The History of Annuities
Annuities have been around for thousands of years. They actually date back to the times of Babylon, 2500 B.C. In those days, individuals would take assets or property or land, and use those as a means to secure income. So, the earliest basis for an annuity actually goes back that far.
The modern application of an annuity or the definition of an annuity today is essentially a contract that exists between an insurance company and an individual. An individual can make a contribution, or a premium payment, to an institution, usually an insurance company, in exchange for a systematic or periodic stream of income payments. That’s more the classic broad definition of an annuity today.
The shift of responsibility in pension plans
Annuities have gained in popularity in recent years and there’s been a higher demand for them, the evolution of annuities can explain why there is a resurgence of their popularity, but you have to go back to the 1980s, when there was a shift by employers from defined benefit plans to defined contribution plans. Defined benefit plans loosely translate to the pension plans that our fathers and grandfathers had where you would work for a number of years for a company, and then that company in retirement would take care of you and provide a guaranteed income for you while you retired as a reward for your service to that company.
In the 1980s, there was a shift from that type of plan to a defined contribution plan, which was really a 401K plan, and 401K plans essentially said that the employer would define the contribution, not the benefit. They would define the contribution on the front end to make a contribution to the employee’s retirement plan but not worry about or guarantee the benefit to be delivered in retirement.
What that did was change the market considerably and created some risk for the employee and a lot of challenges in the retirement planning area. Essentially it created instability in retirement. There was a massive transfer of risk from the employer to the employee in the process of moving from defined benefit plans to defined contribution plans. Folks who used to not have to worry about the performance of their retirement plan, their 401K plan, all of a sudden had to worry about making sure there was enough contribution going into the plan to deliver the income they needed in retirement.
Some would say that there was an advantage to that in that there was a control over your investment decisions, which is true. There was more control put into the employee but along with that control was a very substantial risk.
Instead of the employer guaranteeing in retirement that income stream, the employee essentially plays the stock market throughout his retirement years, and, if the performance of the funds within the 401K are strong, then you can have a strong result in retirement. If, on the other hand, the performance of the 401K plan and the underlying mutual funds and investments inside of that plan do not perform in that employee’s tenure, and, most importantly, right up until the point they are going to retire, they could have a significant shortfall and a gap between what they expected
to have in retirement or need in retirement as an income and what they have. So once again, this theme of risk in terms of how much income one would have in retirement was transferred from the employer to the employee.
The Annuity evolves to meet the demands of retirement
Times have changed but people’s needs have not and that is that niche that annuities fills. The annuity marketplace today is filling the gap between the loss of pension plans. In other words, it is filling in the gap where defined contribution plans are falling short.
The core idea of an annuity is to deliver a systematic payment of income to an individual, so essentially the annuity marketplace has responded to this gap, this gap between what defined benefit plans would deliver and what the defined contribution, or 401K plans, ended up with. The annuity takes on a pension-like feature because, annuities are one of the only vehicles out there that says “in exchange for a sum of money, we will guarantee a guaranteed predictable rate of return and a guaranteed income in retirement.”
Today there are different types of annuities and the demand for annuities in the marketplace has brought about quite a lot of product development and newer evolutions or iterations of annuities to address some of the various nuances and different challenges people face in retirement because of the lack of income.
Four types of annuities
1) Immediate Annuity: an immediate annuity is probably synonymous with what one would understand the basic definition of an annuity to be. In its rawest form, you make a contribution to an insurance company for a sum of money or a premium, and we will guarantee a stream of income for a period of time. That contribution of capital is surrendered to the insurance company, and the insurance company’s obligation is to deliver that stream of income either for a lifetime or some other stated period of time.
2) Fixed Annuity: Many would call a fixed annuity a CD-type annuity. Its structure and the way it’s designed would be very similar to that of a CD, so there is a term, length, for three to five years. There is an expressed guaranteed rate of return that is promised and guaranteed to an individual from point A to point B. That is the essence of a fixed annuity. It is a CD-type annuity.
3) Variable Annuity: Variable annuities have the chassis and a lot of the same benefits of an annuity. One fundamental difference is that the variable annuity is sort of tantamount, or the equivalent, of mutual funds. We think of annuity with mutual funds inside of it. That would describe a variable annuity. There is an opportunity for gain and also for loss. There is not a principal guarantee component to a variable annuity, so along with the opportunity for growth, there is also no guarantee of principal but variable annuities have become very, very popular over the past fifteen or twenty years.
- a) Tax Advantages with a Variable Annuity: The gains inside of a variable annuity, meaning as mutual funds are bought and sold for a gain, they are not taxable inside of the annuity. So there is an advantage to a variable annuity in that regard. Of course, once the money comes out of the variable annuity, then taxes will occur.
4) Fixed Indexed Annuity: or what is also called the hybrid annuity: Everybody loves hybrids these days and it really is the best of both worlds!
The hybrid annuity really attempts to pull from the attributes of the other three. A hybrid annuity will guarantee an income stream for life. It also has a fixed rate of return, and it also has upside potential like a variable annuity. There are some caps and some other features to them to fully understand them, but they really do grab and draw from the essence of all three.
Tax implications of annuities
The fixed annuity, the variable annuity and the hybrid annuity all have the same exact tax treatment in terms of gains that are credited and accrued and grow inside of them. No tax while it’s inside and taxable once it is withdrawn.
Can pre-tax money be used in annuities?
Monies accumulated in 401K or an IRA, or something similar can invest in annuities. That would be considered qualified money; IRAs, 401K rollovers; can flow into annuities. The number one reason is that a lot of times folks that are in retirement, or as they approach retirement, are shifting from an accumulation phase in their life to a distribution phase of their life, meaning they are not so concerned about the return on their investment. They are more concerned with the actual income that can be delivered from that nest egg that they worked so hard to save up for their entire lifetime. So the annuity has a very strong application to take that nest egg and deliver a predictable stream of income.
So essentially, a retiree can create a retirement from using an annuity or they can actually take their retirement and move it into an annuity; either way it fits both applications?