The concept of single premium immediate annuities (SPIA) actually sprang from a much simpler time when there weren’t any stock markets, interest rates or financial institutions peddling scores of different financial products. The original annuities were a simple arrangement between a government and its citizens to provide for annual income payments in exchange for a lump sum of money. These days governments issue bonds as a way to borrow money from their citizens for which they are paid interest. And, SPIA annuities are now issued by life insurance companies, but little else has changed in terms of their purpose.

Anyone who is concerned with the possibility of outliving their income sources is a strong candidate for an SPIA annuity. And that might include the vast majority of Baby Boomers, 80% of whom think that their retirement savings are insufficient to be able to generate 20 to 30 years of income. With an SPIA annuity, for all or a part of their retirement income they could be assured that they won’t outlive their income.

How SPIA Annuities Work

It is a simple exchange, one commitment for another. An individual commits a lump sum of money to a life insurance company that then commits to that individual a guaranteed stream of income payments. As determined by the individual, the income guarantee can cover a specific period of time, or it can cover the person’s lifetime. In either case, the life insurer guarantees that all of the principle plus all of the interest it is projected to earn, will be paid out in equal periodic installments, typically monthly, until it is completely distributed.

The most important aspect of that guarantee is that, even if the individual lives beyond his or her life expectancy, the life insurer is still committed to make the periodic payments until the individual dies. This is the longevity insurance that makes SPIA annuities so unique and compelling, especially in an era of uncertainty for people approaching retirement.

SPIA Annuity Steps

Determining the Amount of Deposit

Once a lump sum of money is deposited with a life insurer and the income payments begin, the money cannot be returned except through the periodic payments. So, it is vitally important to make a sound decision as to the amount of money to be deposited. Most planners will work from an income need standpoint. That is, calculating your overall need for income and how much can be generated from various income sources. If you have multiple income sources, the SPIA can be used as a part of a portfolio of income investments to create a safety net, or foundation of income to act as a stabilizer.

Given a certain amount of income that would be needed on a monthly basis, a life insurer could calculate the amount of money that would need to be deposited. Or, given a dollar amount to be deposited, the calculation would produce an amount of monthly income that could be generated.

Calculating the Payout Rate

In either case, the calculation involves several key factors, such as your age when the income is to begin, your life expectancy based on actuarial tables, and a project interest rate. Once the number of payment periods is determined (either specified number of periods, or the number of periods as determined by your life expectancy), the life insurer comes up with a payout rate, which is fixed percentage of the annuity balance that is to be paid each period. The payout rate includes an exclusion ratio that determines the amount of the payment that is comprised of principal, and is, therefore, excluded from taxes. Much like a mortgage in reverse, the SPIA annuity is calculated to distribute the entire principal along with interest earnings by the last scheduled payment period. If the schedule of payments is based on life expectancy, the number of payment periods becomes indefinite once the individual lifetime surpasses its life expectancy.

Structuring SPIA Payments

One of the more important steps in the SPIA process is to determine how the annuity payments are to be structured. In its simplest form, an SPIA is paid out on a single life which means that, if the individual dies prior to life expectancy or a specified period of time, the income payments simply stop and the life insurer keeps the remaining balance.

Individuals with spouses will usually structure the SPIA as a joint life annuity so that, the annuity payments will continue for the second spouse after the death of the first spouse. The payout rate for joint life annuities is reduced by an amount that covers the additional cost of insuring two lives.

Additionally, an SPIA can be structured to return all or a portion of the annuity balance to a named beneficiary at the death of the primary annuitants. Instead of continuing the annuity payments, the annuity proceeds are paid to the beneficiary in installments over a five to ten year period.

Summary

The fact that SPIA annuities have been providing income security for hundreds of years is somewhat of a double-edged sword when it comes to appreciating their importance. On one side, they are nearly as old as the hills, which might lead to a characterization of being stodgy or even out-dated. On the other side, they are still the only financial instrument that can offer the ultimate in financial security which, if you ask millions of retiring Baby Boomers, would never get old.

