What is a Deferred Annuity?
June 28, 2021 12 min read  This story originally appeared on Due    Over the weekend I jumped in the car and went for a leisurely drive. During my ride, Tom Pettys The Waiting came on. While belting out Yeah, the waiting is the hardest part, I became curious. In the United States, we absolutely think of our time as an individualand also as our scarcest resource, says Jason Farman, a professor at the University of Maryland and author of Delayed Response: The Art of Waiting from the Ancient to the Instant World. When we imagine a productive timetime being used wisely, time being used wellwaiting is contrary to all of that.  If you make me wait, youre limiting my ability to be successful in this life, he adds. Other people control our time in a way that makes us feel powerless. We dont feel in control. I think that sense of powerlessness and lack of control really drives our hatred of waiting.  As my mind continued to go down this rabbit hole, I thought to myself that maybe, just maybe, this is why people arent fans of deferred annuities. Case in point, Ken Fisher, founder of Fisher Investments, proclaimed in a USA Today opinion piece that deferred annuities are bogus. Here, you upfront cash for a contract that pays later. Meanwhile, your principal contract value supposedly grows.  Theyre usually marketed as safe investments, with guaranteed income, when youre ready, he adds. Most buyers never see the truth. Its buried in huge, complex, jargon-filled contracts that normal folks cant understand without a dictionary, gallons of coffee, and a claimants lawyer. Few read them.  Fisher does bring forth some valid points. But, with uncertainty surrounding retirement income like Social Security, turbulent economic conditions, and life expectancy growing, maybe deferred annuities deserve a second look. Perhaps thats why deferred annuity assets have risen from $2,218 billion in 2019 to $2,377 billion in 2020. And, according to the LIMRA Secure Retirement Institute, its anticipated that over the coming years, deferred annuities are forecast to have the largest annuity growth rates. When you go to buy an annuity, you decide if you want to receive annuities right away, which is an immediate annuity, or you can wait. If you go with the latter, thats known as a deferred annuity. A deferred annuity is simply a long-term investment. You transfer a sum of money, either in a lump sum or series of payments, to an annuity provider who will invest it on your behalf  based on the strategy and type you chose. After the initial sum has accrued interest youll receive payments. So far, a deferred annuity is working like another type. The key difference is that are two distinct components;  The accumulation phase begins when you purchase the annuity. It ends when you make your last contribution. And, during this time, its accumulating interest on a tax-deferred basis. Just know that how this accumulation takes place will vary depending on the annuity type. begins when you purchase the annuity. It ends when you make your last contribution. And, during this time, its accumulating interest on a tax-deferred basis. Just know that how this accumulation takes place will vary depending on the annuity type. The payout phase kicks in when you receive your first payment. You can either receive a lump sum payment or a series of payments for a set amount. If you want to receive a series of payments, this will be for a specific period of time or for the remainder of your life. If youve ever bought a certificate of deposit (CD), this probably sounds familiar. In fact, there are also similarities between deferred annuities and retirement accounts like 401(k)s and IRAs. You set aside a chunk of money and the longer you leave it alone, the more it will grow. In turn, youll have larger payments. Moreover, this money grows tax-deferred. As such, funds will be taxed as ordinary income when you begin receiving payments. But, you can expect a 10% penalty fee from the IRS if you make a withdrawal before the age of 59 . Types of Deferred Annuities  If youre sold on a deferred annuity, you should know that there are several different types to choose from. Each has its own unique features that will influence your future annuity income. Usually, deferred annuities will be based on classifications like the return, term length, and funding style. Annuity Types by Return  Variable Deferred Annuities  The main criticism regarding variable annuities is that theres not a guaranteed rate of return. However, your money is placed into an investment account consisting of subaccounts. This resembles mutual funds, which are made up of assets like stocks, bonds, and money market accounts. As long as the investments that youve selected are performing well, your balance will grow. And, that will increase the amount that your future payouts will be. But, if your investments underperform, your future payouts will decrease as your balance stifles  it may even shrink in size. But, thats the risk you assume with variable annuities. In exchange for more growth potential, you more actually lose the money that youve initially invested. Fixed Deferred Annuities  On the flip side, theres a fixed deferred annuity. Its arguably the safest annuity option since it works like a CD. By that I mean, that youre guaranteed a minimum interest rate your funds will earn. As such, youll know exactly how much is coming your way down the road. However, this interest rate will typically be smaller than market returns. Still, if you have a low-risk tolerance and strive for predictability, then a fixed deferred annuity is right up your alley. Index Deferred Annuities  Index deferred annuities are considered to have the best of both worlds  at least when it comes to payment growth. Thats because returns rely partially on a market index, such as the S&P 500. So, when the market is doing well, your money grows more. But, when its tanking, your earnings will also plummet. It should. However, unlike a variable annuity, index annuities also have a minimum guaranteed return. Moreover, theres a set limit on the highest possible gains, as well as the