Introduction to the Annuity
Introduction

Annuities as well as pensions have long been used to fund retirements. This chapter will discuss the basic principles of annuities, covering the basics in different types of payout options, as well as covering deferred and immediate and, in simple terms, the comparison of variable and fixed rate annuities.

Annuities and pensions are periodic income payments that can help make retirement financially possible. Understanding the financial concepts of these instruments will help agents better provide for the needs of their clients. Some people feel they will never retire; some only see this possibility when they are a few years from actually retiring. Whatever the case, or whenever an individual retires, they will need an income of some sort to fund their retirement needs. This may be the biggest hurdle to overcome: helping the prospective client to realize that they will need an income of some sort to fund their retirement needs and that Social Security may not fund them adequately.

In the broadest or most basic sense, annuities can be categorized as either:

1.     Individual annuities, based on separate individually owned annuity contracts, or

2.     Group annuities, which is in the pension field of insurance. Not all group pensions are insured, but all pensions use the annuity concept. Many private pension plans use insured group annuities to guarantee the payment of the pensions.

An annuity may be defined as a periodic payment, or regular or fixed amount of payment. The basic principle of an annuity is the systematic liquidation of its assets to provide the client's income. Payment may start at a stated or contingent date and may be continued to a designated person for a fixed period or for the life or lives of the individual or individuals entitled to receive payment. The person entitled to receive payment of an annuity from the insurance company is called the annuitant.

An annuity may be defined as a fixed amount of payment.

People have many different options when choosing an annuity. An annuity can be set up to pay as an annual payment, but most often it is set up to pay a monthly payment to the annuitant. An annuity can be set to start at a fixed future date, or it may start on an unknown future date depending on a death. Once the payments start, they can be continued for a limited number of years or, under a Life Annuity, the payments would continue until the annuitant dies. For people investigating annuities, this may seem very confusing to have all these choices. They may even choose something simpler or more known to them. Annuities can be an extraordinary benefit for people planning a retirement, if these confusing barriers can be overcome.

Annuities Compared to Life Insurance

Private annuities are like a life insurance contract in many ways. Annuity contracts are based on similar concepts as those found in life insurance contracts such as mortality tables, present value discounting, reserves and beneficiary designations.

Annuities and life insurance help individuals meet the peril of old age and are important in estate planning. They can be participating policies (paying dividends) or nonparticipating policies. Private annuities, like life insurance, are sold through individual or group contracts and the policy provisions are quite similar.

The differences between annuities and life insurance contracts are very important as well. The following table lists some differences between the two.

Differences Between Annuities & Life Insurance

Annuities

Life Insurance

Emphasizes liquidation.

Creation of assets.

Payments stop at death.

Payments begin at death.

Frequently uses lump sum or single-premium purchase.

Normally uses installment purchase.

Normally requires no medical examination before issuance.

Normally requires a medical examination before issuance.

Uses a set of mortality tables that results in much higher rates for females.

Uses a set of mortality tables that results in much higher rates for males.

Issues contracts much more on joint lives.

Issues contracts mainly on individual lives.

Uses group method for issuing contracts.

It has been estimated that two-thirds of annuity premiums come from group annuities.

Uses individual sales to promote product.

Life insurance, however, has been estimated that one-fourth of life insurance premiums come from group contracts.

Insurance companies write these private annuities either as separate contracts or as supplementary contracts, which means using the proceeds of life insurance policies to purchase annuities. The separate contracts are issued on an individual or group contract basis. Thus a third type of an annuity is identified:

1.     Individual contracts,

2.     Group contracts, and

3.     Supplementary contracts.

Annuity investments can be offered while selling a life insurance policy. At this point in the household, an agent may be aware of many financial facets of the family being insured. If a trusting relationship has been built, the prospective clients can even approach the agent on the effectiveness or the opinion of their present investment options. With the aggressive marketing of annuities, as well as other investment options available through banks and other institutions, the possibilities are seemingly endless. The prospective client is going to want the most effective tool available. The ongoing exposure of annuity investments has already opened the door to another option. Recognition is one hurdle overcome by rigorous advertising. Explaining all the benefits of this option will just come naturally. When the contrasts are made to other options, annuities may seem like the logical way to invest one's money.

