Listed below are some of the common terms you may hear when speaking to an agency. These can be some what confusing for some, but if you want to have a some information handy, here is a good resource.
The amortization process is a complicated mathematical process on how funds are distributed over a length of time. Insurance companies use this process for all of their annuity distributions. While it might be a difficult math problem to overcome, the logic behind it is much clearer. Remember, the actual math is done by computer, making it far more accurate when dealing with fractions of pennies.
Your annuity, regardless of whether it’s a fixed annuity or a variable annuity, gains interest over time. It gains interest while it is in the accumulation phase, where you are supplying a consistent stream of premiums. But what happens to the amount that you have invested after you begin distributions? This is where the concept of amortization comes in. Your money doesn’t just stop gaining interest during the annuitization phase. Interest still accumulates on a regular basis.
This will be more apparent with an example. Assume you have $100,000 in an annuity. If your distributions equal 1 percent of your investment each month, you are going to receive distributions of more than $1,000—even though 1 percent of $100,000 is $1,000. Amortization tables come into play here and raise the distribution amount. Things like your underlying interest rate, the amount you have invested, and your distribution type all dictate these numbers. So you might actually be getting around $1,250 each month instead.
Interest accumulates even when you stop contributing to your annuity. The insurance companies extrapolate where they think your investment will go for the length of time you are going to be receiving distributions. If you choose a straight life distribution, mortality tables come in and help them find an average based upon the general populations life expectancy. The insurance companies don’t know how long you as an individual will live, but they do have numbers that reveal the average life expectancy for the entire population. The law of large numbers allows insurance companies to find out the average age of their clients and they adjust their figures to account for this. Some clients will receive more and some will receive less—but over a large enough sample size these all even out.
So let’s say that your $100,000 annuity has a fixed rate of 3 percent. Untouched, this would be $3,000 per year. If the mortality tables say that you have twenty years, on average, left to live, the $3,000 would build up every year. So after year one you would have $103,000. After year two, you would have $106,090. The interest gains interest here as well, accounting for the additional $90.
But what happens when your yearly numbers start changing? The amortization calculators determine your interest in this instance. Let’s go back to our example and see how this could theoretically work. If you get yearly distributions of $1,250, you would be getting compounded interest on your amount, but it wouldn’t give you interest on the full $100,000 since you have withdrawn $15,000. Nor does it give you interest on the final yearly number of $85,000. The amortization table looks at how much interest is gained per day, and then applies the specific amount at the end of the month or year, depending upon your annuity’s structure. In reality, you are getting interest credited based upon how much you have in your account on a daily basis. The daily interest rate is extremely low—3 percent per year comes out to about 0.008 percent per day. So to find your amortization rate, you need to calculate your balance on a daily basis with that 0.008 percent interest and see where that lands you.
With the original balance of $100,000, this comes to $8 per day on day one. So for the first 30 days, you would earn slightly more than $240. I say slightly more because you are adding 0.008 percent interest every day and that interest is also gaining interest—but this is occurring at such a small rate the difference is less than a penny. The new balance of your account is then around $100,240 at the end of the month. After the $1,250 is withdrawn, your account now stands at $98,990. Then the process repeats itself for the life of your annuity.
This is, as you can see, a complicated method of accrediting interest, but the bottom line is that you will gain interest on your investment even after you begin receiving distributions. The amortization tables will give you a more exact number than the example above, but the math here is based upon the same logic, only simplified so you can better understand where the tables are coming from.
The participation rate ultimately decides how much your equity indexed annuity will gain in a given year. This is a formula that determines how much will be credited to your annuity’s balance. If you have a 75 percent participation rate and the index rises by 5 percent, you will only see a rise of 3.75 percent in your annuity’s balance. This might seem unfair at first, but it is a way to make sure that your annuity is protected during poor market times. Participation rates can change from year to year. But they are designed to deliver consistent performance with your investment—even if your investment loses money. Because participation rates necessarily give you lower returns than the actual market performance dictates, there is money available for your annuity even in years that the market goes down in value.
