What Is an AD?

An annuity is insurance against living too long and an AD is a deposit to an annuity policy issued by a regulated insurance company. Because annuities are a significant retirement planning tool, they have been granted special tax treatment. (see Power of Tax Free Growth). When annuities are properly selected and integrated into an overall retirement plan, they can play a key role in minimizing taxes and maximizing retirement income.

In order to get the most financial mileage from annuities, it is important to understand both how they work and the different forms they can take.

	Immediate vs. Deferred

An immediate annuity is one that pays a retirement income in the immediate future (usually defined as within one year). A substantial deposit is made to the insurance carrier, which in turn guarantees an income level for a stated time period or for life or some combination of the two. An immediate annuity transfers the longevity risk to the insurance carrier and is designed to protect people from outliving their income. Individuals with a properly selected annuity income provisions will receive a lifetime income stream, regardless of how long they live. For example, if an individual with a life expectancy of 10 years purchases a life annuity of $2,000 a month and then lives for 50 years, the $2,000 benefit will be paid each and every month for the full fifty years. There will be no reductions or limitations on the income stream. If this same individual had attempted to self fund their retirement with the same total amount, they would have dissipated their assets and spent many years in poverty. Immediate annuities appear simple at first glance, but they offer many different combinations of payout options, which require careful consideration and analysis. See Do Not Outlive Your Income.

In addition to an income you can’t outlive, annuities also offer an accumulation phase. Annuities in the accumulations phase are called Deferred Annuities, because both the taxes and the retirement benefits are deferred. Deferred annuities are an excellent long term savings source and millions of Americans use annuity accounts to postpone taxes on their retirement accumulations, without any intention, or requirement, to elect at an annuitized payout.

	Fixed vs. Variable

The primary design feature of a fixed annuity is the protection of the principal. Like banks, credit unions and savings associations, insurance companies take in deposits and use those deposits to make loans and purchase bonds and mortgages. They then use the return from these efforts to pay interest to their account holders. Deposits to a fixed annuity become a general asset of the insurance company and the entire portfolio of the insurance carrier is used to support interest payments and protect principal. The account value of all fixed annuities is guaranteed by the issuing insurance carrier, and backed by all of its corporate assets.

A variable annuity is an annuity that allows depositors to place their funds into a segregated portfolio of stocks and bonds, which are maintained inside the annuity. The segregated portfolios are much like mutual funds and are subject to the fluxuations of the bond and/or the stock market. Variable annuities do not protect principal. Variable annuities pass the market risk to the consumer (the risk that the market value of a stock or bond portfolio will decline). For this reason, they will not be discussed here.

A variable annuity is an investment; a fixed annuity is a savings account.

	Traditional vs. Indexed

Fixed annuities come in two general funding varieties. Traditionally, fixed annuities have offered fixed interest rates. The insurance company announces its guaranteed interest rates for different time periods and consumers make their deposits accordingly. Since an insurance company receives most of its investment income from mortgages and bonds, the interest rates it pays on annuity deposits will, in the long run; track the rates available from these kinds of financial instruments. See

In the late 1990’s another kind of fixed indexed annuities began to gain popularity. A fixed indexed annuity pays a guaranteed minimum interest rates, plus additional bonus interest that is based on the performance of a specified stock market index, such as the Dow Jones average, the S&P 500 Stock Average or the NASDQ Stock Index. Indexed annuities pay higher than fixed during periods of rising stock prices and lower than fixed when the market declines. Over the long term, expects indexed annuities to out perform traditional fixed by an additional 1% to 2% return.

American consumers have deposited over billions of dollars in indexed annuity accounts. Because of this popularity there are literally hundreds of indexed annuities for consumers to choose from, each with their own unique policy features and interest crediting methods. Please see Zero Market Risk for a more detailed discussion of indexed policies and indexed planning tips.

Both fixed-interest and fixed-indexed annuities guarantee the depositor’s principal. The difference between these policies is how interest on the annuity account is calculated and credited. A fixed indexed annuity is not an investment; it is a saving account. The amount of interest credited by the carrier is tied to market performance, but deposits are not placed in the stock market either directly or indirectly. When you purchase an indexed annuity, you are not purchasing a mutual fund or a segregated stock account, you are making a deposit to a fixed annuity and the insurance company guarantees the safety of your principal. See How Safe is Safe?

	Qualified vs. Non-Qualified

A qualified account is a government sanctioned accumulation plan. IRA’s and 401k’s are the most common examples and they provide tax deductible contributions and tax free accumulations. A Roth IRA is also a type of qualified account. Roth IRA’s allow tax free growth and tax free distributions, but the contributions are made after taxes are paid. In exchange for the tax qualified status, the IRS places limitations on who can contribute and how much they can contribute. There are also rules mandating certain minimum distribution patterns. (See IRA and Roth IRA)

Non-qualified simply means accumulations that are not qualified in any way. The special tax advantages of annuities are derived from a separate section of the tax code and are therefore non-qualified and can be used by anyone and, for the most part, without anyone limitations. Some financial planners use annuities to supplement qualified accounts, others place some annuities inside a qualified account. There is no tax advantage to placing an annuity into an IRA, but the other features of an annuity may make it prudent in some situations.

	Short Term vs. Long Term

Both immediate annuities and deferred annuities are long term financial tools. The expense structures and policy features of annuities are designed with the assumption that the policy will remain in force for several years or of the life of the annuitant. Annuities are not short term instruments. If you have a short term savings need, a bank CD or money market account is a much better choice than an annuity. However, if your goal is long term retirement success, then an annuity is an excellent addition to your retirement portfolio.

	This Policy vs. That Policy

Because of their broad use in retirement planning, annuity carriers have developed a wide selection of annuity features. Some of these policy provisions are unique to specific products, while others are universal to all annuities, even though they may take different forms in different policies. Because of this feature diversity, it is vital that consumers, who choose an annuity as a retirement tool, understand the range of annuity policy provisions available to them, and how each possible provision could impact their retirement planning. An experienced agent is the best source of help in selecting policy features.

	Company vs. Company

Not all insurance companies are equal. Some are giant international companies, some are giant US companies and others are smaller regional carriers. Size is only one factor in financial strength. We have all heard of huge corporations filing for bankruptcy or just plain imploding.

Insurance companies are rated by several independent financial ratings firms, who analyze a number of financial factors from size to portfolio make up to management history. These rating are published and updated no less than annually. Always know the rating of your insurance carrier. For further information about ratings see How Safe is Safe?

*These are hypothetical comparisons, solely intended to illustrate the advantage of tax deferral. It does not represent any particular investment or savings account; nor is it intended to recommend any specific course of action.