You have finally decided to buy yourself an annuity but are overwhelmed by hundreds of options available in the market. Or, your financial advisor has been persuading you to buy an annuity for a long time. In either case, you have landed at the right place. This guide will help you to understand everything you need to know about annuities.
Annuities are one of the most commonly misunderstood, misselled, and misused financial products as of today. Many people consider annuities as bad because they are sometimes misselled blatantly.
Annuities aren’t bad. The ways the annuities are marketed are bad. Annuities are so vast in themselves that generalizing it would be an injustice to the good ones available. There are so many different types of annuities, but you are often sold only the ones that maximize the agent’s commission. Even though annuities offer a relatively low return, they are the only product that has the potential to offer lifetime income, no matter whether the market crashes or we are attacked by the zombies!
Annuities can really prove to be helpful in your retirement if you properly understand your needs and plan well. Thus, it’s essential that you are well-informed and educated when you shop for annuities. In this blog, we will discuss how you can choose the best annuity plan for yourself.
How do I get started?
There are several types of annuities and hundreds of types of variants when you combine it with different time duration, riders, rates, etc. So, how do you get started?
The first and foremost thing to do while getting started on finding the best product for you is to identify your goals. You can essentially divide your goals into two categories:
- Are you looking for lifetime income? OR
- Are you looking for principal protection?
These goals are not exhaustive, and we can even achieve both the goals with some riders attached to our plans or by taking multiple plans; I will discuss this in the latter part of this article. But, at a very high level, it is essential that you divide your goals into either of these categories.
Every individual has different goals, and there is no one-fit-for-all plan in the market. For example, receiving lifetime income should be preferred by those who fear outliving their income. Now, someone like Warren Buffett does not fear outliving his income, so he would probably go with a plan that offers principal growth + protection.
I am looking for a lifetime income
Although lifetime income annuities are legally called investment products, they are essentially insurance products. By taking a lifetime income plan, you are effectively transferring your risk of outliving your income to the insurance company. The insurance company creates a pool of annuitant (insured) people like you to average out early mortality and longevity, and over it, earn profits for themselves.
In these types of plans, you don’t get your principal back, but you are guaranteed by the contract that as long as you live, you will keep getting the contracted periodic payments, usually monthly or annually. For lifetime income annuities, the annuity rate (percent of your premium that you receive annually) is primarily based on your life expectancy at the time you pay the premium, and interest rates play a secondary role.
Again, there are many annuities that offer lifetime income, but the most common types are:
- Single-Premium Immediate Annuities (SPIA)
- Deferred Income Annuities (DIA)
- Qualified Longevity Annuity Contracts (QLAC), and
- Income Riders attached to some deferred annuities
All of these products are similar in nature but have slightly different contractual terms and tenure. Lifetime income annuities can be further classified into immediate or deferred annuities.
SPIA is an immediate annuity that starts paying an income stream immediately (typically monthly or annually). DIA is an annuity that begins paying income at a future date that is agreed in the contract. One benefit of deferred annuities is that they help in providing tax-advantaged savings. With a deferred annuity, you begin receiving payments years or decades in the future. In the meantime, your premiums grow tax-deferred inside the annuity.
A QLAC is similar to a deferred annuity, but it is funded only from a qualified retirement account or IRA. One unique benefit of QLAC is that you can defer the payments until the age of 85. The more you defer the payments, the higher the payments insurance companies will pay out to you once the income stream is started.
Finally, there are many riders that are available in an annuity plan. Most of them are not that necessary, but a few of them, like income riders and death benefit riders, can be really useful. Riders often come at a cost, dependent on the annuitant’s situation (life expectancy), and vary among different annuitants. Income Riders are typically used to provide lifetime income payments to enhance your overall retirement income plan. The guaranteed growth percentage grows tax-deferred and provides an annual step-up in benefits until you decide to start the payments. It’s an excellent way to guarantee future lifetime income as those payments are known in advance.
Note that the lifetime annuities quotes differ from person to person and are dependant on a number of factors such as age, sex, marital status, riders, etc.