Annuity Uses

There are many benefits and uses for annuities. Individual annuities have been encouraged by tax-sheltered Keoghs, IRAs and other plans. Annuities occupy an important role in estate planning and insurance programming. The settlement options of life insurance contracts are one important example for the uses of annuities in estate planning and insurance programming. For the retirement needs of clients, annuities are one of the most certain, convenient and complete protections against old age that can be arranged through voluntary action. Because of the reserve requirements and legally prescribed supervision, annuities relieve the annuitant of the uncertainties of management and investment found in other forms of investments.

For the retirement needs of clients, annuities are one of the most certain, convenient and complete protections.

Another important function of an annuity is the use of capital so that it will last your clients throughout their lives. Given a substantial fortune coupled with investment skill, some clients prefer to handle their own investments and are able to do so providing themselves with an adequate income for living without drawing on their principal. Some clients, however, may find that upon retirement, they need to use some of this capital. The annuity provides a means by which this capital distribution can be spread over a client's lifetime.

For the clients who need their capital distribution to fund their retirement, the annuity assumes grave importance. Clients who invest in other types of retirement programs or rely on their own savings accounts may find it mentally distressing if they cannot totally live on the interest of such investments and start depleting the principal as well as drawing on the interest. Clients can purchase a Single Premium Life Annuity and have their mind put at ease. The annuitant has the guarantee that they will have income for life, which may help calm a weary mind. It has been contended that freedom from financial worry tends to prolong the life of the annuitant, and thus has given the annuity an adage "Annuitants never die." Or "Annuitants live longer than people."

A Life Annuity, also termed as a Straight-Life Annuity, covers the annuitant's lifetime, each month receiving a fixed monthly, quarterly or annual income - guaranteed. This type of annuity has been known to pay the highest possible monthly check. Under a Life Annuity, if the annuitant dies before reaching their life expectancy, the insurer keeps the money.

An alternative choice would be the Period-Certain Annuity. Under this annuity the client's income covers their lifetime or a fixed number of years whichever is longer. For the clients who cannot stand to use the Straight-Life Annuity for fear they will die the day after signing thus leaving their beneficiaries nothing, the period-certain annuity may work well for. Two variants of the period-certain annuity are the Installment Refund Annuity, also called Installment Payments, and the Cash Refund Annuity. Both of these annuities guarantee enough payments to policyholders to match the full, original investment. The cash refund annuity pays the policyholder in a lump sum while the installment annuity makes installment payments. But both contracts reduce the size of the policyholder's monthly income.

The Installment Payments Annuity is an alternative to the straight-life annuity. The policyholder signs up for a fixed number of payments over a period of time chosen by the policyholder. The policyholder could, though, outlive the income. On the other hand, if the policyholder dies, the money left over goes to the beneficiary.

There are many types of annuities with different options to suit most any prospective client. One of the key advantages of an annuity is the tax deferral advantage not found in most investments. One key point to remember, however, is that if a client buys a tax-deferred annuity late in life, they may face surrender charges on some of their withdrawals. Normally, the annuity must be kept for seven years or longer before surrender charges expire, although annuitization bypasses these charges.

A key advantage of an annuity is the way

money grows on a tax-deferred basis.

Interest earnings are not the only cost factor that determines the amount charged for annuity benefits. Where the insurance cost is called a premium, the annuity cost is in the purchase price. The cost of an annuity is based on mortality rates of annuitants, just as in life insurance where the premiums are based on mortality rates of the insured.

Are annuity mortality tables the same as life insurance mortality tables?

If an insurer determined the cost of an annuity by a mortality table based on insured lives, they would dangerously underestimate the risk. Most people with serious health impairments would never buy an annuity. In life insurance groups there will be many impaired lives of retirement age. At this age only people who feel in good health would make a substantial payment of principal in return for a life annuity. In this situation, a smaller amount of deaths is expected than under other life insurance contracts. Annuity payments would continue longer than expected, and the annuity insurer would soon be in financial trouble. Annuitants represent a separate group and special mortality tables must be used in predicting their deaths. Early annuity tables may be used by some insurers and consultants, however, most use 1971 tables developed separately for individual and for group annuities. These tables are modified in several different versions in order to reflect the improving longevity modern science is giving mankind thus the anticipated continuance of decreased mortality.

