Annuities 101

Don’t understand annuities? Join the club — they’re complicated products. This starter’s guide offers up the basics for life insurance producers interested in adding annuities to their offerings.

Annuities can be extremely multifaceted, which makes it all the more important for financial service professionals to understand them, inside and out. This beginner’s guide to the product will help you educate consumers on the many features, terms, agreements, benefits and costs they need to know about before making a purchase.

What is an annuity?

It is a financial product that provides a stream of payments. These payments are the result of a contract purchased from an insurance company in exchange for a specified sum of money. Payment can be made in a lump sum, with payments beginning immediately. This is known as a single premium immediate annuity.

Another option allows consumers to pay small amounts to an insurance company over a longer period of time. At the end of the savings period, the customer would then begin receiving the payout, or annuity period. This is known as a deferred annuity. This is typical of the annuities used by millions of Americans to fund their retirements.

What makes annuities special? In the entire universe of investment vehicles, they are the one investment that can provide a lifetime, or longer, stream of income.

In a sense, annuities are the opposite of life insurance. Life insurance protects survivors from the risk of a breadwinner dying too soon and fully providing for them. Annuities, on the other hand, can protect individuals and the surviving spouse from living too long and running out of money in retirement. This is known as longevity risk. In short, life insurance protects one from dying too soon, and annuities protect one from living too long.

Funding and payouts

Annuities can be categorized in a number of ways. As mentioned earlier, they can be categorized by the manner in which they are funded: immediate or deferred. They can also be categorized by the manner in which they pay out their income: straight life or pure annuity. With straight life, payments will be made for as long as the annuitant is living. In the second case — life with 10 years certain — payments are made for as long as the annuitant lives. If, however, the annuitant should pass away within the first decade after the payouts begin, this contract guarantees that payouts will continue for a minimum of 10 years.

While a straight life annuity will result in the highest total annual payments to the annuitant, it is rarely the best choice, because the risk of losing one’s investment before recovering the principal is too much of a psychological barrier during the purchase process. The life with a period certain option is by far the most popular choice.

Fixed vs. variable

Annuities can also be fixed or variable. Fixed annuities are considered to be insurance products and are not subject to oversight by the SEC or FINRA. Variable annuities, because of their separate accounts structure, are considered to be investments. This makes them subject to SEC and FINRA oversight. To sell variable annuities, you must be licensed to sell securities.

But what is the difference between the two annuities? Fixed annuities have a guaranteed interest rate and will provide a fixed return. Variable annuities allow the investor to choose from a number of separate accounts, representing a range of investment risk levels, such as conservative, moderately conservative, moderate, moderately aggressive and aggressive. The further along the continuum the investor proceeds, the greater the risk and, likewise, the opportunity for reward. A major concern among regulators is the opportunity for investors to purchase these products without fully understanding the inherent risks. For this reason, variable annuities require that a prospectus be provided to investors prior to purchase.

Fixed index annuities

A third type of annuity having gained popularity in recent years is the fixed index annuity, also known as the equity indexed annuity. The major selling point of this annuity is its purported ability to guarantee no investment loss, since the product’s return is tied to an index and cannot return less than zero. That selling point, however, ignores the fact that investors can get back less than they initially invested in certain circumstances. While the upside potential is factually correct, it is often oversold, while the risks associated with this type of annuity are sometimes understated. An indexed annuity has so many moving parts that many insurance professionals do not understand it sufficiently to explain it to clients. Because of this, some companies simply refuse to include the product in their portfolios, avoiding the risk of selling unsuitable products.

There is no such thing as a perfect investment. However, for the purposes of addressing the No. 1 concern of those in retirement, “Will I outlive my retirement income?” perhaps the annuity is as close to being that perfect investment as we will find. Only an annuity can guaranty a life-long stream of income. Stocks can’t do it. Bonds can’t do it. Mutual funds and ETFs can’t do it.

Whether you and your client decide on a fixed annuity, with all its guarantees, or a fixed index annuity, for the hope of a higher return in exchange for a lower guaranteed return, that choice needs to be best for the client. He can even elect to purchase a variable annuity, if he is concerned about his income stream having a hedge against inflation. At least he can today. Who knows what new obstacles and/or regulations will be placed in your way in the future, in the name of protecting consumers?

By Jarret Barnett for March 2012 issue of Life Insurance Selling Magazine.  Jarret works in public relations at The American College, the nation’s leading educator of financial services professionals.

 

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