Age: The higher the age at the time of payout, the more is the annual payout. It is because as you grow older, your life expectancy will start to diminish, and the insurance company will need to pay for fewer periods. This is the reason why deferred annuities have more annual payout rate.
Sex: Male annuitants have more payout rate compared to female annuitants. It is because females have more average life expectancy than males.
Marital Status: Joint policy generally has a “period certain with life” clause. For example, “10 year period certain with life” means if the annuitant passed away during the 10 year period, the remaining balance of what has not been paid out goes to the joint holder. Now, as this clause benefits the annuitant, it comes with a cost of a lower annual payout rate. The higher the number of clauses that benefit the annuitant, the lower the annual payout rate.
Riders: Riders are additional clauses that you can take with your annuity plan. Different people have different needs, and sometimes, riders can benefit them largely. There are many types of riders. The most popular ones are Income rider, Death benefit, Cost of living (COLA) riders, etc. As these riders benefit the annuitant, the higher the number of riders, the lower the annual payout rate.
Now, let’s have a look at an example of lifetime income annuities. Note that quotes differ from person to person, so we will take a dummy example of Mr. Anthony, a male 70 years old and his spouse is 65. He has a corpus of $200,000 to invest and is looking for a lifetime income stream. He further wants that his payments are at least protected for 10 years; even if he dies during this time, the remainder of payments must go to his wife. The rates are calculated for annuities beginning in the year 2021.
In this case, below are the approx annual payout Mr. Anthony will get in Single Life Man, Single Life Woman (Wife), and Joint Life immediate annuity plans, respectively, for different companies. Note that in Joint Life Policy, there is a “period certain with life” clause that promises a minimum payment of 10 years. If Mr. Anthony dies during this 10 year period, his remaining payments will go to his wife.
|Plan Type||Annual Payout Rate||Annual Payout (in $)|
|Single Man Life||Between 6.50 %- 6.80%||$13,000 – $13,600|
|Single Woman Life||Between 6.20% – 6.40%||$12,400 – $12,800|
|Joint Life with period certain||Between 5.10% – 5.30%||$10,200 – $10,600|
Approximate Payout in SPIA
Now we will consider the same example but with a twist that Mr. Anthony is 60 years old and his spouse is 55 years old, and he enrolls into a deferred income annuity and will start receiving annual payouts beginning 10 years from now (when he is 70 years old).
|Plan Type||Annual Payout Rate (after 10 years)||Annual Payout (in $) (after 10 years)|
|Single Man Life||Between 9.20 %- 9.50%||$18,400 – $19,000|
|Single Woman Life||Between 8.50% – 8.75%||$17,000 – $17,500|
|Joint Life with period certain||Between 7.05% – 7.30%||$14,100 – $14,600|
Approximate Payout in DIA
Note that these annual payout rates are an approximate range for the given situation in the year 2021. These rates vary slightly across different companies and different locations. We will briefly discuss how to select the best company for you in the latter part of the article.
We will end our lifetime annuity part for now.
I am looking for principal protection
In the lifetime income goal, we do not usually get our principal back, meaning that the insurance company is no longer liable to pay anything to the annuitant’s heirs once the annuitant dies. Now, many people will not be comfortable not getting their principal back, and lifetime income products may not even be suitable for them. As I discussed earlier, someone like Warren Buffett will not be interested in a lifetime income product. Instead, he would like to have his invested principal back so that it can be passed to his heirs.
For people with such goals, principal protection products are suitable, where they are certain that they will get their principal back. On the flip side, they do not offer lifetime income; and the tenure of the annuities is fixed upfront during the contract initiation.
There are many types of principal production products, but the most popular ones are:
- Multi-Year Guarantee Annuities (MYGAs)
- Fixed Index Annuities (FIAs)
Both these products offer principal protection. However, in the case of Multi-Year Guaranteed Annuities (MYGAs), we are certain about both the annuity rate and the time period in which we will get our investment back.
In the case of a Fixed Index Annuity, we do not know the annuity rate because the annuity rate is tied to the return of a stock market index. But unlike variable annuities, we know that we will at least NOT lose any part of our principal. We will discuss more about it shortly,
Multi-Year Guarantee Annuities (MYGAs)
MYGA is the simplest form of annuity available in the market. It is pretty similar to a bank Certificate of Deposits (CD).
