expire. If the initial surrender fee designated is higher, you could be stuck with a contract that will be extremely costly to escape down the road.
4. How do the funding options offered in a variable annuity typically perform? Don’t automatically assume that last month’s top performer is the way to go. When you’re shopping around for annuity performance at various insurance carriers, check out the last three to five years at least. While past performance won’t necessarily guarantee the best results, utilizing rankings published in resources such as Barron’s and The Wall Street Journal can give you valuable information about different carriers that you probably won’t hear from the carriers themselves.
5. Does the variable annuity offer a variety of funding options in case your investment strategy changes in the future? Prioritize contracts that provide a range of funds so your retirement savings can diversify as your needs evolve.
6. When you begin taking distributions, will your regular income tax rate exceed the relevant capital gains rate? Under these circumstances, you might end up paying more in taxes than you would by choosing another form of retirement investment. On the other hand, don’t forget that the money your annuity accumulates is accrued on a tax-deferred basis. When you choose an annuity over other retirement investments, you avoid paying regular annual income tax on your earnings while your money continues to grow.
7. How highly is the insurance company rated? Any properly licensed professional (banks, agents, and brokers, for instance) can sell annuities; however, the actual annuity contract is issued by an insurance company. That means researching the insurance carrier behind the annuity contract is an important step before signing. Look for companies that are financially strong and have a solid history of paying claims.

You can use the following four questions to help you narrow down your options before choosing which annuity is right for you.

1. How important is security to you? If you’re most comfortable with guaranteed returns, you should go with a fixed annuity. If you’re comfortable taking some risks for a potentially higher return on your investment, choose a variable annuity instead.
2. What payment method would you like to use? If you wish to make one lump sum payment to cover your whole annuity, choose a single premium annuity. Should you prefer to make regular payments over time, you’ll be happier with a flexible payment annuity.
3. When would you like to begin receiving payouts from your annuity? If you want to receive income right away, go with an immediate annuity. If you’d prefer to receive your payments in the future (at retirement, for instance), you should choose a deferred annuity.
4. How would you like your deferred payments doled out? If you want to keep receiving payments for the remainder of your life, you’ll want a straight life option. If you want the payments to start going to your spouse after your death, choose the joint and survivor option. If you want payments for life that will then be paid as lump sums to your beneficiaries in the event of your premature death, choose a life annuity with a refund feature.

Never go into a meeting with a bank, agent, broker, or any other licensed seller of annuities without doing the appropriate amount of research and preparation. Here are some questions you should be sure to ask before signing a contract.

• Is this contract a single premium or multiple premium?
• Is this annuity fixed, fixed index, or variable?
• What is the initial interest rate, and how long is that rate guaranteed?
• Does the initial interest rate include a bonus rate? If so, how much is the bonus?
• What is the annuity’s guaranteed minimum interest rate?
• On annuities of the same type that the company issued last year, what renewal rate is being credited?
• Are there any surrender fees or withdrawal charges if I want to end my contract early and take out my money? If so, how much are the penalties?
• Can I complete a partial withdrawal from the annuity without being charged a surrender fee or losing interest?
• Under circumstances like premature death, terminal illness, or confinement in an assisted living facility, will the withdrawal charges be waived?
• Is there a provision for market value adjustment (MVA) in my annuity contract?
• Are there any other charges that may be taken out of my premium or contract value? If so, what are they?
• Will the annuity’s accumulated value or the way the interest is added change if I choose a longer or shorter payout period, or if I surrender the annuity?
• Is there a death benefit provision in the contract? If so, how is it set, and can it be changed?
• What are the income payment options available to me? Once I choose one, can I change it later?

Annuity Associates can put you in touch with trained and highly qualified agents all over the United States. These licensed experts can provide insider tips about all of the various types of annuities and related services to help you fulfill your long-time retirement planning and income-related needs.

To learn more about annuities, get quotes on rates, or ask about purchasing an annuity, please contact a specialist at Annuity Associates for a free, no-obligation consultation today.