There are some differences in the two tables. The life insurance tables reward the younger aged individuals with lower premiums. It is the opposite case with annuities. The younger the annuitant is when payout options begin, the greater the purchase price required for the annuity to fund a designated sum for life. For example, $15,000 will purchase a greater retirement income for life for a person of 70 years than it would for a person of 55. This is because the sum must stretch over a greater length of time.

The sex of an annuitant is also important. Females have a greater lifespan than males and thus receive annuity payments of about the same amounts as males who are five to seven years younger. In these cases a Joint-and-Survivor Annuity works well. The fixed monthly income lasts for the lifetime of the annuitant and the named beneficiary, such as a spouse. Or in other words, the income lasts for the lifetime of both spouses. The size of the monthly income depends upon what the beneficiary will receive after the annuitant's death. The more the annuitant leaves, the smaller the check while they are both still alive, and vice versa.

The life insurance tables reward the younger aged individuals with lower premiums. It is the opposite case with annuities.

There are different approaches to the classification of annuities. The method used will depend on the purpose intended. In simple terms, annuities may be classified:

1.     As a plan of distribution of proceeds,

2.     According to the parties in the contract,

3.     According to the time distribution starts or begins,

4.     According to the method of purchase, and

5.     According to the amount of the annuity payment.

Plan of Distribution

We have already briefly discussed a few of the annuity payout options available. A Straight-Life Annuity provides an income to the annuitant for life, without any guarantee of a minimum amount or number of payments to the annuitant or to a beneficiary. In contrast to the straight-life annuity, most annuity plans provide payments either for a guaranteed amount, period, or cash refund. As stated before, many people do not care for this type of annuity for fear they will die the day after signing the contract, thus leaving nothing to their beneficiaries.

A straight-life annuity, also referred to as a Pure-Life Annuity, agrees to provide payments to the annuitant, which continues throughout the life of the annuitant. The annuity would terminate with the death of the annuitant, regardless of how soon that death occurs. Payments are made to the annuitant annually, semiannually, quarterly, or monthly. The straight-life annuity has no guarantee of a definite number of payments, no cash value and no provisions for a refund of any sort upon the death of the annuitant. This type of annuity is not popular, but it enables an annuitant to receive the largest possible payments for their lifetime, if annuitized. This type of annuity may be ideal for individuals of advancing age without dependents and of limited means who wish to secure the maximum benefit from their accumulations for the remainder of their life.

The straight-life annuity has no guarantee of a definite number of payments, no cash value and no provisions for a refund of any sort upon the death of the annuitant.

Most annuities are written with some guaranteed features which assure the annuitant and the beneficiary's part of or the entire annuity principal.

The Installment Refund Annuity guarantees that, if the annuitant dies before the required number of payments accumulated equals the purchase price, payments will continue to a designated beneficiary until an amount equal to the full sum of the single payment has been returned (the principal). The annuitant, or in some cases the designated beneficiary, is certain to receive an amount equal to the purchase price without interest. The advantage of this annuity is that the annuitant may live long enough to receive payments far beyond the purchase price. The annual payments under this form are somewhat less than the annual payments under the straight-life annuity.

The Period-Certain Annuity, often referred to as an Annuity Certain, is another option with the number of payments guaranteed. This is similar to the installment refund annuity. The payments continue during the life of the annuitant, with a guaranteed minimum number of years of payment. For example, if an annuitant chooses a 20-year Period-Certain Annuity, the insurer guarantees a minimum of 20 years payments to the annuitant, and if the annuitant dies within those years, the remaining amount will be paid to the beneficiary for the remainder of the 20-year contract. If the annuitant outlives the number of years guaranteed, payments are made until the death of the annuitant, and then nothing is paid to the beneficiary.

The Cash Refund Annuity is ideal for the individuals who want to make a provision for final expenses, such as funeral costs. The cash refund annuity can provide an annuity for life, with an additional provision of a lump-sum cash refund guaranteed to a designated beneficiary.