A Multi-Year guarantee annuity (a.k.a. fixed-rate annuity) is a contract that is paid for with an initial lump-sum premium. The contract lasts for a certain time span, which is called the contract term. Usually, MYGA annuities last for 3-10 years. With the annuity, a fixed interest rate is declared in advance.
Generally, this interest rate remains the same throughout the contract term. The insurance company provides a guarantee for this growth and credits interest to the MYGA annuity on an annual basis. In turn, the money grows tax-deferred within the contract. Even if the MYGA annuitant dies, the beneficiaries can withdraw the full account value without incurring any surrender fee.
While it may seem pretty “boring”, some people just want an unchanging, fixed, and a known rate for their money. The idea of changing interest rates, changing terms, uncertainty, etc., doesn’t appeal to them.
How are MYGAs different from CDs?
Although MYGAs functions very similarly to CDs, they are legally quite different instruments. Interest earned on CDs is taxable at the end of each year, while in MYGA, interest is not taxed until the funds are removed from the annuity. In other words, your annuity grows tax-deferred, and the interest is compounded each year. Usually, MYGAs pay higher interest rates than CDs.
CDs are insured by the FDIC. However, MYGAs are insured by the individual state insurance guarantee fund — usually, in the range of $100,000 to $500,000. It’s a good idea to research your state guarantee association before making an investment decision.
Best MYGA rates in June 2021
MYGAs are generally commodity-like products, so you must shop them properly before making an investment decision. MYGA rates only depend on the state and the tenure of the investment. I have compiled some of the highest MYGA rates as of June 2021 for 3 years, 5 years, and 10 years of tenure. All these MYGAs are rated minimum “A” by AM Best and at least have some free withdrawal limits.
Best MYGA rates June 2021, State: California, Tenure: 3 Years
|Company||AM Best Rating||Product||Minimum Premium||Maximum Premium||Yield|
|Sagicor Life Insurance Company||A-||Milestone MYGA 3 CA||$100,000||$750,000||2.25%|
|American National Insurance Company||A||Palladium MYG Annuity 3||$250,000||$1,000,000||2.10%|
|Royal Neighbours of America||A||Choice 3||$50,000||$99,999||2.00%|
|Fidelity and Guaranty Life||A-||FG Guarantee Platinum 3||$20,000||$1,000,000||1.95%|
Best MYGA rates June 2021, State: California, Tenure: 5 Years
|Company||AM Best Rating||Product||Minimum Premium||Maximum Premium||Yield|
|Sagicor Life Insurance Company||A-||Milestone MYGA 5 CA||$100,000||$750,000||2.95%|
|Americo||A||Platinum Assure 5||$20,000||$1,000,000||2.70%|
|Fidelity and Guaranty Life||A-||FG Guarantee Platinum 5||$20,000||$1,000,000||2.55%|
|Royal Neighbours of America||A||Choice 5||$20,000||$300,000||2.50%|
Best MYGA rates June 2021, State: California, Tenure: 10 Years
|Company||AM Best Rating||Product||Minimum Premium||Maximum Premium||Yield|
|Oxford Life Insurance Company||A-||Multi-Select 10||$20,000||$1,000,000||2.70%|
|American National Insurance Company||A||Palladium MYG Annuity 10||$250,000||$1,000,000||2.55%|
|Delaware Life||A-||Pinnacle MYGA 10 Year||$20,000||$1,000,000||2.55%|
|Reliance Standard Life||A++||Reliance Guarantee 10||$20,000||$1,000,000||2.30%|
Note that these are not the highest MYGA rates in the market, but the ones which I recommend based on multiple factors like Credit Rating, Free Withdrawal Limits, etc. If you are just looking for interest rates, there are few companies that offer higher rates but are rated low and do not offer any free withdrawal. If you think your deposit amount will be covered under the insurance and you will not require any withdrawals, you might want to explore them too.
