Understanding How Different Types of Annuities Work
By Wade D. Pfau, Ph.D., CFA, Professor of Retirement Income for the American College of Financial Services
Understanding how annuities work is the crucial first step towards subsequently then exploring the potential role they have in a financial plan. This article is based on material for my new book, “Safety First Retirement Planning,” available through Amazon.
Product allocation for retirement income is that we don’t simply think about asset allocation, which would be the world of the systematic withdrawals from an investment portfolio, but we explore as well how different types of annuities can fit into that mix.
A caveat: for this article, I’m referring to “good annuities,” as not all annuities are created equal. By that, I don’t mean different types of annuities but just are they competitively-priced. Some of these annuities can be complex, and that can obscure the pricing element behind them. The type of annuity I’m talking about can be priced competitively so that they can provide that value to consumers.
What are the Basic Annuity Vocabulary Concepts?
Annuity vocabulary can create much confusion because they can refer to different things, and so it’s not always clear what was meant.
The first issue to address is, are we talking about fixed or variable annuities? These terms don’t simply refer to the returns coming from the annuities. It refers to something deeper. A fixed annuity is taking premium and investing that in the general account of the insurance company. It might provide a fixed return if it’s a traditional kind of deferred fixed annuity, or it may be more of a fixed index annuity where it might have a variable return linked to an index. But it’s still technically a fixed annuity just because that’s how it is regulated and structured. Any fixed annuity will provide principal protection.
However, a variable annuity is regulated differently. It’s more like a security; it can have principal losses; the account value can have a capital loss connected to it. The variable annuity also allows for investments in sub-accounts, which are not technically mutual funds, but which behave in a very similar manner, so you can choose an asset allocation and choose underlying funds and have a variable return. You could also have a fixed return with a variable annuity. Again, the idea is you are investing in a sub-account that gave you a kind of short-term cash-like return, and it’s regulated like a security.
Now the other important concept to address is immediate versus deferred annuities. This can be confusing because it can refer to two different things.
Both a single premium immediate annuity or a deferred income annuity are immediate annuities. What we’re talking about with these terms is, “When is the contract annuitized?” The contract would be annuitized immediately. Immediate versus deferred can also refer to when do the payments start. In that case, an immediate annuity would begin payments within the first year. With a deferred annuity, you would pay the premium today, but the income it provides would not start for at least a year. That’s one way those terms get used, but that’s not the general context of what these terms mean. With an immediate annuity, you annuitize the contract immediately today. When the payments begin is a separate issue. That’s important because we’re going to be talking about deferred annuities with guaranteed living withdrawal benefits.
Now with a deferred annuity, you might start the income immediately – with guaranteed withdrawals – but you’re not technically annuitizing the contract. You still have a contract value, you still have liquidity, and you can still receive guaranteed lifetime payments through an optional living withdrawal benefit, but the contract has not been annuitized. So, you could have a deferred income annuity, but it’s annuitized immediately.
You lose the liquidity for that contract versus just a deferred annuity. You could have guaranteed payments start immediately, but a deferred annuity with a guaranteed living withdrawal benefit can provide a lifetime income without annuitizing the contract the annuitize. The annuitization process is deferred, and it’s contingent upon if you ever deplete the contract value, then that’s when the guaranteed living withdrawal benefit would kick in and provide the lifetime income.
How are Different Types of Annuities Priced?
In terms of how these are priced, it depends on three ingredients:
- Mortality rates, which are going to be based on age and gender. They impact how long the payments will be made. The longer someone is expected to live, the lower the payout rate is because you must extend those payments out for longer. Younger people and women live longer than men so that these factors will reduce the pay rate.
- Interest rates, which are going to impact the returns that the insurance company will be generating with the premium that it places into its general account. Higher interest rates can translate into higher payout rates from the annuity.