The key thing to remember is that straight-life annuities provide annuitants the maximum lifetime income for each dollar paid in. The annuitant needs to decide whether:

1.     They need to leave funds for their dependents, or

2.     Their lifetime needs require their entire capital. Annuitants who have no need to provide for their dependents can increase their income by electing an annuity without a refund. Thus, a disadvantage to these types of annuities is that there is a risk in securing a return in annuity payments.

Parties in a Contract

There are always four parties in an annuity:

1.     The insurer: An annuity may be sold from a local bank, financial planner, brokerage firm or anyone else who is licensed to sell this product. The agreement is always between the investor and the insurer (insurance company). The insurer invests the money according to how the application is filled out.

2.     The contract owner: This is the person who invests in the annuity. A contract owner has the right and ability to add more money, make investment decisions or changes, terminate the agreement, withdraw part or all of the money or change the parties named in the contract. Only the contract owner has these rights. It is their money. A contract owner can be an individual, a couple, a trust, a corporation, or a partnership. The only requirement is that the owner must be an adult. A minor cannot be the owner, unless the policy lists the minor's custodian.

3.     The annuitant: This may be the most misunderstood part of the annuity contract. The best way to understand the purpose of the annuitant is also by an analogy. When a person purchases a life insurance contract, the policy stays in force until the insured party named dies or fails to make the needed premium payments. An annuity remains in force until the contract owner makes a change or the annuitant dies. Thus the annuitant is like the insured party in a life insurance contract. The annuitant has no voice in or control of the contract. They do not have the power to make withdrawals or deposits, to change the names of the parties to the agreement or to terminate the contract. The annuitant must sign the annuity contract. The person the contract owner selects can be anyone - the contract owner themselves, a spouse, child, relative, friend or neighbor. The only requirement is that the annuitant be an actual person who is currently living and is under a certain age, normally 75 depending on the insurer. The annuitant cannot be a living trust, corporation, partnership, or similar entity. A few insurers allow the use of co-annuitants, which means that there would be two measuring lives.

4.     The beneficiary: This role of the contract is played out only after the death of the annuitant. As with the beneficiary of a life insurance contract, the beneficiary of an annuity contract has no voice in the control or management of the contract. The only way for the beneficiary to prosper from an annuity is to still be alive when the annuitant dies. The named beneficiaries can be children, spouses, friends, relatives, neighbors, trust, corporations, or partnerships. The annuity contract allows for multiple beneficiary designations of varying proportions. When a person invests in an annuity, the insurer will need to know the name of the contract owner, the annuitant and the beneficiary. The contract owner and the beneficiary do not have to be people, only the annuitant has to be a living person. The same person can hold multiple titles. For instance the contract owner could be the beneficiary also. This would not make any sense, however, since one of the advantages of annuities is that they bypass probate. If the contract owner named themselves as the beneficiary, the proceeds would go to the estate, thus passing through probate. If the contract owner dies before the annuitant, neither the annuitant nor the named beneficiary has any rights to the investment. The heirs named in the contract owner's will or trust become the new owners. If the contract owner dies without a valid will or trust (intestate), the new contract owner is determined by intestate succession - the decedent's spouse and/or children would be first in line, followed by parents of the decedent.

The owners of an annuity select the beneficiary, annuitant and/or contingent owner and may change either or all during the accumulation phase. The owner also determines when distributions start and in what combinations. This allows the owner to determine their own tax consequences. When the owner dies, the principal of the annuity passes directly to the designated beneficiary without passing through probate.

The owner of an annuity selects the beneficiary, annuitant and/or contingent owner and may change either or all during the accumulation phase.

Normally annuities are written on a single life of one person. Annuities can, however, be written on several or joint lives. Both kinds of contracts are considered individual annuities because there is just one contract even when more than one life is included as the contingency for payments. Group annuities, written for many employees of a common employer could be identified as another major division of annuities.

A single-life annuity is based only on the single life of one person. The payments under the annuity are contingent on the continued life of the annuitant.

A Joint-and-Survivorship Annuity can provide income for more than one person, such as spouses who wish to make provision for the old age of both. The people involved need not be spouses. Any two or more people may utilize them. The joint life contract provides an annuity for the joint duration of more than one life. The annuity guarantees an income for two persons during the lifetime of both, and upon the death of one of them, it continues without reduction until the death of the survivor. There is the option of reducing the survivor's annuity payments to two-thirds or one-half. The annuity contract may also be written to involve more than two persons and in this instance, the income is payable without reduction until the death of the last survivor of the group.

