Annuities are similar to mutual funds, except annuities are designed to provide supplemental retirement income for investors. The Series 7 exam tests you on the two basic types of annuities: fixed and variable. Because variable annuities are considered securities and fixed annuities are not, most of the annuity questions on the Series 7 exam are about variable annuities.
Fixed annuities have fixed rates of return that the issuer guarantees. Investors pay money into fixed annuities, and the money is deposited into the insurance company’s general account. After the investor starts receiving payments from the fixed annuity, the payments remain the same for the remainder of the investor’s life. Fixed annuities are not considered securities and therefore are exempt from SEC registration requirements.
Insurance companies introduced variable annuities as a way to keep pace with inflation. In a fixed annuity, the insurance company bears the inflation risk; however, in a variable annuity, the investment risk is borne by the investor.
Because the investors assume the investment risk, variable annuities are considered securities and must be registered with the SEC. All variable annuities have to be sold with a prospectus, and only individuals who hold appropriate securities and insurance licenses can sell them.
The money that investors deposit is held in a separate account because the money is invested differently. The separate account is invested in securities such as common stock, bonds, mutual funds, and so on, with the hope that the investments will keep pace with or exceed the inflation rate.
The assumed interest rate (AIR) is a projection of the performance of the securities in the separate account over the life of the variable annuity contract. If the assumed interest rate is 4 percent and the performance of the securities in the separate account is equal to 4 percent, the investor receives the payouts that she expects.
However, if the securities outperform the AIR, the investor receives higher payouts than expected. Unfortunately, if the securities held in the separate account underperform the AIR, the investor gets lower payouts than expected.
Putting money into (and receiving money from) annuities
Investors have choices when purchasing annuities and getting distributions. Investors may choose a lump-sum payment or multiple payments, depending on their needs. Investors also have a choice regarding how they want to get their distributions at retirement.
Look at the pay-in phase
Payments into both fixed and variable annuities are made from after-tax dollars, meaning that the investor can’t write the payments off on her taxes. However, payments into both fixed and variable annuities grow on a tax-deferred basis.
If an investor has contributed $80,000 into a variable annuity that’s now worth $120,000, the investor is taxed only on the $40,000 difference because she has already paid taxes on the contribution. If an annuitant dies during the pay-in phase, most annuity contracts require a death benefit to be paid to the annuitant’s beneficiary.
During the pay-in phase, an investor of a variable annuity purchases accumulation units. These units are similar to shares of a mutual fund.
Investors have a few payment options to select when purchasing fixed or variable annuities. Here’s the rundown of options:
Single payment deferred annuity: An investor purchases the annuity with a lump sum payment, and the payouts are delayed until some predetermined date.
Periodic payment deferred annuity: An investor makes periodic payments (usually monthly) into the annuity, and the payouts are delayed until some predetermined date; this is the most common type of annuity.
Immediate annuity: An investor purchases the annuity with a large sum, and the payouts begin within a couple months.
Investors of both fixed and variable annuities have several payout options. These options may cover just the annuitant (investor) or the annuitant and a survivor. No matter what type of payout option the investor chooses, she will be taxed on the amount above the contribution. The earnings grow on a tax-deferred basis, and the investor is not taxed on the earnings until withdrawal at retirement.
During the payout phase of a variable annuity, accumulation units are converted into a fixed number of annuity units. Investors receive a fixed number of annuity units periodically with a variable value, depending on the performance of the securities in the separate account.
When an investor purchases an annuity, she has to decide which of the following payout options works best for her:
Life annuity: This type of payment option provides income for the life of the annuitant; however, after the annuitant dies, the insurance company stops making payments. This type of annuity is riskiest for the investor because if the annuitant dies earlier than expected, the insurance company gets to keep the leftover annuity money. It has the highest payouts of all the options.
Life annuity with period certain: This payout option guarantees payment to the annuitant for a minimum number of years. For example, if the annuitant were to purchase an annuity with a 20-year guarantee and die after 7 years, a named beneficiary would receive the payments for the remaining 13 years.
Joint life with last survivor annuity: This option guarantees payments over the lives of two individuals. As you can imagine, this type of annuity is typically set up for a husband and wife. If the wife dies first, the husband receives payments until his death and vice versa. Because this type of annuity covers the lifespans of two individuals, it has the lowest payouts.
Early withdrawal penalty
As with most other retirement plans, annuity investors are hit with a 10-percent early withdrawal penalty if they withdraw the money prior to age 59-1/2. The 10-percent penalty is added to the investor’s tax bracket. Typically, retirement plans include a waiver of the 10-percent penalty in cases such as the purchase of a first home, age 55 and separated from work, death, or disability.