The biggest thing to think about with participation rates is how they can limit growth. A variable annuity can have potentially unlimited growth. In theory, there is no limit as to how high an asset will go in share price. An equity indexed annuity should be able to enjoy a good deal of growth, minus expenses and reserves for future years. If unlimited growth is your goal, you will want to avoid this type of annuity. Low participation rates might deliver in bad years, but in good years, they can severely limit your earnings. Consider all of your other options before you go with an equity indexed fund with a low participation rate.
Regardless of whether you have a fixed annuity, a variable annuity, or an equity indexed annuity, the best part of saving is when you start seeing the benefits of all your hard work. The accumulation phase is where the hard work comes, but after you annuitize your contract, you will start getting monthly distributions.
When it comes time for the distribution stage, your earnings will be taxed on a last in, first out basis. An annuity’s interest is the first thing that will be withdrawn, so your first distributions will be taxed more heavily than later distributions will be. This is standard for all annuities purchased after 1982. This is where the similarities in distribution methods end. There are many different ways to get distributions from your annuity contract, thus helping you to further personalize the annuity you have bought and put it to the best use possible.
Straight life is the most basic option. This distribution will give you a set distribution amount that you will receive each month for the rest of your life. This is valid regardless of whether you live one month after the annuitization period begins, or if you live for another forty years. If you are worried about outliving your money, this option is your best bet. Once you pass away, the remaining money belongs to the insurance company—even if you have only received a single payment.
Obviously, when you are talking about a married couple, a straight life policy isn’t exactly the best distribution choice. Insurance companies have created joint and survivor distribution options. While the payout for these is generally lower per month than a straight life distribution would be, after the primary owner on the account passes away, the surviving spouse will continue to receive distributions.
There are a few sub-choices available with a joint and survivor method. The spouse can receive up to 100 percent of the distributions if they choose for the remainder of their lives. Or, if you want larger payouts in the beginning of the distribution phase, you can choose the joint and survivor plan with a lower percentage paid out after the primary owner of the annuity dies. For example, you might choose a 75 percent joint and survivor account. This would give you larger payouts while both spouses are alive and 75 percent of the original distribution amount will be given to the surviving spouse after the primary owner passes away. The 75 percent payout in this example would go to the survivor for the rest of their lives.
Period certain is one distribution variation that many people choose. This is pretty simple in nature. You select a time frame, and your investment—plus any gains—will be returned to you over that set period of time. You can choose a twenty year period certain, for example, and the insurance company will determine just how much interest you would earn over that time and will then calculate how much to return to you each month so that you see a consistent amount on your distribution check each month for twenty years.
Life with period certain is another option. With this, you can leave some of your money behind after you die. You need to select a period of time which you want your annuity distributions to continue after your death. This can range from five years up to twenty. The longer the period certain, the smaller your distribution size will be.
Many insurance companies are now offering flexible distributions as well. This is a cutting edge new take on the rigid nature of annuity distributions. With this you have much greater control over your money. You can select a set amount that you would like to receive and a set amount of time for how long you would like to receive it. If there is money left over after the amortization is calculated, you have will have open access to that remainder of your investment.
Your payments into any annuity are referred to as premiums because an annuity is a life insurance product. Payments for insurance policies are known throughout the industry as a premium.
With that said, how do you make your premiums work best for you? The earlier you pay a premium, the more beneficial it is to you. This is because of the interest that is paid into your account. If you have a fixed annuity with a 3 percent interest rate, you are gaining 3 percent interest on your premiums and any residual interest that has accumulated on the annuity. You are also going to gain interest at the above rate on any money that is tax-deferred.
If you are not convinced of the importance of investing early on in your professional career, look at the below example:
Assume Person A invests $2,000 at the beginning of each year for eight years. Person B, who is entering the professional workforce at the same time, doesn’t want to start investing until they have more money. So they don’t invest anything in those first eight years. At the conclusion of the first eight years, Person A stops investing in their annuity and Person B begins. Thirty nine years later, who do you think would have the most money? So Person A contributes a total of $16,000 while Person B contributes $78,000 over the course of the 47 years. For the purpose of simplicity, we will assume that the interest rate is a uniform 10 percent.