Time Distribution Begins

Annuities are classified as:

[    Immediate: Under this category an annuity is either an ordinary annuity or an annuity due. An ordinary annuity begins payments at the end of the first income period. An annuity due begins payments at the end of the period. Immediate annuities are normally purchased with life insurance proceeds, accumulated savings or retirement disbursements.

[    Deferred: Annuity premiums paid over a number of years purchase a deferred annuity. This type of annuity is commonly purchased on a single-premium basis in arranging employee pensions. An Accumulation Annuity can be paid into over a number of years for retirement, thus deferring the payout option until retirement. A deferred annuity can be used in many ways. It can be used to provide an income at a certain age, or it can be used to provide income to a beneficiary upon the death of the annuitant. A deferred pure-life annuity can be written, but it is rare because no payment at all is made if the annuitant dies before the first payment comes due. A deferred refund annuity has a stipulation that the total of the amount payable by the insurer to the annuitant shall equal the aggregate of the payments made for the annuity. Payments may be made in periodic installments, or with a single cash payment.

The retirement annuity is a deferred annuity that enables an individual to provide an income for retirement by making convenient payments during the productive period of life. The annuitant can select the date for commencement of payments, or in simpler words, when the annuity begins paying out. The amount of income is determined by the purchase price and the date selected for the commencement of payment. Retirement income contracts are written with the following provisions for optional settlements:

     Life annuity,

     Cash refund annuity,

     A life income with payments guaranteed for a number of years certain. This contract usually provides for a cash surrender value if the contract is surrendered before the payments to the annuitant start. An automatic paid-up annuity can provide loans during the payout period. This annuity becomes effective upon default in the payments of premiums.

An endowment annuity, also referred to as a retirement endowment annuity, can provide for a payment to the named beneficiary if the insured dies prior to the maturity date. If the annuitant lives to the maturity date, the annuitant may elect either a monthly income for life or a lump-sum settlement. The endowment annuity is basically a retirement annuity coupled with a decreasing term insurance running to maturity. The amount of the term insurance is different each year between the face amount of the policy and the cash value.

Method of Purchase

A Single-Payment Annuity allows the annuitant to pay a lump sum in return for a regular income for life or for a term. The contract does not require any further payments by the purchaser.

An Installment Payments Annuity contract allows the annuitant to make payments to the annuity annually, semiannually, quarterly or monthly. This option allows more people to provide for their income in a schedule of their choice.

Immediate annuities must be a single payment annuity, and they require the deposit of a substantial sum at once. A deferred annuity may be a single payment, or an installment payment annuity.

Amount of the Annuity Payment

Fixed and Variable

In the beginning, an annuity was defined as a periodic payment for a fixed period or for life. Although annuities are mainly sold by life insurance companies for a fixed number of dollars, actually nothing in the term annuity requires that each of the payments be equal.

One of the major concerns of fixed annuities have been the ability to keep up with inflation. To meet this concern, a strong movement in the insurance industry has been to educate the public about variable annuities.

Today, investors have a certain advantage over the investors of the past. Advances in products, services and investment strategies make it possible for the agent to design and implement financial plans for the most demanding of clients and for the most complex situations. As agents, we have at our disposal the most sophisticated computer programs, asset allocation models and other financial design technologies for a relatively low cost. Because of these advancements, an investor can often double or triple long-term returns. When comparing these increased returns to CDs and other guaranteed fixed-income investments, an investor would undoubtedly go the way that makes them more money for their retirement or whatever the purpose of the annuity.

If this is true, why aren't clients racing to purchase an annuity?

The answer is a simple one. The market is flooded with an overload of information so that people have a hard time sifting through the propaganda to find the most accurate information. This tedious research can exhaust them, thus they do not take the first step to investing. Some prospective investors may be intimidated by computers, and even the most basic software can produce volumes of financial information that they have to translate. While education is power, especially when investing, we must learn a common sense approach. The public has also been inundated with news reports of dishonest investment advisors and/or insurance agents, thus people do not tend to trust.