Fixed Index Annuities (FIAs)
Now, we are going to learn about the most debated annuity product there in the market, the FIAs. Although FIAs are the most misselled product in the annuity market, I still love them a lot. It’s just that agents should refrain from using bad sales pitches to sell FIAs.
Coming back to learning more about them. FIA uses both “Fixed” and “Index” in the same phrase. So, what is it? Is it fixed? Is it variable?
Suppose you want to participate in the markets but are too scared of losing your investment. You are looking for a product that only has an upside and no downside. Now, many agents sell FIAs describing it exactly the same, but it is NOT true. If this were true, the Fed itself would have put all its money in FIAs. However, the good news is that it is partially true!
Fixed Index Annuities are contracts between the annuitant and an insurance company in which the insurance company promises to credit interest based on the performance of a certain stock market index. Fixed Index Annuities has an inbuilt feature of capital protection, so even if the index goes down, your principal will remain safe. On the face of it, it seems too good. It is certainly a good product, but it is NOT an “unlimited upside, zero downside” product.
It is worth noting that this contract is linked to the performance of an index without the risk though you’re are not actually invested in the index. FIA is different than a variable annuity (VA). With an FIA, the insurance company assumes the risk, whereas the annuitant assumes the risk with a VA.
We will quickly go over some common terminology/catches in FIAs and then understand it with an example.
- Cap rates: Cap rate is the most important terminology in an FIA. It means at what rate your interest-earning capacity is capped. For example, if an index returned 12% but my contract’s cap rate is 6%. In this situation, I will be eligible for an interest credit of 6% only. It doesn’t matter how much the index goes above the cap rate; the maximum interest I can earn is the cap rate. However, insurance companies are trying very hard to sweeten the deal for people. We are seeing that many companies are starting to offer “uncapped” plans. We will discuss more about it shortly.
- Participation rate: Participation rate describes the annuitant’s participation percentage in a return of an index. For example, suppose the participation rate is 60%, and the index returned 10% over the agreed time. In that case, the annuitant will be eligible for only 60% of the return, i.e., 6%. The participation rate is usually below 100%, but nowadays, we are seeing plans with a participation rate above 100%. We will discuss it with the “uncapped” plans shortly.
- Spread: Spread is the percentage of the index return that the insurance company will deduct from your interest calculation. For example, if the spread in the contract is 2% and the index returned 8%, you will be eligible for the return minus the spread (8% – 2%) i.e. 6% of the return.
- Interest crediting strategy: It specifies how and when will be the interest credited. The most popular one is the annual point-to-point interest crediting strategy. It means that each year my interest will be credited on the agreed date based upon the performance of the index as compared to last year.
Example: I have $100,000. I choose an annual point-to-point interest crediting strategy based on the S&P 500. My cap rate is 6%. Over the first year of my contract, the S&P 500 went up 10%. I’m capped at 6%, so my account value goes up by $6,000, from $100,000 to $106,000 at the end of the first year. Over the course of the next year, the S&P went down 5%. I don’t lose anything, but I don’t gain anything either. My account value stays at $106,000. This goes on until the contract is over.
Uncapped Fixed Index Annuity
FIAs with no caps, and participation rates even higher than 100% are gaining a lot of traction lately. So this means if your participation rate is 100%, then you get 100% of what the index does from anniversary date to anniversary with NO risk to your principal. If there is a spread then it is never taken from the original principal or what has been locked in.
Generally, Uncapped FIA performs better than traditional annuities. According to a report by Zebra Capital Management, “using dynamic participation rates and uncapped index crediting designs, a generic large-cap equity FIA using a large-cap equity index outperformed long term bonds with similar risk characteristics and better downside protection over the period 1927-2016.”
I did extensive research to find some of the popular uncapped FIAs. Please note that the research is based on backtested data and does not guarantee that these FIAs will perform better in the future too.
|Company||Product||Interest Crediting Strategy||AM Best Rating||Minimum Premium||Index|
|American Equity||AssetShield||Annual point to point with par rate||A-||$5,000||S&P 500|
|Great American||American Legend||Annual point to point with par rate||A||$10,000||S&P 500|
|AIG||Power Protector||Annual point to point with spread||A||$25,000||ML Strategic Balanced Index|
|Allianz||Allianz 222||Annual point to point with spread||A+||$20,000||Bloomberg US Dynamic Balance Index II|
Besides it, all these policies have a free withdrawal limit of 10% each year. Moreover, you can also add riders like Income rider and Death benefit riders. Note that this list is not exhaustive and there are hundred of FIAs available in the market, which may perform better than these. I compiled this list considering several factors such as safety, liquidity, history, popularity, etc. It is likely that you may not be concerned about each of these factors, and thus may find better products according to your needs and profile.
