Step 3: Fine Tune Additional Considerations
With a very competitive annuity marketplace, non-qualified annuity payouts amongst different products are often very close. So how does one decide to select one product over another? Often the deciding factor will be one or more of what I call “Additional Considerations.” These are additional characteristics of annuities you must consider when selecting an annuity and/or benefits that the carrier uses to “sweeten the pot” as an enticement to purchase their product. Once you have found one or more annuities that are serious contenders you need to proceed to Step 3. This “fine-tuning” may help you decide which annuity is the best deal for you.
Additional Consideration #1: Single or Joint Life
You can select a payout based on either one life (single) or two lives (joint). If a joint life payout is selected, the payout will be based on the younger of the two lives. If either annuitant dies, the other continues to receive the payout for the rest of her/his natural life. A joint life payout will be lower than a single life payout (based on the same person) because the carrier has the added risk of being on the hook for payouts to two people instead of one.
The joint annuitant does not have to be a spouse. You can name a parent, child, sibling, or any other person with whom you have a relationship and desire to provide income to as the joint annuitant.
CASE HISTORY EXAMPLE – JIM AND JANE
Jim and Jane have a joint life annuity. They are the same age, however, as a female, she has a longer life expectancy than Jim so their payout will be based on her life expectancy. Mike and Marcy’s annuity is based on Mike’s life as he is younger than Marcy.
CASE HISTORY EXAMPLE – MURIEL
Muriel is unmarried and opted for a single life payout.
CASE HISTORY EXAMPLE – BILL
Bill needs maximum income so he would want to choose a single life payout.
Additional Consideration #2: Surrender Charges
The vast majority of deferred annuities have a surrender charge period (also known as a Contingent Deferred Sales Charge (Commonly abbreviated CDSC). There are no-surrender-charge-period annuities available, but they are not the norm. Due to the surrender charge period annuities are not considered to have good liquidity.
A surrender charge is a percentage of the cash value of the contract that will be deducted from the cash value when a redemption of cash value is requested before the surrender charge period has elapsed. Always make sure your annuity sales adviser shows you the surrender charge schedule. After the surrender charge period has elapsed 100% of the cash value of the annuity is available for withdrawal without any surrender charges (if you haven’t annuitized the value yet).
Only purchase an annuity with a surrender charge period with which you are comfortable. Most people, if using the annuity for retirement income are used to the idea of not touching their retirement funds for the long term. In general, the longer the surrender charge, the better the guaranteed benefits of the contract. But regardless of benefits, do not purchase an annuity with a longer surrender charge period unless keeping the money in the annuity for the full surrender charge period will not be a hardship for you.
NOTE: If you own an annuity with a surrender charge period, this does not mean upon receiving the contract you should stick it in the back of the bottom drawer of your filing cabinet until the surrender charge period is over. Like any financial product you own, it needs to be reviewed yearly for performance and comparison to new products on the market. It is entirely possible a different or new product can still work out to be a better deal for you even if the surrender charge period is still in effect.
Some contracts allow a certain percentage of the cash value to be redeemed each year without a surrender charge even if the redemption is during the surrender charge period. Some contracts allow 100% of the cash value to be redeemed under certain circumstances (such as nursing home confinement, diagnosis of a terminal illness, or death) even if the redemption is made during the surrender charge period. Others do not allow any “free” redemptions for any reason during the surrender charge period. Get the facts up front!
CASE HISTORY EXAMPLE – JIM AND JANE
Jim and Jane have a 10-year surrender charge period on their annuity. Additionally, they are allowed up to a 10% withdrawal of the cash value each year with no surrender charge during the surrender charge period.
CASE HISTORY EXAMPLE – MURIEL
Muriel has a 7-year surrender charge period on her variable annuity. However, to keep all of the benefits of her annuity she is not allowed to take any withdrawals at all before year 10. Doing so will not only affect her Guaranteed Income Base it will negate the “step up” provision which guarantees her Guaranteed Income Base will be doubled at year 10.
CASE HISTORY EXAMPLE – BILL
The SPIA Bill was considering does not have a surrender charge period because the premium paid is annuitized immediately and once annuitized, the owner of the contract cannot cash the product out.
Additional Consideration #3: Method of Distribution
There are only two methods of taking income from an annuity. The two methods are 1) annuitization; and 2) withdrawal.
Annuitization
This is usually the default method of taking income. Once annuitization begins (i.e., once the income stream starts), the annuity owner loses all control over the cash value of the annuity. The ability to cash out of the annuity is no longer available, and the income stream cannot be turned off once it has begun. Additionally, the tax treatment of an annuitized income stream is different than that of an income stream produced by withdrawals. With an annuitized income stream, a certain percentage of the monthly or annual income will be considered a return of principle and will be excluded from taxation. The remaining portion of the income stream (considered gain) will be taxed at ordinary rates. Of course, this is assuming the annuity was purchased with non-qualified funds (after-tax monies); 100% of an annuitized income stream from an annuity purchased with qualified funds (pre-tax monies) will be subject to ordinary income tax rates unless the qualified funds are from a Roth IRA in which case 0% of the income stream will be taxed. Always verify with a qualified independent tax professional exactly how your annuity will be taxed.