Variable annuities possess the means to meet

our clients financial long-term goals.

Even with the hurdles to overcome, the increased growth of variable annuity purchases can be cited to at least three primary factors:

1.     Investors are seeking higher returns than possible with certificates of deposit,

2.     Investors are seeking relief from ever more burdensome federal and state taxes, and

3.     Investors have a growing recognition of the ability of professional money managers to deliver consistent and highly competitive returns.

The increased sales of the variable annuity have a beneficial effect for the average investor. Why? Because of the billions of dollars being invested in variable annuities each year, major financial institutions, including insurance companies, want to participate in one of the fastest-growing segments of the investment market. With their involvement, this pushes their employees to gain more knowledge about such products thus advertising them to prospective clients and investors. Another advantage of the involvement is an enhanced level of investment service and technologies that can tailor portfolios to meet an individual investor's goals and objectives for retirement and wealth accumulation.

Variable annuities possess the means to meet our clients financial long-term goals. However, before this decision can be made, an investor must fully understand that an annuity should be an important component of a total financial plan and not the entire financial plan.

Annuity Overview

Before Social Security and the widespread use of retirement plans by individuals and corporations, companies wishing to reward their employees would "pension off" certain ones. Their lifetime retirement income was most often guaranteed by the purchase of annuity. The annuity also offered protection for widows and orphans of families that may have lost the breadwinner.

This system worked well until the country experienced social and economic changes. People started living longer, thus a greater need for retirement funding. Employees started to look to their employers for retirement income through benefit packages. Social Security was introduced to supplement retirement and family social needs.

That system worked well until mergers, downsizing and foreign and domestic competition eliminated many employment positions that provided job security and the depended upon retirement benefits.

With the economy changing so much and so dramatically, more individuals will be responsible for funding most of their retirement. Social Security will be reduced in real terms, despite Congress's denials.

Is an annuity the answer to funding one's retirement?

The answer would depend on the goals of the investor. An annuity would work well if the investor uses the annuity as part of a wealth-accumulation strategy that includes qualified retirement plan contributions, short-term debt elimination and other long-term investments. Annuities are an option for an investor who is retired, financially secure, wishes to defer taxes, and build long-term wealth. To make these decisions, the investor must have a complete understanding of annuities.

Two of the most appealing factors that have contributed to the increased popularity of both fixed and variable annuities is the fact that people are seeking relief from federal and state taxes that in some instances can exceed 50% and the other is that annuity earnings grow tax-deferred. Mutual funds cannot make this same boast.

There are two primary types of annuities:

1.     Fixed Rate: guarantee a return (like a CD), and

2.     Variable Rate: the return is not guaranteed and depends on the performance of the underlying investments (like a mutual fund).

The Fixed Approach

The fixed rate annuity remains the choice of conservative investors, mainly retirees, when rates are competitive because of the annuity's predictability, stability and guaranteed return. To guarantee a fixed annuity return, the insurer invests the fixed annuity premiums in conservative and stable securities. The insurer assumes a fixed annuitys performance risk.

Fixed annuities are often compared to Certificates of Deposit (CDs). Each guarantees the return of principal and fixed interest rates for certain periods of time. Certificates of deposit purchased from national and state banks are guaranteed by the Federal Deposit Insurance Corporation (FDIC). The FDIC is an independent agency of the US. government. Annuities are guaranteed by the issuing insurer's asset reserves. Annuities are not insured or guaranteed against loss by any federal or state agency. The insurers are required to keep a designated amount of money in their reserves at all times to cover the investments through them. In fact, it has been estimated that for every dollar invested, the insurer must keep $1.25 in reserves to cover the investment should the policyholder want the money. Another interesting fact about annuities is that no one has ever lost a dime in a fixed rate annuity. Again, this is because the principal is guaranteed at all times by the insurer's reserves.

The major benefit of fixed rate annuities remains:

should the investor annuitize, the annuitant is guaranteed

a lifetime income and cannot outlive the benefits.