The uncapped Fixed Index Annuity truly seems like an unlimited upside and zero downside product? What is the catch?
Although the interest rates are uncapped, they are not unlimited. These annuities will not necessarily produce the results a more aggressive investor may be looking for. As discussed, there are caveats like Interest rate caps, participation rates, spreads, and different interest crediting strategies. Even if there is no interest rate cap, there might be at least one of these caveats always in a place that will make sure that returns are not truly “unlimited”.
Moreover, these insurance companies do extensive backtesting and are almost always sure about what they are offering. They will never continue a product that is causing them to incur consistent losses. You see, they are “for-profit” organizations.
Finally, the insurance companies always reserve the right to change terms with respect to participation rates, cap rates, etc; And they DO change the terms when it suits them.
With evidence and backtesting, we can certainly conclude that although FIAs are often misselled through bad sales and high-pressure selling, they are still a very good annuity product. The insurance companies are constantly innovating their products to appeal to more and more investors, and uncapped FIA is one such good product. If properly understood, uncapped FIA can “almost” help an annuitant participate in the market without assuming the downside risk. We can conclude that FIAs is the safest way to take risk.
We will end our discussion on FIAs here.
We will now discuss briefly about Variable Annuities (VA). I didn’t mention about the Variable Annuity in the earlier section of the article because I believe that VAs are not suitable for any type of investor. We will briefly discuss it just because you understand what they exactly are.
Variable annuities are annuity contracts in which our premium is directly invested into the stock markets. The premium is invested into sub-accounts, which are very similar to mutual funds. As we are directly participating in the market, our money is now at risk. Unlike FIAs, VAs have downside risks, and we might actually lose money.
In short, VA is actually security, just like a stock, index, mutual fund, or ETF. Now I say VA is not suitable for any type of investor because VAs have high fees embedded.
An investor who is willing to take a market risk could directly invest in stocks, indexes, ETFs, or mutual funds without having to incur complex embedded fees.
VA is not suitable for any investor not willing to take a risk; thus, we can see how VA is not generally suitable for any type of investor. Although VA has one benefit that it allows for the accumulation of capital on a tax-deferred basis.
Laddering the annuities
As you are aware now that annuities can be taken either for fulfilling the goal of lifetime income, or principal protection. At the beginning part of the article, I discussed that we can even achieve both goals by buying multiple plans. This strategy is called a laddering strategy.
Laddering strategies are usually executed by fixed-income investors who invest in Bonds and CDs. They buy CDs and Bonds with staggered maturity dates. There are many benefits of using a laddering strategy; one being that you can access money when the CDs and Bonds mature without paying surrender charges. Another benefit of laddering is that it helps to mitigate the uncertain interest rate movements.
In a similar way, annuities can also be laddered. For example, you want to invest $300,000 in MYGAs. What you can do is invest $100,000 each in three years, five years, and seven years MYGAs.
You can create laddering strategies in the lifetime income bucket also. For example, you have $300,000 and want to secure a lifetime income stream but are concerned that the current low-interest rates might rise in the future. An efficient lifetime ladder would include the purchase of a $100,000 SPIA every two years for three years. Even if interest rates remain the same during that period, the subsequent payouts will be higher based on your age at the time of purchase. If interest rates rise, the payout will be even higher.
Similarly, you can combine one product each from the “lifetime income” and “principal protection” bucket to achieve both goals. For example, you have $300,000 to invest for retirement. What you can do is invest $200,000 in an SPIA and the remaining $100,000 in FIAs. This will ensure that you get a lifetime income and a part of your portfolio is protected of its principal.
