Things to be Aware of Regarding Annuities
The interest rate credited during the accumulation period of a deferred annuity is subject to a stated minimum range as required by state law, usually between 1% and 3% per year. Insurance companies determine the actual rate of interest to be credited on a periodic basis. The method of determining this crediting rate varies among different annuity contracts and insurance companies but is generally based on the company’s investment experience and competition. It is important to remember that current crediting rates are generally guaranteed only for a short period of time, often one year.
Surrenders and Withdrawals
- Upon death or cancellation (surrender) of a deferred annuity, the insurance company is required to provide you with the cash value remaining in the annuity contract. The cash value is generally the account value less the surrender charge, which is an expense charge for surrendering the contract. Surrender charges are often waived if the policy is terminated due to the death of the annuitant. Surrender charges are usually a percentage of the account value and decrease with time. State law establishes minimum cash values. Immediate annuities do not develop cash values.
- Most deferred annuity contracts allow you to withdraw a portion, usually 10%, of the account value without a surrender charge. This is called a free partial withdrawal. The amount that is withdrawn is deducted from the account value.
- Many single premium deferred annuity contracts have bailout provisions. This is a provision that allows you to withdraw the account value without a surrender charge, if the interest rate credited falls below a set rate.
Insurers frequently offer bonus interest as an incentive to purchase an annuity or to retain an annuity to the end of the term of the annuity or maturity. In some cases, a bonus may only be credited if the annuity is retained for a minimum number of years. It is important to carefully review how any bonus feature impacts other features of the annuity particularly the interest rate credited to the annuity. For example, the interest rate for annuities with a bonus may actually be lower than the interest rate credited to an annuity without a bonus. The result may be that the annuity without the bonus feature provides a greater benefit than the annuity with the bonus feature.
Market Value Adjusted Annuities
Market value adjusted annuities guarantee a crediting rate over a specified period above the state minimum guaranteed rate, but if you decide to surrender the annuity, the account value is subject to both surrender charges and an adjustment based on current interest rates. This adjustment is intended to protect the insurance company from the tendency of annuitants to surrender during periods of increasing interest rates.
Unlike the annuities described above, a variable annuity contract does not guarantee a minimum interest crediting rate, nor does it guarantee the amount of income payments per dollar of cash value. A variable annuity generally offers you the option to invest your premium payments in many different investment funds such as money market funds, common stock funds, bond funds, and others. During the accumulation period of the variable annuity, premium payments less expense charges are used to purchase units in a selected fund. The number of units purchased depends on the value of a unit in that fund, much like purchasing shares in a mutual fund. Cash values and income payments then depend on the number of units purchased and the value of each unit at the time the payments are made. Variable annuities are more appropriate for people looking for an investment product without the long-term guarantees provided by other annuity products.
Equity-indexed annuities credits interest or provides benefits that are linked to an external equity index such as the Standard & Poor’s 500 Composite Stock Price Index (S&P 500). Interest credits are determined using a formula based on charges to the index. Two significant features of the formula are the indexing method and the participation rate. The indexing method determines how the amount of change in the index is determined. Examples of indexing methods are:
- Annual reset: the change in the index value from the beginning of a contract year to the index value at the end of the contract year. Interest is added to the annuity each year to reflect the change.
- Point to point: the change in the index value from the beginning of the term of the contract to the end of the term of the contract. Interest is added to the annuity at the end of the term of the contract to reflect the change.
- High water mark: index values at various points during the term of the contract are compared with the index value at the start of the term of the contract. Interest added to the annuity at the end of the term of the contract is based on the difference between the highest index value and the index value at the start of the term of the contract.
- Low water mark: index values at various points during the term of the contracts are compared with the index value at the end of the term of the contract. Interest added to the annuity at the end of the term of the contract is based on the difference between the lowest index value and the index value at the end of the term of the contract.
The participation rate is the percentage of the change in the index that will be used to credit interest to the annuity. Insurers generally guarantee the participation rate for a specified period of time and after this period, a new participation rate will be applicable.
Other Features of Equity Indexed Annuities Include:
- Cap on interest credited to the annuity.
- Floor on interest credit to the annuity. The most common floor is 0%, so that if the index decreases in value, the annuity would be credited with 0% not negative interest.
- An average the index values rather than the actual value of the index on a specific date is used in determining the change in index values.
- A spread in which a specified percent is subtracted from the change in the index. For example, if the change in the index is 4% and the annuity contracts provides for a 2% spread, the interest credited to the annuity would be 4%-2% = 2%
- Loss of interest credits if money is withdrawn from the annuity before the end of the term of the contract.
- Interest is credited to the original premium amount not to the amount accumulated during the term of the contract.
Important Considerations in Considering the Purchase of an Equity Indexed Annuity
- Term of the contract, guaranteed interest rate, minimum participation rate, and length of guaranteed participation rate, interest rate cap and floor, indexing method, spreads, level of surrender charges, and how long the surrender charges apply.
- In addition to surrender charges, some equity indexed annuities credit no or only partial interest, money is taken out of the annuity before the end of the term of the contract.
- Stock dividends are generally not included in the value of the index used to determine interest credited to the annuity. For example, the S&P 500 is the most common index used by insurers and this index is a stock price index that does not include any dividends paid on the stocks that make up the index.
Annuity contracts contain an important tax benefit. Federal income taxes on interest earnings that accumulate during the deferral period are deferred until the annuity is paid out. This can result in a significant saving over a long period of time relative to other methods of saving. If a deferred annuity is surrendered before age 59 1/2, the amount of the cash value that is larger than the total premiums paid is subject to a 10% federal tax penalty in addition to the required income taxes. The tax penalty generally does not apply if the annuity is surrendered due to death or disability, nor to equal periodic payments made over the lifetime of the annuitant. Consult a tax advisor before you purchase or surrender an annuity in order to thoroughly understand the tax consequences.