Fixed rate annuity sales have always been dominant over variable annuity sales although the gap is narrowing because conservative, long-term investors are now more willing to assume market risks. The major benefit of fixed rate annuities remains: should the investor annuitize, the annuitant is guaranteed a lifetime income that cannot be outlived. This, combined with a guaranteed interest rate, guaranteed return of principal and tax-deferred wealth accumulation has made fixed annuities attractive investments for many conservative investors.

Fixed rate annuities are like CDs in that both the principal and the interest rate is guaranteed for a specific time period, normally one year or more. As with CDs, fixed annuity sales are directly affected by the interest rate environment. They are less popular when interest rates are low, and increase when interest rates are rising.

Though the fixed rate annuity remains a popular choice, there are three main concerns that lessen an investor's enthusiasm:

    Inflation eats away their money's purchasing power,

    Equities outperform fixed-income portfolios, and

    Many investors are now more willing to assume moderate risks as a conservative approach to long-term wealth accumulation.

The Variable Approach

A variable rate annuity is a life insurance contract that is particularly well suited to aide investors in meeting their long term financial goals and objectives. The variable rate annuity combines the advantages of tax-deferred wealth accumulation with the flexibility and investment opportunities of mutual funds. It offers nonguaranteed investment options, and in most circumstances, has an emphasis on stocks. The variable annuity increases an investor's potential for higher returns while eliminating return guarantees thus shifting the investment performance risk to the investor (with the fixed rate annuity, the performance risk is with the insurer). If interest rates are high, investing in fixed rate annuities increases. Variable rate annuities increase in popularity when fixed interest rates decline and investors are willing to assume the risk for the return for an opportunity of receiving a more competitive long term return.

The chapter has discussed the classic setting of an annuity contract in that it guarantees a fixed or variable rate for a specified time, normally for life. The contract owner makes a lump-sum and/or periodic payments and receives a lump-sum or a series of payments immediately or at a later date. But annuities have another side to them. Annuities are also an investment vehicle that can be incorporated into asset allocation and diversified portfolio strategies to meet retirement, wealth accumulation and asset diversification requirements. For the investors that want to assume the performance risk, this can be an exciting side to an annuity.

While fixed annuities are often compared to certificates of deposit (CD), each guaranteeing the return of principal and fixed interest rate for certain periods of time. Variable annuities are often called mutual funds with insurance protection. They offer investors numerous choices including a large selection of the stock, bond and money market sub-accounts (mutual funds).

The most well informed investor may be unaware of fixed and variable annuity benefits. The following list provides seven critical points that perspective investors (or anyone already in an annuity) should know:

1.     Tax-deferral,

2.     Compounding interest,

3.     Consistent performance insures long term wealth accumulation,

4.     Access to expert money managers,

5.     Diversification which reduces risk,

6.     Should only be used as long-term investments, and

7.     Contract owners control the tax and disbursement options.

The most popular facet that draws people to annuities is the

tax-deferred compounding.

Of all the features, benefits and options of the annuity, the most popular fact that draws people to annuities is the tax-deferred compounding. The Federal Tax Code allows tax deferral on annuity earnings. In other words, earnings are untaxed until disbursed. The date chosen for disbursement may begin many years from the purchase date. For emphasis: ALL earnings and capital gains are tax-deferred, thus the investment grows more quickly than similar taxable investments. The principal, which consists of the contributions made by the investor, and the accumulated interest, continue to compound at an accelerated rate until either:

O      The death of the annuitant,

O      Withdrawn, or

O      Annuity distribution begins.

For those of us who have abhorrence toward paying current income taxes, the annuity's feature of tax deferral addresses that need. This feature of the annuity meets a financial goal of creating opportunities and investment alternatives while deferring taxes. The ultimate financial goal is for wealth accumulation. Those who understand the necessity of providing for retirement as well as meeting other long term financial objectives, will appreciate annuity strengths.

For those investors who do not want to take an active part in their annuity's investments, access to expert money managers is an important benefit. In todays world, professional money managers have raised the investment decision making process to a fine art. Their approach is comprehensive. They no longer simply select individual stocks and bonds, but now make short and long term economic predictions and strategic asset allocations based on current and projected interest rates, corporate earnings, macro-industry and micro-industry studies, general economic conditions, diversification, time horizon, risk tolerance and expected investment returns. The money managers take all this information into account and then structure the portfolio to meet the sub-account's investment objective (sub-accounts will be discussed in a later chapter). The money managers seek this diversification, consistent performance and competitive returns by maximizing a portfolio's return while assuming the minimum level of necessary risk.