SPIA annuities are not difficult to understand. It’s their application in an individual’s retirement plan that requires careful analysis to determine their suitability and their value. While they may not be suitable for everyone, they can play a vital role in just about anyone’s retirement income portfolio where stability, predictability and general peace-of-mind are desired attributes.

Most of the information available on annuities today emphasizes their record of safety and their role as an asset and income safety net in the context of an overall financial plan. And, while there are many reasons to trumpet their advantages and benefits, owning annuities doesn’t come without some risk. On the risk-reward spectrum, all investments entail some sort of risk. Understanding annuities and how they work in relation to your own specific needs, priorities, and tolerance for risk will help to expose what risks, if any, they present to you.

Liquidity Risk

Perhaps the biggest risk factor associated with annuities is the restriction on access to funds. Although annuities do allow for complete access through surrendering the contract, the fees and penalties that could be triggered could adversely impact the principal amount. An investment in an annuity needs to be made with the knowledge that it is a long term investment which may not perform to expectations if funds are accessed too early in the contract.

Annuities should not be considered if there is not a sufficient amount of liquid assets available elsewhere in your portfolio. Still, they do allow for partial access through a once-annual withdrawal of up to 10% of your account balance without incurring a fee. A surrender fee, ranging from 5% to 12%, is charged on any withdrawal that exceeds 10% in a year during the contract’s surrender period. Because the fee gradually declines throughout the surrender period, they eventually vanish.

Market Risk

Anytime your assets are exposed to the fluctuations of a market, such as stocks or bonds, they are subject to market risk, which means they could lose value. Market risk is not an issue for fixed annuities as the rate of return is based on a fixed yield and supported by rate guarantees. But, with variable annuities, which include separate investment accounts, the risk of fluctuation in the value of the accounts is tied directly to the performance of the markets. Indexed annuities, while linked to the movement of stock indexes, provide enough downside protection that market risk is not a concern.

For investors who have low or no tolerance for market risk, fixed or indexed annuities are the most suitable investment choices. Some variable annuities offer the option to purchase a minimum rate guarantee which would ensure that, even in market declines, your account value will receive some positive rate of return.

Interest Rate Risk

The risk of interest rate movement affects all annuities in some way or another. For fixed annuities, especially those with a multi-year rate guarantee, the risk is that interest rates rise quickly while your funds are locked into a lower yield. Conversely, if your rate is guaranteed for just one year, the risk is that interest rates suddenly fall, and your renewed rate is lower than your initial rate.

Interest rate movements also affect the stock and bond markets. If you own a variable annuity with funds invested in stock and bond accounts, an increase in interest rates could cause those markets to decline. The best risk mitigation strategy is to have a balanced and diversified allocation strategy so that any movement in interest rate will only adversely affect one part of your portfolio.

Inflation Risk

The risk of inflation affects the long term impact of your annuity accumulation, and ultimately, the purchasing power of future annuity income. In terms of its devaluing capabilities, a dollar today will be worth half as much in 20 years based on the current rate of inflation. Should the rate of inflation increase, that timeframe will shorten. This puts any portfolio that isn’t properly invested as a hedge against inflation at risk. While the owners of fixed annuities may enjoy the current comfort of having no market risk, the risk of inflation can have even more devastating consequences. Only a properly balance and diversified portfolio of varying asset classes can provide the essential offset to inflation.

Taxation Risk

There are two types of taxation risk associated with owning annuities. The first has to do with the potential tax consequences of the annuity contract itself. The big advantage of annuities it the tax deferral of earnings within the contract. They are then taxed when withdrawn at retirement. One of the planning theories behind owning annuities is that your tax bracket is higher while you are accumulating earnings, and then it drops after retirement so that you will pay fewer taxes on the annuity withdrawals. The risk is that your bracket remains the same, or, due to an unforeseen change in the tax law, it increases. It still doesn’t erase the impact that tax deferred earnings had over the years on your accumulation.

The second kind of taxation risk it the possibility that changes in the tax law could impact the tax treatment of annuities in the future. Although it’s not mandated, most tax law changes that affect investments include a “grandfather” provision which protects existing investments.