Two most important riders
Earlier in this article, I briefly touched upon income and death benefit rider. I want to emphasize that they are the two most important riders in any annuity plan.
In an SPIA, a regular income stream is started immediately but this is not the case in other annuity plans like FIAs and VAs. But the good news is that you can take an optional income rider in such plans. The income rider acts as a pension that will distribute a guaranteed income for life to a retiree.
It is also known as the “Guaranteed Lifetime Withdrawal Benefit” because it guarantees to distribute a retirement income until the day the owner dies. It still holds even if the annuity has run out of money. The good thing is that while the annuitant receives retirement income from the income rider, the annuity still continues to earn interest.
Income rider quotes are different for different levels of annuity income; you can request different quotes for the income rider option from your advisor or the issuing company. To determine the required annuity income, I always suggest a simple formula,
Annuity Income Required = Current Annual Expenses + Inflation Expense – Social Security Benefits
Note: Retail inflation rate is about 2-4% in the USA
We learned that SPIAs and DIAs are lifetime income plans and the insurance company is no more liable to pay our beneficiaries after our death. But the good thing is that we can attach a “death benefit” to our annuity plan.
Let’s take an example. Suppose we attach a death benefit to an SPIA that says “Life with 50% death benefit”. If you live to a very old age of 110, the annuity company, according to the contract, will be liable to pay you an annuity no matter how long you live. But the death benefits ensure that no matter what happens with your SPIA policy, 50% of the initial premium will go to your beneficiaries upon your death. So, if you put $300,000 into a “Life with 50% death benefit” SPIA policy, then $150,000 will go to your beneficiaries upon your death.
You will be wondering if it is better to take a Life Insurance policy instead of attaching a death benefit rider. You have a valid question, but not everyone can get life insurance. In order to get life insurance, the person needs to go through medical tests as well as an in-depth review of his health history. So, not everyone is eligible for life insurance. Whereas there is no underwriting or approval process while attaching a death benefit to an annuity.
How to choose the best annuity company for yourself?
There are several companies that sell annuity in the US. Unlike your money in the banks, annuities are not guaranteed by the FDIC or SIPC. Thus, you should do proper research before taking an annuity.
Different companies’ plans would be suitable for different types of annuitants. For example, a company may not offer fee-free withdrawal but pay higher rates. Similarly, a company may offer low rates but has an option to opt for death benefits. It really depends upon person to person for what benefits they are looking for.
I am putting a checklist that contains several factors to consider before choosing your annuity company.
- Ratings from independent rating companies like AM Best, S&P, Moody’s, Fitch, etc.
- Fee-free withdrawal limits
- Surrender Fee
- Riders like income and death benefits
- Minimum guaranteed return
- Administrative and annual fee
- Reviews and complaints on trusted online platforms like Better Business Bureau (BBB)
I hope that by now, you are aware of the very high-level aspects of annuities and how they work. There is no “perfect” annuity that can be suggested to a set of investors. Each individual has different goals, and the perfect annuity for each investor varies. You first need to identify your primary goal, and then you can customize your policy by choosing suitable interest crediting strategies and riders. Below is a simple table where I have tried to summarize the whole article.
Types of Annuities
|Primary Goal||Annuity Type||Interest||Risk||Reward|
|FIA||Changes according to the stock market index but cannot go below zero.||Low||Potentially high, cannot go below a certain level|
|Variable||VA||Tied to an investment portfolio||High||Low-High|
Riders/Strategies that may be useful
|Income Rider||Helps to establish a known and regular income stream, even in plans like FIAs and VAs|
|Death Benefit||Helps with legacy planning. It can leave a corpus for your beneficiaries after your death. Suitable for those who can’t get life insurance|
|Laddering Strategies||Helps with better access of our money without paying surrender charge; helps to mitigate uncertain interest rate risk|
|Life with period certain annuity||Pay a certain number of years even if the annuitant dies before the end of the period.|
Finally, If you ever end up in an annuity that isn’t right for you, you can always get out free of charge during the free look period. If you cancel your policy during the free look period, you get a complete refund, no questions asked. Free lock periods vary by state and can be anywhere between 10 to 30 days.