Buying an Annuity

by Steve Goodman

CPA, MBA – President & Chief Executive Officer

Contact Steve today for more info.

Buying an annuity is not like buying a car or deciding which college to attend. There are numerous review websites, blogs, and books to help a buyer evaluate cars and colleges. There is no equivalent for annuities.

There are no substitutes for knowledge and curiosity. Buying the product that best suits your needs requires that you identify your needs and match them with the types of annuities offered. Armed with this knowledge, a smart buyer is ready to engage an agent. The agent will listen to your needs and offer recommendations.

A typical consumer will buy, at most, one or two annuities in his/her lifetime. These are big dollar purchases that warrant effort on your part. Identify the right annuity, from a financially sound company, that provides a competitive price. The time you invest before you buy could mean thousands in additional payouts years down the road.

This article will lay out the questions you should ask, the information you should request, and the pitfalls you need to be aware of before you commit to an annuity.

1. Who are you dealing with?

Agents fall into one of three camps. There are independent agents who sell products from a variety of companies. There are captive agents who may work for one of the major life insurance companies. The third group consists of registered investment advisors (RIA’s), broker-dealers, and bankers. The products an agent will offer are a function of what the agent can sell. No agent can sell the universe of products the industry has to offer. To buy products from some of the larger insurers, you must deal with their agents. To obtain multiple quotes with a minimum amount of time, talk to an independent agent. There are over 2,000 life insurance companies doing business in the USA. No one has the time to look at even a tenth of their annuities. But you should look at a half dozen as a comparison.

The financial strength of the annuity issuer can become a critical concern in a difficult financial environment. Once an annuity enters the payout phase, an annuitant is locked into a company. In the case of an immediate annuity, that happens instantly after the premium is paid, hence the name immediate. You want to do business with a company that can honor its contractual commitment. Check the insurer’s financial status with the major rating agencies; Standard & Poor’s, Moody’s, AM Best, and Fitch.

What are you buying?

Annuities have so many options, riders, and guarantees these days that it can be difficult to know exactly what you are buying. Insurance companies give their products names that may not even have the word annuity in their product title. The names reflect marketability at the expense of clarity. Start with a solid understanding of the product being presented. Hybrid products may be difficult to classify. When you can properly categorize the annuity you are being asked to consider, you will have a better handle on the right questions to ask.

2. Common Items to Note for all Annuities.

There are a few things every annuity buyer should understand.

  • The more guarantees, options, and conditions offered on an annuity, the more the buyer will pay in fees, expenses, and policy restrictions. By assuming some risk, you can potentially increase your returns.
  • Costs, expenses, and policy restrictions may be hard to find. It is in your best interest to have a full understanding of what is in the annuity you are considering. The time to find this information is before you start making payments.
  • If you need an understanding of how a fee is computed or any other feature of the annuity, ask for it in writing – from the company. Ask the salesperson to sign it. That signature is your guarantee that you are going to receive the correct and complete answer.

3. Who buys annuities and why?

There are five types of people who buy annuities.

  • People with substantial cash balances in CD’s, money markets and other low interest bearing accounts.
  • People looking for a way to share in a rising stock market but with minimal downside risk.
  • People looking to invest in the stock market in a tax-deferred way.
  • People seeking asset protection
  • People seeking a guaranteed income stream in their retirement years.

Risk-averse people, who have accumulated capital over the years, see annuities as a low risk, tax-deferred means of securing an interest rate that exceeds what CDs pay. A deferred fixed annuity serves their needs.

Those looking to share in a rising stock market, but with limited risk and personal commitment, are candidates for an indexed annuity. These deferred annuities can accumulate gains over the decades. Many companies offer an annuity that protects the annuitant from losing money in any year due to negative market performance.

Variable annuities are a solution for people seeking a way to invest in the stock market in a tax-deferred way. Many people turn to variable annuities when they have maxed out their pre-tax retirement savings options. In comparison to the indexed annuity, the variable annuity allows the annuitant to play an active role in managing his/her funds.He/she can expect more reward for taking on the investment risk. Some insurers offer annuities that will shelter the annuitant from losses in the event the annuitant’s account loses money. Prospective annuitants should recognize that variable annuities with floors typically require the annihilation of the product.

People seeking asset protection include professionals such as doctors. Certain annuities enjoy protection from creditors in some states. In those states, fixed annuities are popular with professionals who may choose to conduct business uninsured or underinsured.