Withdrawal
In contrast to annuitization, the withdrawal method of taking income from an annuity allows the annuity owner to turn the income stream on and off as desired and also allows for the possibility of cashing out of the annuity in a lump sum if so desired after income has begun (not possible under annuitization). However, the advantages of withdrawing income rather than annuitizing it usually requires the purchase of a rider for an extra fee.
The withdrawal option discussed in this section is not the same as the withdrawal of cash value. The withdrawal option discussed in this section refers to taking lifetime income benefits; the previous section refers to withdrawing all or part of the cash value of the annuity after the surrender charge period has elapsed.
When an income stream is created via withdrawals from an annuity, the tax code currently considers the income stream from a LIFO (last-in-first-out) perspective. Always check with an independent, qualified tax professional to determine which portion of an annuity withdrawal will be taxable. Do not take the salesperson’s estimate, guesstimate, or word for it.
CASE HISTORY EXAMPLE – JIM AND JANE
Jim and Jane’s purchase of a Lifetime Income Benefit Rider (for an additional fee) with their fixed index annuity gives them the option to withdraw their income rather than have to annuitize it. This means they can start and stop the income stream at will and can even withdraw the entire cash value after starting the income stream. (Withdrawing the entire cash value, of course, will end the income stream and they will lose any lifetime benefits to which they had been entitled.)
CASE HISTORY EXAMPLE – MURIEL
The rider guaranteeing Muriel’s income base also allows her the option of withdrawals instead of annuitization. This rider costs her an additional fee.
CASE HISTORY EXAMPLE – BILL
The SPIA Bill was considering pays out via annuitization. He does not have a choice. Once annuitized, Bill cannot cash the product out or to stop the income if he so desires.
Additional Consideration #4: Death Benefit
In general, an annuity is not primarily purchased for legacy reasons. But it is natural people want to leave whatever residual amount is in their annuity at their death to their estate beneficiaries instead of an insurance company.
It is vitally important you find out what the death benefits are for the annuity you are considering. There may be different rules for the death benefit depending on whether or not income has started, and whether or not a surrender charge period is in effect. It is also possible a purchased rider contains a provision for an “enhanced” or “upgraded” death benefit based on the Guaranteed Income Base rather than on the cash value (which is usual).
SPIAs (immediate annuities) are notorious for having no death benefit (the family of Bill’s Uncle Mel found this out); having no death benefit, of course, also accounts for SPIAs having the highest payout value. If you want or need a higher payout value it may make sense for you to purchase a SPIA especially if you have other assets you will be leaving your beneficiaries, if you are in very good health, have a family history of longevity, and/or anticipate using up all of the annuity purchase prices and then some.
However, the insurance industry is very sensitive to the competitive marketplace. So there now are SPIAs which do have death benefits (including “refund certain” benefits) so do not automatically dismiss SPIAs without investigating them thoroughly.
CASE HISTORY EXAMPLE – JIM AND JANE
The “Lifetime Max Income Rider” Jim and Jane added to their annuity give them a death benefit based on the Guaranteed Income Base rather than on the cash value. If they should both pass away (this is a joint annuity) before starting income, their beneficiaries (their two daughters) will receive the value of the Guaranteed Income Base at the time of their passing. This amount can be taken in full over five years or as a discounted lump sum. After income starts, the death benefit is equal to the Guaranteed Income Base when the income was begun less any withdrawals.
CASE HISTORY EXAMPLE – MURIEL
The death benefit on Muriel’s annuity is equal to the greatest of either the annuity’s cash value, surrender value, or purchase amount less any withdrawals.
CASE HISTORY EXAMPLE – BILL
The SPIA Bill was considering has 3 different types of death benefit each tied to how income is taken:
- Life Only – Bill receives income payments for the rest of his life. Upon his death, his beneficiaries receive nothing – no death benefit. (This is what his Uncle Mel had chosen.)
- Life with Period Certain – Bill selects the number of years he wants guaranteed payments. He then receives income payments for the rest of his life. If Bill dies before the number of years of guaranteed payments has passed the death benefit for his beneficiaries will be the remaining number of payments due. If he dies after the number of guarantee payment years has passed, his beneficiaries receive nothing.
- Life with Refund Certain – Bill receives income payments for the rest of his life. If Bill dies before the total payments made to him equal the premium he paid for the annuity, his beneficiaries will receive the difference between what he paid and what he had already received. If he dies after the total payments made to him equal or exceeds the premium he paid for the annuity his beneficiaries receive nothing.
