Using Fixed Income Annuities to Build Your Portfolio Ladder, in addition to introducing the fixed income annuity strategy, was intended to be a primer on annuities in general. Although, as we learned in Immediate Income Annuities: The Cornerstone of a Successful Retirement Income Plan, fixed income annuities have a long history, tracing their roots to Roman times with private sector annuities being available in the United States for over two centuries, they are an often misunderstood and misused investment tool.
Unlike CD’s to which they’re often compared, fixed annuities offer many more potential benefits, including generally higher rates of return over comparable terms, tax-deferral when used in nonretirement settings, potential death benefit, and availability of annuitization with guaranteed (subject to individual insurers’ claims-paying ability) and tax-favored (when used in nonretirement accounts) income, often for life. Annuitization, the last potential benefit, is the one that is the most misunderstood and misused, especially when the purpose of the annuity purchase is to produce retirement income.
When you purchase an annuity, unless it’s a single premium immediate annuity (“SPIA”) or a deferred income annuity (“DIA”), you’re generally not required to annuitize your investment. If it’s a fixed annuity, after the initial fixed, pre-defined term ends, you can withdraw your investment plus earnings subject to a potential surrender penalty, renew it similar to a CD, or invest in a new annuity contract via a 1035 exchange, deferring income taxation on the gain in the old contract, all without ever annuitizing your contract.
If you decide to annuitize a traditional annuity or if you purchase a SPIA or DIA, you will be presented with a confusing array of payment choices. In addition to deciding upon a payment method, i.e., fixed or variable, and payment frequency, i.e., monthly, quarterly, semi-annual, or annual, you will also need to choose a payment option. Annuity contracts generally offer the following four types of annuity payment options:
- Life annuity
- Life annuity with guaranteed period
- Joint and survivor annuity
- Period certain
A life annuity is also referred to as a straight life annuity. This is an annuity that makes periodic payments to an annuitant that terminate upon the annuitant’s death. This option generally offers the largest periodic payment.
Life Annuity With Guaranteed Period
To protect against the possibility of receipt of a limited number of payments as a result of premature death, insurance companies offer a life annuity with a guaranteed number of years of payments. The number of years can vary, however, it is often for five, ten, fifteen, or twenty years. The periodic payment amount for this option will be less than that of a straight life annuity due to the guarantee feature.
Joint and Survivor Annuity
A joint and survivor annuity is designed to provide for ongoing income to a survivor, whether it be a spouse or some other individual, upon the death of the annuitant. In addition to receiving the identical payment amount as the annuitant, there are generally three other survivor options available:
- Specified percentage of the annuitant’s benefit, e.g., 75% or 50%
- Same payment with a guaranteed period, e.g., 5, 10, 15, or 20 years
- Specified percentage of the annuitant’s benefit with a guaranteed period
The final payment option, period certain, is also referred to as term certain. This option provides for a payment for a specified number of months or years. The payment will be made by the insurance company for the specified term to the annuitant, and potentially to an annuitant’s beneficiary(ies) in the event that the annuitant dies before the end of the term. This is the only payment option whereby the insurance company’s liability is fixed at the commencement of annuitization since a specified payment will be paid to the annuitant and potentially to his/her beneficiaries for a specified period of time regardless of when the annuitant dies.
After making the decision to annuitize an annuity, the choice of payment options is one of the most, if not the most, important financial decisions that you will ever make since it will determine both the amount and duration of income that you, and potentially other individuals, will receive from your investment. Professional guidance is highly recommended given the fact that it’s an irrevocable decision with lifelong consequences for you and your survivors.