- Overhead costs are the extra charge the annuity provider needs to cover both its business expenses and to manage the risk around pricing an annuity. They will make assumptions on mortality rates and interest rates. They need a bit of a cushion or a reserve if they are wrong about their estimates. This will be reflected in overhead costs.
The way an income annuity is priced is it is simply a present value calculation. It’s a little bit more than just a present value because it also accounts for survival probabilities.
We’re looking in an example for a 65-year-old female. We’ll make the yield simpler by assuming a flat yield curve at 3%. What would be the cost for this 65-year-old female to fund $10,000 a year of income for her lifetime? The first step s to determine how much it would cost to build that through a bond ladder. If she buys individual strip bonds maturing each year – so they’re not paying coupons to make the calculations a little simpler – how much does she need to set aside for each future payment? Through age 100, it would cost her about $225,000 to fund $10,000 a year of income through age 100 with just a bond ladder.
In terms of the 4% rule style, like what is a sustainable spending rate, that would be the $10,000 of spending divided by a $225,000 cost or a 4.45% withdrawal rate.
Now the annuity considers the cost of the bond ladder. But because of the risk pooling element where the insurance company can rely on the law of large numbers, they can apply survival rates to those numbers, and those survival rates decline with age.
So, the cost of the annuity would be summing up not just the discounted values, but those discounted values multiplied by their survivor probabilities. If we add those up through age 104 (even longer I did with the bond ladder), that’s still just about a $173,000. Funding retirement with bonds to age 100 would just cost roughly 30% more than funding retirement through an annuity that would provide that payment for a lifetime (for a life only version).
This implies an annuity payout rate of 5.78%, which is the $10,000 of annual spending, divided by the $173,000 cost. This is the basic way a simple income annuity gets priced.
Now you could see lower payments if you want more certainty for the payments, like if you want period-certain or a cash refund. If I want ten years of period-certain payments, the adjustment is those survival probabilities for ages 65 to 75 would all stay at 100%. It’s not that the individual is immortal at that point, but those payments continue regardless of whether the individual is alive. This would raise the cost of the annuity and lower its payout rate.
Same concept with other provisions. If you want a joint life payout instead of a single life, there is a higher probability that at least one person of a couple will still alive versus the likelihood of just one individual in isolation, so that would lower the payout rate. Or if you want a cost-of-living adjustment on the payments to increase over time, there would be a lower initial payout to account for that.
What are the Fees on Annuities?
The consumer media just mixes every kind of annuity into one jumbled mess, so if they talk about no liquidity and high fees, that’s not something that exists.
The high fees part usually is a variable annuity feature. These are the potential fees on a variable annuity:
- Underlying fund expenses, just like any sort of expense ratio on a mutual fund.
- There’s a mortality and expense charge. For the traditional annuity that’s commission-based, this would be used in the long run to support the commission to that advisor, as well as cover other company expenses and support the basic death benefit of the contract.
- There can be a surrender charge schedule that doesn’t apply to guaranteed distributions. If you just want a free distribution that is not part of the guaranteed living withdrawal benefit and it exceeds a certain level, typically, the annuity will allow you to take up to 10% of the account balance every year without a surrender charge. But if you want more than that back, for that liquidity in the early years of the contract, there’s a surrender charge scheduled that will decline over time, and eventually get down to zero. So, it’s not a factor for long-term holders, but it can impact a short-term holder.
- Then there are charges for the optional living benefits such as the GLWB or other death benefits or living benefits.
Now today, we see more in the way of fee-only annuities, so they don’t pay commissions. The framework is there now for the advisor to treat annuities as any other assets under management that the advisor could charge an AUM fee on if they wish. Because there’s no commission built into the contract, that can substantially reduce mortality and expense charges and substantially reduce or possibly even eliminate surrender charges so that it can dramatically reduce the overall fees on a variable annuity.
When we think about variable annuity fees, there are two issues to think about. With a systemic withdrawal strategy, you might be looking at the lower payout rate because you’re worried about outliving your money. So even if the annuity has a higher fee drag, you might be able to fund your retirement goal with fewer assets. And in that regard, it’s not the fee drag that matters; it’s how expensive is it to fund your retirement? The variable annuity might allow you to support a retirement spending goal with a smaller asset base.
