Annuities 101

What an annuity is

An annuity is a long-term contract issued by a life insurance carrier. The consumer is the owner. The carrier is the issuer. The contract specifies the premium paid, the payout type, the timing of payments, and the financial guarantees the carrier provides.

Some annuities are pure income products: a lump sum becomes a stream of payments. Some are pure accumulation products: the contract grows tax-deferred and pays out at a later date. Some combine both phases. The six categories listed below cover the structural variations.

The six categories

• Fixed Indexed Annuity (FIA). Principal-protected accumulation product. Credits interest based on a market index, capped or scaled, with a 0% floor.
• Multi-Year Guaranteed Annuity (MYGA). Fixed declared rate for a fixed term. The annuity equivalent of a CD with tax deferral.
• Single Premium Immediate Annuity (SPIA). Lump sum becomes guaranteed monthly income that starts immediately.
• Deferred Income Annuity (DIA). Lump sum today, income at a future date. Used as longevity insurance.
• Variable Annuity (VA). Subaccount-based contract with market exposure. Optional riders can guarantee income or principal. Registered as a security.
• Qualified Longevity Annuity Contract (QLAC). IRA-funded DIA structured to reduce required minimum distributions.

Accumulation and payout phases

Most deferred annuities have two phases. The accumulation phase is the period during which the premium grows inside the contract. The payout phase is the period during which the carrier pays income to the consumer.

Some products have only an accumulation phase (most MYGAs, most FIAs without an income rider). Some have only a payout phase (SPIAs). Some have a long accumulation followed by a payout that runs for life (DIAs, QLACs, FIAs with income riders, VAs with GLWB riders).

Annuitization is the act of converting a deferred contract into a payout phase. It is generally irrevocable once initiated. Modern annuities often provide income through a withdrawal benefit rider instead of annuitization. This preserves access to the contract value while paying a guaranteed income.

How carriers make money

Life insurance carriers fund annuity guarantees through the difference between what they earn on premium reserves and what they pay to contract owners. The carrier invests premium receipts primarily in investment-grade corporate bonds, government securities, and a small share of commercial real estate and structured credit. The yield on that portfolio funds the rates offered to consumers, the rider guarantees, and the carrier's profit margin.

For FIAs, the carrier purchases options on the chosen index to finance the upside. The cost of those options is funded by the portfolio yield. When rates rise, options become relatively cheaper and the carrier can declare higher caps. When rates fall, caps decline.

Who regulates annuities

Annuities are regulated primarily at the state level by each state's department of insurance. The carrier must be licensed in each state where it sells. Each state has a guaranty association that provides limited coverage if a carrier becomes insolvent.

Variable annuities are also regulated federally because they are registered securities. The SEC requires a prospectus. FINRA regulates the broker-dealers and registered representatives who sell variable annuities.

The National Association of Insurance Commissioners (NAIC) publishes model regulations that most states have adopted, including Suitability in Annuity Transactions and the Buyer's Guide to Annuities. The NAIC also publishes the Buyer's Guide to Fixed Deferred Annuities and the Equity-Indexed Annuity appendix.

How to read a quote

Every annuity quote should disclose the following:

• Carrier name and current A.M. Best financial strength rating
• Product name and contract series
• Premium amount and any premium bonus
• Term length or surrender schedule
• Declared rate (MYGA), cap and participation rate (FIA), or subaccount allocation (VA)
• Free withdrawal allowance
• Market value adjustment terms (if applicable)
• Optional rider charges and benefit base growth rates
• Death benefit treatment
• Tax classification (qualified or non-qualified)

If any of the above is missing or vague, ask for it in writing before signing.

Fees, an overview

Fees vary by product type.

• MYGA and base FIA. No explicit annual fee. The cost is embedded in the declared rate (MYGA) or in the caps and participation rates (FIA).
• FIA with rider. The rider fee (0.95% to 1.50%) is deducted annually.
• SPIA and DIA. No explicit fees. The cost is embedded in the payout rate calculation.
• Variable annuity. Multiple layers: M&E (0.85% to 1.40%), administrative (0.10% to 0.25%), subaccount fund expense (0.20% to 1.20%), rider charges (0.50% to 1.50%). Total commonly 2.5% to 4% per year.

Read the fees complete guide for the full breakdown.

Taxes, an overview

All annuities are tax-deferred during the accumulation phase. Growth is not taxed annually. Withdrawals are taxed as ordinary income, not as long-term capital gains. Pre-59½ withdrawals may incur a 10% federal tax penalty.

Annuities can be funded with qualified money (IRA, 401(k) rollovers) or non-qualified after-tax money. Qualified contracts are subject to standard IRA tax rules. Non-qualified contracts have an exclusion ratio that determines how much of each payment is return of premium (not taxed) vs interest (taxed).

When annuities fit

Annuities address specific retirement risks. They are not universal vehicles. They fit best when one of the following applies:

• Longevity risk. The consumer wants insurance against living past actuarial life expectancy. SPIA, DIA, QLAC, and FIA or VA with income riders all address this.
• Sequence-of-returns risk. The consumer is in or near retirement and cannot afford a major market loss. FIA and MYGA both protect principal.
• Guaranteed yield need. The consumer wants a fixed rate of return for a defined period. MYGA fits.
• Income certainty. The consumer wants a paycheck that does not depend on market performance. SPIA fits.

Red flags during a sales conversation

• The salesperson cannot or will not produce the product brochure or prospectus before the meeting.
• The total annual fees are described in vague terms or omitted entirely.
• The product is described as "guaranteed market upside with no downside." All annuities have tradeoffs.
• The salesperson recommends placing a large share of net worth into a single carrier and product.
• The bonus is emphasized but the longer surrender period and lower caps that pay for the bonus are not mentioned.
• The conversation pushes a decision today rather than allowing time to read the contract.

The buying process

The standard process:

1. Define the goal. What retirement risk is the annuity addressing?
2. Identify the product type that fits the goal.
3. Request quotes from multiple carriers. Match payout type and contract terms exactly.
4. Read the brochure and (for VAs) the prospectus.
5. Verify carrier financial strength ratings.
6. Complete the suitability questionnaire.
7. Sign the application, fund the contract, receive the policy.
8. Use the free look period (10 to 30 days) to confirm everything is as represented before the surrender period begins.

The how to buy an annuity guide covers each step in detail.

Sources

• National Association of Insurance Commissioners
• National Association of Insurance Commissioners
• NAIC Annuity Consumer Information
• SEC Investor Bulletin: Variable Annuities
• FINRA Variable Annuities Resource Page
• IRS Publications