September 2010
How To Help Annuity Customers Understand The Basics
By Emma Isakson, Legal Intern
What should every annuity client know about their annuity? This may seem like a simple question, but as you know, annuities are unique and complex products. It can be difficult to determine what is truly important for a consumer to know. Here’s our list:
Five Key Things Every Annuity Client Needs To Understand
- Interest crediting
- Accessing funds
- Taxation and penalties
- Financial strength of the insurer
- Suitability
1. Interest crediting
Consumers need to know how their fixed annuity will make money. The answer is interest crediting. An annuity begins with the consumer's first deposit of principal, which can be purchased with a single premium payment, fixed payments or flexible payments. An insurer will guarantee that the consumer will receive the principal and a given level of interest of their annuity either beginning immediately or at some future date. Interest rates are determined by the insurance company and usually depend on how long of an accumulation phase the consumer agrees to in their contract. The interest rate that is earned during this accumulation phase grows income tax free and is not taxed until it is withdrawn, which is one of the great benefits of an annuity. When looking at the overall picture of gains in an annuity, the first amounts of interest grown are treated as interest income and further amounts are considered a recovery of cost.
2. Accessing funds
Consumers should also have a clear understanding of the various ways to access funds from their annuity and whether a surrender charge will apply. Deferred annuities typically provide for a wide array of withdrawal options - everything from a withdrawal of a portion of the proceeds (perhaps with a minimum withdrawal amount and/or a minimum amount which must remain to keep the annuity in force) to a complete surrender, or termination, of the annuity contract. But in exchange for this access, or liquidity, a surrender charge is typically imposed (for example, a "five year surrender charge schedule" - five percent the first year, declining 1% annually thereafter) on any withdrawal taken during the surrender charge period. After the surrender charge period, any funds may be withdrawn without imposition of a surrender charge.
Consumers should also understand how to access funds during the surrender charge period without surrender charges. For example, a deferred annuity may provide for "interest paid as earned," meaning that interest may be paid out as it is earned without incurring a surrender charge; or it might offer a“10% free out," meaning that up to 10% of the annuity value may be withdrawn without a surrender charge; or if, after purchasing the annuity, a consumer should need to enter a qualified nursing home, funds may be withdrawn without a surrender charge; or the deferred annuity may allow for the consumer to initiate an income option (for example, a single premium immediate annuity for the life or life expectancy of the consumer) without imposition of surrender charges.
3. Taxation and penalties
An important piece of consumer information related to receiving payments is taxation and penalties. One of the benefits of some types of annuities is that the consumer has the chance to shift into a lower tax bracket before payments begin. However, there are some things to be aware of. For example, if a consumer receives a lump sum of their annuity, it could result in a significant tax burden. Also a 10% penalty tax is imposed on withdrawals of accumulated interest prior to age 59 ½, in addition to regular taxation. There are a few exceptions to this rule however, including terminal illness or if the annuitant becomes a nursing home resident.
4. Financial strength of the insurer
An important aspect to choosing an annuity that people sometimes overlook is the strength of the insurer that issues the annuity. It is important to compare the relative financial strength of insurance companies through services such as A.M. Best, Moody’s Investor Service or Standard & Poor’s. A consumer should insist on a strong credit rating. For example, The Standard is rated A (excellent) by A.M. Best, A1 (good) by Moody’s, and AA- (very strong) by Standard & Poor’s.
5. Suitability
Finally, a client needs to be able to gauge whether an annuity is the right investment for their personal financial goals - in other words, whether is it suitable for them. For example, an annuity might be a good investment for a consumer if they want retirement income that cannot be outlived. Another example is if an investor wants a guarantee that a given level of interest will be credited to his/her investment, or an investor wants a conservative complement to other more aggressive investment vehicles. Some important things to consider when recommending an annuity to a consumer are financial status, risk tolerance, investment goals and age. Prospective clients may not be financially sophisticated, so they must be given information which describes the product and its features as well as the company offering the product.
The detailed key concepts above should be a helpful tool when describing annuities to consumers and help give them all of the basic information they need to know before making this investment.