The percentage payout Bill receives may differ based on which death benefit he selects. (He forgot to ask the annuity sales adviser about the death benefit, remember?)
Additional Consideration #5: Cost-Of-Living-Adjustment (COLA)
Most annuities offer the purchaser the option to have the income payments increase on a yearly basis to address the on-going concern of the effects of inflation over time. Payments will start out lower than if a level payment option is selected and will increase annually either by a fixed percentage or some other identified cost-of-living index. The fixed percentage of the increase or the cost-of-living index to be used should be in writing in the annuity contract.
CASE HISTORY EXAMPLE – JIM AND JANE
Unfortunately, we will never know if adding a COLA was important to Jim and Jane – Josh never brought the subject up.
CASE HISTORY EXAMPLE – MURIEL
As Muriel was convinced she would certainly have a lengthy retirement, she was most certainly interested in a COLA provision. But Alex had not checked that box when he filled out the paperwork for her, and she was not savvy enough to notice the omission. She would have to check to see if she could add it after-the-fact.
CASE HISTORY - BILL
Bill was not interested in a COLA provision – that lowered his initial Guaranteed Payout Amount, right? He knew the value of his house was keeping up with inflation and he knew he’d get regular COLA adjustments to his Social Security payments, so he was fine with just a level payout from an annuity.
Additional Consideration #6: Long-Term Care (LTC) Coverage
Some annuities and/or riders contain provisions in the event the annuitant ends up needing long-term care. Usually this provision allows the annuitant to receive the income stream on an accelerated basis for a certain amount of time or until the cash value is completely depleted (whichever comes first). The accelerated rate is typically 2x the regular rate.
This provision is not intended to or designed to take the place of a good LTC policy. However, if you do not have or have been unable to obtain an LTC policy and are therefore self-insuring, this provision can be helpful.
Sometimes the provision does not require the annuitant to be in a nursing facility; it can apply when the annuitant is still at home but unable to perform at least 2 of the six routine Activities of Daily Living (ADL). Home care by a paid home care provider must be utilized under this provision. Also, there is usually a waiting period (typically 1-2 years) after the purchase of the annuity before this provision can be used and the annuitant must have been able to perform all of the 6 ADL’s during this waiting period.
If long-term care becomes necessary for the annuitant during the surrender charge period, some annuities allow surrender-charge-free withdrawals. Check on it.
CASE HISTORY EXAMPLE – JIM AND JANE
The annuity Jim and Jane purchased had an LTC provision included automatically in the Lifetime Income Rider they purchased. It would be an adjunct to the LTC policies they already had.
CASE HISTORY EXAMPLE – MURIEL
Muriel’s annuity did not have any provision in the event she needed long-term care. It wasn’t an issue for her – she felt she could comfortably self-insure.
CASE HISTORY EXAMPLE – BILL
The annuity Bill was considering did not have any provision for accelerated payments should Bill be confined to a long-term care facility. Bill felt his level of physical fitness was insurance enough.
Additional Consideration #7: Carrier Rating
In this book, the word “guaranteed” is bandied about liberally. As an annuity is a legal contract between the annuity owner and the issuing insurance company, the only guarantees an annuity owner has are the guarantees from the issuing insurance company. This makes it critically important you feel comfortable the issuing insurance carrier is in sound financial condition.
- Ratings for insurance carriers are provided by A.M. Best, Standard & Poor’s, Fitch, Moody’s, and Weiss Ratings. Each rating service has its formula and what is an “A” rating from one service may be an “A-“ or “A+” from another so when comparing ratings, always use the same rating company for each carrier. Not all rating services rate all carriers so do your research! There is no substitute for this.
A lower rating = more risk. Only you can decide what level of risk you are willing to take on.
It is important to remember annuities are NOT guaranteed by any government entity of any type. Immediately disengage from any annuity sales adviser who gives the impression they are.
CASE HISTORY EXAMPLE – JIM AND JANE
The annuity Josh sold Jim and Jane was from a carrier with an A.M. Best rating of A-
CASE HISTORY EXAMPLE – MURIEL
The annuity Muriel was sold was from a carrier with an A.M. Best rating of A-.
CASE HISTORY EXAMPLE – BILL
The annuity Bill was considering was from a carrier with an A.M. Best rating of A+.
WHY THIS INFO IS IMPORTANT TO YOU
These “additional considerations” are the little “extras” insurance carriers use to make their annuity offering just a little bit more attractive than the ones offered by their competition, thus giving them an edge in the annuity marketplace.
You need to know about them because one or the other may just make the difference between which product you deem the best fit for yourself and thus the product you select. For instance, if the payout amount is fairly close, one of these additional considerations may tip the scales for you in favor of one product over another.
See Also: Non-qualified annuity payments.