The last group is the people for whom annuities were originally designed. These are people with limited retirement funds looking for a secure income stream in retirement. They are also looking for a solution to the concern that they could outlive their savings. These people are excellent candidates for fixed annuities, both immediate and deferred, including longevity annuities.

4. The Accumulation Phase

Deferred annuities have two phases; an accumulation phase and a payout phase. Immediate annuities have no accumulation phase. As the name implies, they begin to payout immediately. This section will identify the information you should identify by annuity type in their accumulation phase.

A more complete list of questions and answers by annuity type is available in the Questions tab on the Annuity section of this website.

  • Fixed annuities – The primary concern when considering a fixed annuity is the interest rate paid. The annuity contract will identify a guaranteed minimum interest rate. The rate is typically guaranteed for the life of the annuity or until the surrender charge period expires. The contract will also provide an initial rate. This rate will be contractually guaranteed for one to three years. After the initial period, the contract will identify the frequency of rate changes. Annuitants can usually expect annual rate changes following the initial rate period. Look for these guarantees and rate change frequency language in the contract.
  • Indexed annuities – If you see that the S&P 500 went up 12% last year, how much of that did you make in your annuity? Recognize that the reported 12% increase in the S&P 500 includes dividends. Annuity indexes are almost always adjusted to exclude dividends bringing the 12% increase a roughly 9% to 9.5% increase. Find out what index your policy uses and ask if you have a choice of indexes either in the same product or other products the salesperson has to offer. Also, find out how much of that index change will be credited to your account. This percentage is known as the participation rate.

Indexed annuities have clauses in the contracts that limit an annuitant’s return based on the market index specified in the contract. Caps limit your upside, typically on an annual basis. Assume an index increase of 9% excluding dividends. If the cap is 8%, then everything above 8% is not considered. The participation rate identifies how much of the index gain will be credited to your account. If the participation rate is 80%, the cap is 8% and the index increases by 9% in a year, the calculation is as follows:

Cap=The lesser of 8% or the index increase (9%) adjusted for excluded dividends

Cap = 8%

Participation rate = 80% of index adjusted for the cap.

Participation rate = 80% x 8%

Amount credited = 6.4%

The cap and participation rate are used by the insurance company to provide annuitants with floors and to hedge index changes. While an annuity may cap an index, in many cases the same annuity will eliminate index losses to make them zero. The annuity provides an annual floor such that you cannot lose money in a year. This protection comes at a cost.

The insurance company creates a derivatives portfolio that approximates the annual index performance. There are costs to do this and depending upon the techniques employed, the portfolio will not match the index 100%. The company needs to cover the mismatch and the costs to hedge. The cap rate and participation rate cover the costs of these guarantees and annuity features. As a prospective buyer, you need to understand the terms and conditions that define your account’s growth potential.

  • Variable annuities – There are three principal areas that a prospective buyer needs to understand when considering a variable annuity. They include restrictions, fees, guaranteed accounts. Many variable annuities offer features not found in a vanilla variable annuity. Like indexed annuities, many variable annuities offer a floor that limits losses in a bad year to zero. Prospective annuitants should recognize that floors in variable annuities come with a price. The annuity must be annuitized (transitioned to the payout phase), to receive the benefit of the floor guarantee.

Accounting for the floor guarantee is maintained in a side or guarantee account. This account is the annuity version of a company maintaining two sets of financials based on two sets of rules. The annuitant’s cash account will reflect actual gains and losses from changes in the variable portfolio subaccounts. The guaranteed account will show the same results adjusted for the floor and other annuity guarantees. If the annuitant wants the guaranteed balance, he/she will need to annuitize the contract. The guarantee account is not eligible for the lump sum option.

Variable annuity fees tend to run in the 1.5% to 4% range annually. Over the course of an extended accumulation period, those fees can weigh heavily on an annuitant’s account balance.

Certain annuity riders also require the side or guaranteed dual account structure. Riders that offer guarantees are executed via a side account. Two popular variable annuity guaranty riders include one concerned with total cash payouts (Guaranteed Minimum Benefit Rider or GMBR) and another based on annual payouts (Guaranteed Minimum Withdrawal Benefit Rider or GMWB). (A more extensive explanation is provided in the Questions – Variable Annuities article in the Questions tab under Annuities.) When an annuitant selects either rider, which must be done prior to beginning the annuity, the insurance company will establish a ‘guarantee’ account that mirrors the annuitant’s cash account. The guarantee account meets the rider’s requirements. The cash account follows the actual investment account as it changes annually.

