What is a Deferred Annuity?
A Deferred Annuity is an annuity that, by design, delays the start date of annuity payments. You can usually have a payment stream of as little as 1 payment or as long as your lifetime. There will be an “annuity start date” which is the date by which you must initiate income. This can be age 95 or even 100 in some cases.
While you are delaying the “annuity start date,” you will earn interest. That interest grows tax-deferred, so you won’t pay taxes on your earnings until you remove them to go spend. So with a deferred annuity, you earn tax deferred interest on the account and don’t pay tax until earnings are withdrawn.
Three Main Types of Deferred Annuities
The first one is the most complex and the one that most people get worked up about. It is the Variable Annuity.
Many folks find this type of account to be complicated and often expensive. Like everything else these days, there are variations and options which can add or subtract cost. Like a mutual fund, REIT or many other investments, the cost and options can vary greatly. This type of annuity is generally good for someone who wants some downside protection for their principal, but really wants to be invested in mutual fund style accounts called SUB-ACCOUNTS. These will usually guarantee that your beneficiary will get at least as much as you put in, regardless of whether the Sub accounts made any money or not.
These accounts usually have a wide variety of investment sub accounts, sometimes there can be as many as 200 or more to choose from. However, today, more than ever, you must read and study whether the costs, fees and options being offered are going to provide value to you and your objectives. This information can be found in the prospectus. I would urge you to read all of the pertinent sections on costs, fees, riders, transfers and penalty free withdrawal availability. That is the only way to know if the cost is worth the benefit. While doing this, make sure you write down all of your questions and get the person you are dealing with to answer them to your satisfaction and understanding!
I’ll give you an example as to why this is important. I recently met a new client. They had purchased one of these about a year ago in anticipation of their retirement. The contract included the optional “lifetime income rider” which will provide an income that will last as long as both them live, even if the account runs out of money. They will enjoy a high withdrawal percentage and have the ability to earn interest based on the performance of the underlying sub accounts (remember, the ones like mutual funds, but inside a variable annuity).
All of this sounds pretty good, right? They will get a strong, guaranteed lifetime income which will cover both the husband and wife’s lifetime. They have a chance for the income to increase based on the performance of the sub accounts. They can take penalty free withdrawals in the meantime of up to 10% of the value of the contract each year.
Well, as usual, there are two sides to this coin. Because they included the “guaranteed lifetime income rider,” they can only use a limited number of the offered sub accounts. These are options that will be less volatile (in theory) and should experience fewer extreme swings in value. The trade off, is that these options won’t earn very much when compared to other options during periods (like last year) of large market gains.
The other part of the story is the cost. The contract has a 1.15% mortality and expense charge (M&E). This covers the guarantee of principal at death. Then the options selected for the income rider will run about 2.1% in cost per year. And finally, the investment sub accounts that were selected have an average disclosed expense ratio of an average of just over 1%. This means that the client must earn over 4% each year just to pay the expenses! Now you should understand that there are options we will be exploring that could drop that cost by at least 1.5%, which will still provide the outcome they are looking for. Let’s summarize:
Pros of a Variable Annuity
- Professionally managed sub accounts
- Guaranteed death benefit to equal at least the original investment amount
- Wide variety of investment options
- Guaranteed lifetime income availability
- Tax deferral for non-qualified accounts
- Surrender charge free access to a portion of the account
Cons of a Variable Annuity
- Restrictions on which sub accounts can be used
- Can be relatively high expense
- Complexity, need to read a prospectus
- Surrender charges
Want to learn more? Click on the links below:
Are Annuities Good Investments or Bad Investments?
What are Deferred Fixed Annuities?
What is a Fixed Indexed Annuity?
At Gainer Financial, we are here to answer your questions and help you have a better understanding of how you can retire happy. We’re located in downtown San Rafael, serving clients throughout the Bay Area.
Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance and a Certified Paralegal for Estate Planning.