Credit Risk

Annuity contracts and all of their guarantees and obligations are backed strictly by the assets of the issuing life insurance company. Perhaps the greatest risk an annuity owner faces is that the issuing life insurer runs into financial trouble or becomes insolvent. It is also important to note, however, that this risk has yet to materialize to the extent that an annuity owner has ever lost any money. While there have been some instance of insolvency, the collective strength of the life insurance industry has, time and again, come to the fore to rescue the policyholders of a diminished life insurer.

Any degree of credit risk can be reduced, if not eliminated, by investing in annuities issued by the most credit worthy life insurers who meet the stringent standards of independent rating companies. The most highly rated companies have the strongest balance sheets and are deemed to be resistant to economic cycles.

Summary

For any one investment, there really is no way to get around risk. It comes in many different forms, and some forms are less obvious, but potentially more destructive than others. Annuities are inherently low risk investments; however, to limit your allocation to one type of annuity could actually increase your exposure to risk. One of the most effective risk reduction strategies is to own a portfolio of annuities that can counter the different exposures to risk. A portfolio consisting of a variable contract (or two), an indexed annuity and a fixed annuity, would provide enough countering effects to minimize any type of risk.

The decision to purchase a particular annuity is based on several factors including an investor’s financial circumstances as well as the features present in the product that, at the time, closely matched the investor’s needs and preferences. As time passes, financial circumstances can change and an annuity’s features may no longer be the match they once were. Or, perhaps the annuity is no longer performing as expected. There could be any number of reasons why someone would want to change their investment, and annuity contracts do allow for such changes, however, a “rollover” from one annuity to another annuity is not one of them.

What is a Rollover?

It is possible, however, to change from one annuity to another, but that process is referred to as a direct transfer which is described below. First, let’s take a step back and define “rollover” so that the difference is clear. A rollover, as described in the tax code, is when the holder of a qualified plan such as an IRA takes a complete, physical distribution from the plan, and then rolls it or deposits it into another IRA. The rollover must occur within 60 days of the distribution in order to avoid a tax consequence.

Annuities are non-qualified plans which aren’t covered under the rollover rules. If a full distribution is taken from an annuity it requires that the annuity contract be surrendered which automatically triggers a taxable event. The amount of the distribution that is comprised of earnings from the contract will need to be reported as ordinary income and taxed in the year of the distribution.

If annuity is purchased inside of a qualified plan, then technically, the distribution, or surrendered funds, can be rolled over to another qualified plan and another annuity can be purchased inside that plan. And, it is possible to roll a qualified plan distribution into an annuity as long as the annuity is set up by the life insurance company as an IRA annuity. The bottom-line is that a tax-free rollover can only occur between two tax-qualified accounts.

If not a Rollover, then What?

Annuity owners are allowed to change their annuity investment through what is known as a direct transfer which is allowed under IRC. Section 1035. Also known as a 1035 Exchange, the direct transfer is facilitated by the current annuity provider and the new annuity provider, so the annuity owner never touches the funds. This is the only way that the transfer can occur without a tax consequence.

In order for the transfer to occur, the first annuity has to be surrendered. That means that, if it occurs during the contract’s surrender period, a surrender fee will apply. If the surrender period has expired, then the funds can be transferred without charge. And that is one of the main caveats of a tax-free 1035 exchange of annuities, and that is when a new annuity is purchased, the surrender period begins anew.

Exchange with Care

If you have made the decision to exchange your annuity, great care should be taken to ensure that you will be improving your situation. Obviously, the new annuity should be fully vetted for a complete understanding of its fees, expenses and surrender provisions. Understanding that you will be purchasing a new annuity with a fresh surrender period, it is important to have a long term time horizon in your thinking. You may be able to find an annuity with a shorter surrender period, but be aware that it may have higher internal expenses as an offset.

Also, once you have made the exchange decision, and have selected a new annuity, you could be at risk if the exchange process is delayed at either end. For instance, you may have selected an annuity based on its high promotional rate. If the exchange process takes too long, it is possible that the promotional rate on the new annuity is no longer available when the funds are finally received by the new provider. Although annuity providers are required to begin processing an exchange as soon as they receive the request, they have been known to take the as much time as they are allowed in order to keep your money working for them as long as possible. So, it is possible to miss a promotional rate or a significant move in the market (if you’re exchanging to a variable contract).