The answer is Person A. Because of compounding interest, Person A has a nest egg of over $25,000 at the eight year point while Person B has nothing. At the end of the 47 year total period, Person A will have $1,035,161 and Person B will have $883,185.
Paying your premiums early on in life is essential to financial success down the road. Waiting only eight years put Person B at a huge deficit, one that he was never able to compensate for. If you want to have a good retirement, making plans early on will greatly increase your financial well being.
Annuities have different stages in their growth. The first stage is called the accumulation phase. This is where your annuity is accumulating funds. Through either a single lump sum contribution or by flexible premiums, your annuity is funded by your contributions. Interest also begins to grow during this phase. In other words, the accumulation phase is all about increasing your savings. Between the money you put in it and the interest that those funds incur, this is the phase where you grow your wealth.
The next phase is the annuitization , or payout, phase. Here, the money starts coming back to you. There are a lot of variables and customizations that you can attribute to your annuity, but during this phase, your money and its growth is returned to you. These funds are taxed on last in, first out basis, so you will have to pay more taxes on your first distributions than you will later on in the life of the annuity.
You can choose to have money come back to you instantly in an immediate (sometimes called “income”) annuities. Or you can have a deferred annuity where your funds grow for at least a year before you start receiving distributions. There are also advanced life deferment annuities. These products are generally straight life products and do not start giving out distributions until the annuitant is at least 80 years old. This is a great way to make sure that you never run out of money.
Once the annuitization phase begins, your annuity is locked in place. You cannot add more money to it, nor can you change your distribution options. In rare instances, this can cause a problem for people, especially if an emergency arises and they need a large sum of cash immediately. While you have the annuity still within the accumulation phase, you can withdraw money, with a penalty added in most instances. But once you annuitize your contract, you are locked into the repayment plan that you selected.
There are a couple solutions to this. While in most cases, you will want to leave your annuity untouched—they are designed to fund your retirement—you have an out if you do need money. If you have not yet annuitized your contract and you’ve had your annuity for over ten years, in the vast majority of cases, the insurance company will not penalize you for withdrawing all of your money. You will still get the interest you accrued in this instance, but there will be no annuitization of your contract. The downfall here is that your money becomes more limited; you will no longer gain interest on your savings, nor will you have the budgeting benefits that annuitized contracts come with.
Going to an institution that buys annuities is a last resort if you need a lot of cash fast and you have already annuitized your contract. These companies will pay you a lesser amount than what your annuity is actually worth and will receive the benefits from the insurance company instead of you for the rest of the contract’s life. Such measures should only be used if absolutely necessary as you will lose quite a bit of money. But if you need instant access to your money and your savings are locked into an active contract, this can provide you with cash quickly.
Qualified vs. Non-Qualified
A qualified annuity is purchased and funded by pretax dollars. In other words, this is money that comes to your straight from your employer without any taxes being withdrawn from it. IRA annuities, Roth IRA annuities, and 403(b) plan annuities fall into this broad category. You will ultimately be paying for this type of annuity eventually, but earning interest on money that would otherwise be lost to taxes will greatly increase your earning potential. Tax deferment is a great quality with annuities—this type of annuity plays tax deferment to the fullest degree.
Nonqualified annuities are bought with post-tax dollars. This type of annuity does not have the maximum benefits that qualified annuities do, but they are still superior to most other investments. For one, you don’t have to worry about where the money for these comes from. Premium payments can come from anywhere, not just earned dollars. This type of annuity will still be taxed, but at the exclusion rate. This formula determines how much of your distributions are taxable and how much are not. Annuities are taxed in a last in, first out basis, thus making your first few distributions the most heavily taxed. The more you withdraw, the less your taxation rate will be.
Qualified annuities seem to carry the most benefits, but there are exceptions to these. They are not always accessible to everyone. For example, 403(b) retirement plans are not available within the private sector, so while they might have more tax benefits, Nonqualified annuities also have an important place within your portfolio.