Increased competition dictates that money managers balance risk and return in their management styles and produce consistence, competitive returns. Sub-accounts that cover all major asset classes are not available to variable annuity investors. This abundance of subaccounts offers the investor options to meet most investment needs. Asset allocation and diversification are available through the use of a variety of sub-account investment options. In fact, most variable annuities offer from 10 to 20 sub-account investment options. Sub-account exchanges do not create taxable liabilities and have no sales or transfer charges, although some insurers set limits on the number of annual exchanges before a transfer fee is charged.

Money managers seek diversification, consistent performance and competitive returns by maximizing a portfolio's return while assuming the minimum level of necessary risk.

Responsibility of reviewing their portfolios to determine if their investment performance expectations are being met falls on the contract owner themselves. The accountability is also essential to money management programs.

For an investor a major advantage of hiring expert money managers is:

[    Investors review and compare portfolio performance,

[    Investors do not have the responsibility of selecting individual securities, micromanage investments, or interpret the variations of modern portfolio theories.

The majority of annuities are non-qualified investments. The Federal Tax Code sets no limits on annual nonsheltered annuity contributions. While nonqualified annuity contributions are not tax deductible and are made with after tax dollars, earnings are not taxed until they are disbursed. This fact alone may swerve some investors to annuities. Using investments such as certificates of deposit and mutual funds create taxation.

If investors are used to using these short-term vehicles, they must understand that annuities are long-term investments. The money must be committed for an extended investment period, normally six to ten years - minimum. If the money is withdrawn earlier, they can be subject to substantial early-withdrawal and in certain situations, IRS penalties. Another advantage for retirees is that the tax liability on Social Security retirement benefits is eliminated during an annuity's deferral period. Unlike tax-free municipal bonds, annuity earnings are not included in the recipient's adjusted gross income (AGI) until the earnings are withdrawn.

Using certificates of deposit and mutual funds for

wealth accumulation is basically the use of

short-term investment vehicles to meet long-term goals.

An investor's concerns about liquidity, the ability to easily withdraw money from an investment, is another hurdle that must be considered. Most annuity contracts cover this hurdle easily. They allow both systematic withdrawals and lump sum distributions. Many annuities allow systematic withdrawals without penalty after the first year, and can be subject to certain percentage restrictions. Unlike individual retirement accounts (IRAs) or other qualified retirement programs, there is no statutory age dictating the commence of mandatory withdrawals. Both variable annuities and qualified retirement plans can be subject to early withdrawal and tax penalties. An annuity also pays the greater of either the contract value or the principal value at the owner's death. Many annuity contracts also reset the annuity's guaranteed value after a certain number of years.

An investor using a diversified investment program, which includes annuities, can meet most investment goals and objectives. Combining qualified retirement plans, variable annuities, fixed annuities and municipal bonds can be particularly effective in meeting retirement financial goals.

Another advantage is that investors control their contract options. They dictate the amount and regularity of their contributions, how the contributions are invested and how and when the money is distributed. The obvious benefit for those looking at annuities, variable or fixed rate, for retirement is that they can guarantee a lifetime income.

Variable annuities can be an integral part of many retirement investment strategies that combine employee-sponsored retirement savings programs and Social Security benefits. As with other long-term retirement investment programs, variable annuities have three phases:

1.     Investment: premiums are paid in either in a lump sum or periodically and are usually not subject to an initial sales charge. All proceeds are invested in sub-account portfolios of either stocks, bonds or cash (money markets).

2.     Accumulation: earnings compound on a tax-deferral basis. They are not subject to taxation because of the reallocation of assets.

3.     Distribution: offers annuity owners numerous withdrawal options, including a Life annuity, Period-Certain annuity, Cash Refund or Installments Refund annuity.

The advantage of tax-deferred compounding cannot be over emphasized in this book or to the clients we deal with. The compounded earnings, which are not subject to taxation, can produce profound results. Variable annuities allow an investor the ability to reallocate assets without incurring a taxable liability.

In Summary