The same care taken with your initial annuity investment should be taken with the exchange into another annuity product. The new annuity product should be a solid match for your investment objectives, timeline, preferences and risk tolerance. When done properly, an annuity exchange should put you in a better financial position than before the exchange.

Annuities have come a long way since the days when they were a simple exchange of cash for income. In their 2000 year history they have been used primarily as a way for governments or institutions to raise capital which was repaid to an individual in the form of a lifetime stream of income. Not until the 20th century did their use expand to serve the savings needs of individuals who had lost confidence in the banks during the Great Depression. Today, annuities are used in many ways to address the needs of individuals and businesses.

Income Needs

Secure Retirement Income

The original purpose of annuities was that of an income generator. But, for a Roman citizen who wasn’t expected to live much beyond the age of 28, the need for a secure, lifetime income source was not nearly as great as the need today with life expectancies stretching out beyond the age of 87. Annuities are still the only vehicle that can assure retirees that they won’t outlive their income source.

Annuity payouts are based on the amount of the initial investment amount, the number of payment periods, and an assumed rate of interest. For a lifetime income, the number of annuity payments is based on a person’s life expectancy. Annuities are an insured contract, which means that, if a person lives beyond his or her life expectancy the life insurance company is obligated to continue the income payments for life.

Installment Payments

Annuities are often used by individuals and businesses to structure a payment schedule for a specific number of payments, based on a specific payment amount. Businesses might use annuities to establish a payment plan for compensating an employee or a business partner in a buyout situation. These are legal arrangements that usually require structure and guarantees that can only be provided by instruments such as annuities.

Annuities are the primary vehicle used when a financial settlement is made between parties involving a series of payments as opposed to a lump sum payment, also referred to as a structured settlement. Lottery winnings also use a structured settlement annuity when they are paid in equal installments over ten or twenty years.

Accumulation Needs

Supplemental Retirement Savings

During the Great Depression, life insurers added a savings component to annuities to enable people to safely put money aside for retirement when the banks were closing up shop. Back then, annuities were considered to be safer than bank savings because the savings deposits were kept on reserve by the life insurer as opposed to being loaned out to borrowers as the banks would do.

Today, annuities are still considered to be among the safest savings vehicles because of the strict reserves requirements to which life insurer must adhere as well as the state guaranty funds that protect policyholder accounts up to $250,000 in some states.

Tax Sheltered Investment Alternative

After World War II, when incomes started to climb and the top tax bracket topped out at 90%, an annuity investment was introduced that allowed investors to earn stock market returns without having to pay taxes on their earnings. Essentially, life insurers adapted the savings component of annuities to incorporate separate investment accounts, similar to mutual funds in which investors could choose among professionally managed stock and bond portfolios.

Because annuities are afforded the same tax treatment as qualified plans, as far as the tax deferral of accumulated earnings, they became attractive alternatives for investors who could benefit from tax savings on their investments. During the 1980’s, when interest rates climbed into double digits, fixed yield annuities became a popular alternative to taxable bank CDs and other fixed yield investments.

Sleep Insurance

For hundreds of years, people have turned towards annuities for assurance in times of uncertainty. The safety and guarantees built into the contracts that are backed by life insurance companies provide people with peace-of-mind that is sorely needed after the shocks of market crashes or economic meltdowns. Even the more risk tolerant investors need to inject some stability and predictability into their retirement portfolios and annuities are a way to do that.

Asset Protection

Under state and federal statutes assets such as pension plans, life insurance and annuities are protected from civil liabilities, liens and debt claims. It is an accepted practice for individuals to arrange their assets in a way that will shield them from claims so long as it is not done with intent to defraud. In some states, assets held in annuities are fully protected against liability claims, but in others, their exemption in limited to a specific dollar amount. In a few states, annuities are not exempt and, therefore, they are vulnerable to claims.