There’s also the asset allocation issue, where if the owner of the annuity is comfortable investing a little more aggressively, the additional equity exposure could more than offset, or a potentially offset much of the fee drag, and not necessarily reduce the long-term net legacy from the contract. Fees don’t necessarily have to lead to smaller legacies if it’s accompanied by a little bit riskier asset allocation as well.
What is the Return on an Annuity?
One issue that confuses consumers is the idea that some think that the payout rate implies a rate of return from the annuity. That’s not the case. You don’t compare the payout rate on the annuity to a return from building a CD or a bond ladder, because the payout rate on the annuity includes the return of principal. It is comparable to a 4.4%-rule style calculation in terms of a spending rate from a portfolio that also implies spending down principal if you have the matching assumption on whether there’s an inflation adjustment or not, but that’s the idea. The payout rate involves interest, return a principal, and mortality credit. It’s not just an interest rate that you’re earning.
Though, there is an underlying investment return that would be part of the insurance company’s general account where they’re investing those premiums and that they are factoring into the payout rate they can provide. If they’re able to earn a higher rate of return on the general account, they can offer a higher payout rate on the annuity. So that general account is primarily a fixed-income investment, but they’re able to use asset-liability matching. They have a good idea of their expenditures each year, so they can match bonds to those expenditures so that they have comparable maturities. That can allow them to earn a higher fixed income yield than a household might be able to earn, especially if the household is not in mutual funds and bond mutual funds. The insurance company can focus on a longer maturity, have more diversification for the credit risk, and invest in less liquid bonds because they have less need for liquidity. They’re holding those assets to maturity and benefiting from institutional pricing on trades so that they can get a pretty good underlying fixed income return relative to the household. That’s working behind the scenes; that’s not observable. What you do observe is the payout rate from the annuity.
Now a common question is, are annuities expensive? For an income annuity, the answer, “Compared to what?” Fixed annuities are spread products. They don’t charge external fees, so in that regard, you don’t see a fee associated with it, but it’s just like with a checking account. The insurance company is expecting to earn more on the deposits then it pays out as an interest rate.
If you want to know the implied cost of the annuity, you just do your calculation. It’s called a money’s worth measure, where you should be realistic for the household. What could the household earn on its fixed-income investments, and that would lead you to the discount rate or even to use an entire yield curve. Then you also want to think about what are reasonable mortality assumptions/survival probabilities for that household?
Then with those ingredients, what would be the fair price for the annuity? You take whatever payout rate you get from that, and you compare it to the commercial payout rate. A reasonable price would be 5.8% as a payout rate, and then you look at the commercial annuity, and it’s a 5.7% payout rate. That is a 10-basis point difference, which is the implied cost of the annuity.
With deferred income annuities, they’ll offer higher payout rates for two reasons:
- You’re delaying the payments until later ages when you have a lower probability of survival
- Because you’re paying a premium beforehand, that premium has a chance to grow in the insurance company’s general account.
These two factors would allow you to translate from a single immediate annuity versus a deferred income annuity and in the higher payout rate it provides.
What are Income Annuities? (SPIAs and DIAs)
Simple income annuities are all immediate annuities because they will annuitize the contract immediately. They do not have liquidity. This could be a single premium immediate annuity (SDIA) or a deferred income annuity (DIA), but it’s deferred because payments start later. It’s immediate because you are annuitizing the contract when you pay that premium.
So, who’s covered by these types of income annuities? You have an owner who will receive the payments, the annuitants whose lifetime the payments are based on. Usually, the owner and annuitant would be the same individual, but they can be different. Then the beneficiary would be anyone eligible for a death benefit from the contract. The payments could be started immediately, or they could be deferred. You could have this for one life or a joint annuity for two lives.