Consider a GMBR that guarantees a 5% annual return over the accumulation period. Assume the one-time premium was $100,000 and the accumulation period was 15 years. The ‘guarantee’ account will contain $207,893 after 15 years.

If the annuitant’s cash account falls below $207,893 after 15 years, the GMBR will provide the annuitant with the full $207,893 for the payout phase. If the annuitant’s account is greater than $207,893, then the annuitant has access to the full cash account amount.

When an annuity includes one of these dual account situations, readers are cautioned that their cash out provisions will be restricted. They will be forced to annuitize to benefit from the rider. Annuitants should review the terms and conditions included with these unique riders.

  • All deferred accounts – What are the surrender charges? If you decide to cancel the annuity or need to make a withdrawal during the accumulation phase, what penalties will you incur? How will the withdrawal affect your payout calculation when the annuity enters the distribution phase?

5. The Distribution Phase

Immediate annuities commence the distribution phase immediately after payment of the principal. Most annuitants who annuitize their payouts generally do so at the time they retire. Some annuities, commonly referred to as longevity annuities, anticipate a payout commencing at age 80 to 85.

  • You need to review your distribution options and their costs. Common options include joint spousal payouts, period certain payments, cost of living riders and repayment of principal riders. It is critical that you understand the payouts associated with each option and the amounts to be paid out. (See Item 7 – Annuity Replacement).
  • Not all annuities reach the payout phase. Fixed, index and variable annuities are available to be taken in a lump sum distribution. These tend to be annuities purchased for reasons other than lifetime income guarantees.
  • Some fixed annuities allow you to take larger initial payments than those specified by the standard schedule. You need to understand how much you can withdraw if you need to make such a withdrawal and what it will cost. One cannot know their financial status 10 or 20 years in the future. In the event you need this option, find out if it is available and what its cost will be.
  • Look at the payout schedule in combination with the distribution options. Some annuities appear to offer outstanding accumulation phase returns but then they limit the payouts. If you don’t live to 85 or longer, you won’t realize all the benefits of the accumulation phase. It takes a spreadsheet to lay out your situation, but it is well worth the effort. By putting it all on paper, you can see how sometimes the advertised guarantee will only be enjoyed by the few who live long enough.

Annuities have evolved from the plain vanilla financial instruments. Insurance companies have worked to make them more profitable yet marketable. Every feature has a cost. The insurer can recover those costs via fees, restrictions, caps, and reduced payouts. Read the annuity contact when you receive it. Look for the distribution percentages. Identify the fees, restrictions, and other recovery techniques. Use them to compare across companies. Obtain copies of the contracts and compare.

6. Annuity Replacement

If you are being advised to cash in an older annuity, think twice. Annuities offered prior to 2008 provided more generous terms than current annuities.

  • Interest rates were higher. They had been higher for many decades. 5% was a modest rate 15 years ago. Many annuities offered a safe haven money market option with a 3% or 4% guaranteed return that they assumed would rarely be used. Some 15 years later, 4% is an excellent rate. Many annuitants are unaware this option exists. If it is in the contract, it is available.
  • Many older annuities offered a joint spousal payout at no additional cost. If the policy stated you received 5% annually, you could select your spouse as your beneficiary. When you passed away, your spouse would receive the same 5% until death. Recent annuities offer a lower distribution rate for the joint spousal payout option.
  • Pre-2008 annuity payouts were generally higher than they are today. Falling interest rates have forced insurers to cut costs. One source of revenue they identified was reducing payouts. What is now 5% may have been 6% 10 to 15 years ago.
  • Understand the possible bias of the person recommending that you replace your existing annuity. Is the person advising you to cash in the annuity looking to replace it with another? Sometimes there is a good reason to do so. Or does the person want to recover the capital to reinvest it in some other financial asset that he/she sells? Before you cash in an existing annuity, recognize that the existing annuity may offer certain protections unavailable in other investments. While evaluating relative returns, don’t forget to include risk in the computation.

7. Legal and Tax Concerns

With the possible exception of a Qualified Longevity Annuity Contract (QLAC), annuities do not normally belong in qualified retirement accounts. Annuities are already tax-deferred.


CPA, MBA – President & Chief Executive Officer

About Steve Goodman

For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.

He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.

Email Steve today for the business succession planning you deserve.

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It took a lifetime to build your legacy. Give us a call to see how we can help you preserve it.

It took a lifetime to build your legacy. Give us a call to see how we can help you preserve it.


Get in touch with Steve Goodman today

CPA, MBA – President & Chief Executive Officer