Summary

Very few investment vehicles are as multi-faceted as annuities. Their unique features and characteristics combine to create a number of possibilities for their use in a variety of financial situations, which is why they remain one of the more popular financial planning tools today. Their immense popularity is only exceeded by their complexity, so, there use should be considered along with the guidance of a knowledgeable financial professional who specializes in annuities.

Annuities are renowned for the safety and security they can provide for savers who need to accumulate funds for retirement as well as for retirees who rely upon them for a guaranteed stream of income. And for both of those purposes, the tax implications are fairly straightforward: Tax deferral during accumulation and ordinary income taxes due on earnings when withdrawn or taken as income. Annuities that are transferred to heirs as part of an inheritance may create a more complex set of tax consequences, so it would be important to fully understand inheritance options in order to minimize problems and taxes.

One of the distinguishing features of annuities is their guaranteed death benefit which, like a life insurance policy ensures that beneficiaries will receive, at the very least, the principal investment made by the annuity owner. Annuities held over a period of time will have accumulated earnings which are also payable as part of the death benefit proceeds. Because earnings are allowed to accumulate tax deferred while the annuity owner is alive, they will become taxable as ordinary income when they are paid to the beneficiaries. The beneficiaries do have several options for taking receipt of the proceeds which, depending on their situation, could impact the level of taxation at any one time.

The Annuity Taxation Shock

What few annuity owners (and their beneficiaries) realize is that annuities, unlike most other investments, do not receive a stepped up basis when they are passed into an estate. For other investments, a step up in basis occurs when the assets are passed through the estate. If the investment has a gain in value, the basis of the investment is increased to equal the original principal plus the gain which, in effect, means that there would be no tax consequence on the gain.

This can prove to be a shock to annuity beneficiaries when they realize that the full amount of earnings that accumulated over the years is suddenly includable in their own taxable income. Annuity owners should prepare their beneficiaries for that fact, at least to the extent that they can help them plan for them or understand their options.

Five Year Withdrawal Limit

When annuity proceeds are made available to the beneficiaries, they can take up to five years to withdraw the funds. This is important because only the portions of the proceeds withdrawn are subject to income tax and the funds remaining in the balance continue to accumulate tax deferred. Generally, funds can be withdrawn in any increment so long as they are completely distributed within the five years. It is possible to simply wait a full five years before taking any withdrawals, thereby maximizing the tax deferral on the earnings.

When annuity proceeds are withdrawn, it is important for the recipient to plan accordingly for the additional taxes that will be due. Based on their individual tax brackets, beneficiaries should plan on setting aside an amount equal to their tax bracket percent into a separate account, or, better yet, simply send it to the IRS. So, as an example, if $10,000 is taken from the proceeds and the beneficiary’s tax bracket is 25%, $2,500 should be set aside to pay the taxes. An income tax analysis should be done to determine whether the withdrawal will actually bump the tax bracket to the next level, which would mean that the proceeds would incur a higher tax.

Income Option

Alternatively, the annuity could be converted into a stream of income for a specified number of years of for the life of the beneficiary. When this happens, also referred to as annuitization, the beneficiary will receive the proceeds as period payments. The payments will consist of a portion of the deceased annuity owner’s principal, which is not taxable, and interest earnings which are taxed as they are received.

Taxation of Annuity Income after Annuitization

If an annuity owner dies after the annuity had been annuitized and payments had been received, the income could continue to a spouse who was named as a joint owner of the annuity. The payments would be received as established and the spouse would continue to pay taxes on the interest portion. If additional beneficiaries were named, and a refund option was selected, the beneficiaries would incur taxes on the portion of the refund that is earned interest.

Summary

The taxation of annuities is fairly straightforward for owners who are using them as accumulation vehicles or as a guaranteed income source. At the death of an annuity owner, the taxation of annuities can be somewhat perplexing for survivors who are prepared for their tax treatment. The guaranteed death benefit in annuities can be great source of comfort for annuity owners, but if they want to maximize their comfort as well as they value of their legacy, it is best if they prepare their family members ahead of time.