You can have different flavors of payouts. With the life-only version, you’re offering the most risk to the risk pool. If you sign the contract and then get hit by the bus leaving the office, you would lose the entire premium, but because of that, you’re going to get the highest payout rate. You are offering the most mortality risk to the risk pool, so you’ll get the most mortality credit back from the risk pool.
If you’re not comfortable with that approach, though, you can have other provisions like a lifetime payment but at least maybe ten years. So, if the annuitant passes away in the first ten years, payments would continue for at least ten years.
Or you could have a cash refund whereas the premium is returned as payments, if the annuitant passes away before the entire premium has been returned, the difference would be refunded to the beneficiary. It’s a similar idea with installment refunds, but instead of getting one lump sum refund, it would be provided in installments. You can even have annuities that are not linked to lifetime payments, but that are simply a fixed number of years, and so can be an alternative to building a CD ladder or a bond ladder. As well, payments can be fixed, or they can grow over time. They could be level payments. They could have fixed cost of living adjustments such as a 2% or 3% annual increase that you’d try to benchmark to what you believe inflation might be. Or they can be inflation-indexed through the CPI, although since November, there is currently no commercial provider of an inflation-indexed income annuity.
What are Deferred Variable Annuities?
General features of a deferred variable annuity are:
- If you add an optional guaranteed lifetime withdrawal benefit (GLWB) that gives you downside spending protection. Spending is no longer linked to market performance because even if the contract value depletes, you get that guaranteed income at that spending level.
- At the same time, you have upside potential because you are now able to invest in sub-accounts, and can you have asset growth.
- The GLWB could have a provision that will lead to higher income step-ups as well if the contract value is growing.
- Also, because it’s a deferred annuity and the contract is not annuitized, you do have liquidity. You can take out more than the allowed guaranteed levels. If you want, it will reduce the subsequent guarantee, but that would be true for an investment portfolio as well. You can spend more from your investment portfolio if you want, but you better anticipate spending less subsequently.
- Any deferred annuity is also going to provide a tax deferral element. Another popular use for deferred variable annuities with RIA-type (registered investment advisor) fee-only advisor is to use a low cost, investment-only variable annuity to get tax deferral. If the annuity cost is less than the tax deferral benefit, you’d have an advantage there.
Behaviorally, with the deferred variable annuity, you can get the value of that risk pooling in the mortality credits without “sacrificing” the asset. With an immediate annuity, you are annuitizing the contract, and then the asset disappears from the balance sheet. Advisors who are used to managing their clients with a portfolio statement and with account balances, now with the fee-only variable annuities that are out there, that’s all still on the balance sheet. It’s an asset, you have sub-accounts, and you can invest it. That’s something that you can get the value of lifetime income without behaviorally-speaking, giving up that asset for the household. You still see the assets on the balance sheet. It may also provide some comfort to invest a little more aggressively because you have the guarantee in place. That GLWB is like a put option on the stock market. If the stock market tanks, income is protected on the downside. If the stock market goes up, you might be able to get some step-ups.
So, you have downside percent protection with some upside exposure. It can also help to stay the course with market volatility as well, because then if the market tanks, a client may be less likely to panic and sell off their stocks because they know they have that guarantee in place.
What are Fixed Index Annuities (FIA)?
Fixed index annuities have a lot of the same general features as the variable annuity. They have:
- Principal protection; the contract value cannot experience a capital loss.
- Lifetime spending protection through the optional GLWB.
- Some degree of upside potential, but generally, the idea is there somewhere in the middle between an income annuity and a variable annuity, where there is more downside protection than the variable annuity but less upside potential in the variable annuity.
- Liquidity because they are a deferred annuity. The contract is not being annuitized.
- Tax deferral to the extent that is a potential benefit as well for the client.
- The power of risk pooling to the GLWB without “sacrificing” the asset as you would with an immediate annuity that annuitizes the contract. You can still see the asset on the balance sheet. It’s something the advisor can manage.
