An annuity is a stream of income paid to the client over a specified time period.  Generally, annuities can be either:
  1. Fixed or variable-where the amount paid is based on the nature of the underlying investments,
  2. Single premium or flexible premium-how the annuity fee is paid,
  3. Immediate payout or deferred payout- which determines when the annuity payments begin.
Aside from these basic categories, annuities have a broad range of additional options available to customize the type of policy for the appropriate needs of the client.  Annuities have four main parties:
  1. The insurance company providing the annuity contract,
  2. The owner who purchases the annuity contract,
  3. The annuitant over whose life benefits are paid, and,
  4. The beneficiary who may receive payments after the death of the annuitant. 
Payouts are determined based on the life expectancy of the annuitant.  Payments are initially made to the annuitant then finally to the beneficiary based on the payout and survivor benefits selected.  Payouts can be for a certain period of time (term certain) or for the life of the annuitant with some portion to the remainder beneficiary.

Growth of annuity assets is tax deferred while the investments are in the annuity account. Tax treatment when benefits are distributed depends on the method of payment of the annuity contract. Non-qualified annuities are purchased with money on which income taxes have been paid. According to Section 72, withdrawals and annuity payments from a non-qualified annuity are taxed using an exclusion ration so that a portion of each payment is return of principal and a portion is taxable.  Return of principal (basis) is tax free while the rest is taxed at ordinary income. 

Qualified annuities are generally sponsored by employers, meaning that most of the purchase cost of the annuity contributions will be pre-tax (i.e. not taxed) when added to the account.  As such, they are subject to required minimum distributions at age 70.5 with taxes due on the entire distribution amount as ordinary income.  Distributions before age 59.5 are assessed a penalty and taxes for both non-qualified and qualified annuities.

Once the appropriate retirement spending need has been identified, it is possible to discern which expenses make up the base level of spending versus the discretionary level of spending.  One useful strategy is to purchase an annuity to provide the base level of expenses while keeping assets aside for the discretionary expenses and potential medical expense shocks that may occur. 

Specifically, an immediate life annuity could serve as the fixed income portion of the overall portfolio along with an equity portfolio.  An annuity is considered as an alternative to other fixed income because as explained by Pittman (2013, November) “Annuities are designed to perfectly hedge one’s retirement spending liability, and they tend to have a higher yield to the retiree than a bond due to mortality credits” (p. 56).  Purchasing the immediate annuity could take place at multiple times depending on specific needs with consideration given to liquidity, bequest motives, longevity, and maximization of income.  Pittman (2013, November) confirms that this combination will allow the annuitant to:
  1. maintain liquidity for as long as possible, have the option to fulfill bequest motives for longer should death occur prior to the annuity purchase,
  2. secure income for core expenses through the remainder of their life thus partially transferring the longevity risk to the annuity company, and
  3. receive a higher income than a combination of bonds with equities by adding in the mortality credits from the annuity contract (p. 60).
Annuity contracts are complex investments and require considerable analysis to ensure the annuity contract purchased is the best vehicle for the client. We, at Paragon Financial Advisors, will assist in the analysis of those contracts. As fee only advisors, we do not sell annuities—we only attempt to verify they are in the best interests of our clients.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Pittman, S. (2013, November). Efficient retirement income strategies and the timing of annuity purchases. Journal of Financial Planning, 56-62.


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