- A fee-only version of the fixed index annuity is just like another asset class that the adviser manages with principal protection. You’re not at risk of a loss with a market downturn, and compared to bonds, if interest rates go up, you can have a capital loss. There’s no capital loss on a fixed index annuity so that can potentially allow for more comfort with investing a little more aggressively elsewhere because you have essentially a bond-like asset that’s not even exposed to a capital loss as part of that asset allocation.
The return on an FIA credits interest to the contract that could be a fixed interest rate or this is where you could get a variable return, where the fixed interest that’s credited could be linked to the performance of an external index like the S&P 500 or others.
When the FIA is linked to an external index, the FIA is not actually investing in that index. The interest that it will credit is based on the performance of that index as calculated using financial derivatives. That means the interest credited will be based on the price returns of the index – it doesn’t include the dividends – so it’s not the total return of the index. It’s the price return without the dividends.
You have principal/downside protection, which implies the contract value does not decrease, even if the index experiences a loss. If the contract value is linked to the S&P 500, and the index is down 40%, the contract has a floor of zero, and you don’t have any loss. The trade-off, of course, is you’re going to have to give up some of the upside exposure to have that downside protection.
In terms of the fees on an indexed annuity, you’re not investing in the fund, so there are no underlying fund expenses. There are no mortality and expense charges. So, you cross both of those out, and that’s where you can hear the concept that an FIA is no fees. There is a fee, but it’s a spread product. As with an immediate annuity, the fees are baked into the idea that the insurance company is generating more on the premium than it’s going to be paying out to the individual.
There can be a surrender charge schedule attached to the contract. If you do want the GLWB to provide lifetime income, that’s an optional thing that you’re adding to the contract, and that does have a fee that will be charged against the contract value. There is also this unobserved internal spread, just like a single premium immediate annuity where you don’t see it. Still, the insurance company is getting a higher return than what they’re paying out.
We now have fee-only, fixed index annuities that are much more friendly for the RIA. They don’t pay commissions, which can reduce surrender charges or potentially eliminate surrender charges and reduce that unobserved internal spread as well. Because they’re not compensating the advisor through the annuity, the adviser would make that charge separate from the annuity. You might still like to have a surrender charge schedule on an FIA, not because it was needed to pay a commission, but because that allows the insurance company to invest in less liquid, longer-term bonds that could potentially yield more. If you hold the contract for the long-term, you might get a better return from it and never have to realize any surrender charges.
- Understanding how annuities work can help to illuminate why they may add value to a retirement income plan.
- Annuitized contracts lose liquidity and upside but generally offer the highest guaranteed income.
- Deferred annuities with living benefits continue to provide liquidity and upside.
- Variable annuities generally offer more upside potential, but less downside income guarantees than fixed index annuities.
About Wade D. Pfau, Ph.D., CFA, Professor of Retirement Income for the American College of Financial Services
Wade D. Pfau, Ph.D., CFA, is a Professor of Retirement Income in the Ph.D. program for Financial and Retirement Planning at The American College in Brin Mawr, PA. He also serves as a Principal and Director for McLean Asset Management, helping to build retirement income solutions for clients, and Chief Planning Strategist of software provider inStream Solutions. He holds a doctorate in economics from Princeton University and publishes frequently in a wide variety of academic and practitioner research journals on topics related to retirement income.
Wade hosts the website and is a monthly columnist for Advisor Perspectives, a RetireMentor for MarketWatch, a contributor to Forbes, and an Expert Panelist for the Wall Street Journal. His research has been discussed in outlets including the print editions of The Economist, New York Times, Wall Street Journal, Time, Kiplinger’s, and Money Magazine. He is the author of Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement and How Much Can I Spend in Retirement? A Guide to Investment-Based Retirement Income Strategies.
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©2020, Wade D. Pfau, Ph.D., CFA, Professor of Retirement Income for the American College of Financial Services. All rights reserved. Used with permission.
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