highest possible loss. Index deferred annuities can get complicated. Overall though, theres more safety and predictability than a variable annuity, but your growth potential isnt as much as a fixed annuity. Its simply an annuity that converts your balance into a series of payments. For example, you can set it up where youll receive payments for 5 or 20 years. If you pass away prematurely, the remaining payments will go to your beneficiaries. Also, once the term ends, youll stop receiving payments. This is true even if youre still alive and kicking. Lifetime Deferred Annuities  As the name implies, with a lifetime deferred annuity youll receive recurring payments for your entire life. Whats more attractive about this is that you can not outlive your annuity income. Just note that when die, these payments will cease  even if the cost of the annuity hasnt been recouped. There is a way to get around this limitation  at least partially. And thats opting for a dual life annuity. This promises payments for someone else, like an heir. Or, you could tack on a death benefit. Be aware that that will lower the monthly payments. Annuity Types by Funding  Single-Premium Deferred Annuities  A single-premium deferred annuity is straightforward. You buy the annuity contract with one lump sum payment. For instance, you could use a tax return, inheritance, or the money in a savings account and convert that into a series of future payments. Just note that if you purchase the annuity using transferred funds from a tax-advantaged traditional retirement plan, except to pay income taxes. This money hasnt been previously taxed. Flexible-Premium Deferred Annuities  There are also flexible-premium deferred annuities. Instead of one big payment, the premium payments can be spread out over time through a series of smaller payments. The more you put towards the contract, the greater your future income will be. However, theres also the flexibility to pad your account over time. The Advantages of Deferred Annuities  Despite what naysayers, like the aforementioned Ken Fisher, there are several advantages associated with deferred annuities. These include the following perks;  Tax-deferred gains. As with all annuities, a deferred annuity lets owners build their wealth inside a tax-advantaged vehicle. This is thanks to the fact that annuities are tax-deferred investments. That means your earnings wont be taxed until theyre withdrawn. Also, if you make contributions with after-tax money, theres no additional income tax liability. As with all annuities, a deferred annuity lets owners build their wealth inside a tax-advantaged vehicle. This is thanks to the fact that annuities are tax-deferred investments. That means your earnings wont be taxed until theyre withdrawn. Also, if you make contributions with after-tax money, theres no additional income tax liability. Unlimited contributions. Speaking of contributions, there isnt a limit on how much you can contribute to the principal amount. Thats a huge advantage over other retirement plans like a 401(k) or IRA that have contribution limits. Speaking of contributions, there isnt a limit on how much you can contribute to the principal amount. Thats a huge advantage over other retirement plans like a 401(k) or IRA that have contribution limits. Guarantees against loss. Most deferred annuity contracts have guarantees against the loss of principal. Or, at the very least, guaranteed rates of return. Most deferred annuity contracts have guarantees against the loss of principal. Or, at the very least, guaranteed rates of return. Range of benefits. Survivors benefits, death benefits, and a guaranteed minimum lifetime payout are just some of the benefits that are included with a deferred annuity. Survivors benefits, death benefits, and a guaranteed minimum lifetime payout are just some of the benefits that are included with a deferred annuity. The power of time. Heres what really makes a deferred annuity so appealing. The longer you delay annuity payments, the more time your money has to compound. As a result, the higher your payments will be when you begin receiving them. The Disadvantages of Deferred Annuities  Despite its advantages, there also some drawbacks that come with a deferred annuity. And, if you arent careful, some of these can be rather substantial. Complexity. As with most annuities, a deferred annuity contract can be long and complex. If you dont clearly understand whats in the contract may not be able to spot the hidden fees included in the fine print. As with most annuities, a deferred annuity contract can be long and complex. If you dont clearly understand whats in the contract may not be able to spot the hidden fees included in the fine print. Expensive. Deferred annuities can be pricey. For example, the sales commission can run up to 6 or 7 percent. Also, there are administrative fees, funding expenses, charges for special features, and riders. As if that werent enough, you may face a 10 percent early withdrawal penalty from the IRS. Deferred annuities can be pricey. For example, the sales commission can run up to 6 or 7 percent. Also, there are administrative fees, funding expenses, charges for special features, and riders. As if that werent enough, you may face a 10 percent early withdrawal penalty from the IRS. Illiquid. Perhaps the biggest knock against deferred annuities is that its difficult, if not impossible, to access your money. Even if you can anticipate a surrender fee. Lets be real, a deferred annuity isnt for everyone. For example, if youre already in retirement and need money within the next year or two for medical expenses, an immediate annuity makes more sense. If you choose to go forward with a deferred annuity, always make sure that you clearly understand whats spelled out in the contract. If you dont, always ask or work with a trusted financial advisor. It depends on the term of the contract. For example, you could defer the annuity indefinitely. That wouldnt make much sense unless leaving it to an heir. The point is that you can wait to annuitize or take action on the annuity for as long as your want, like not initiating payments until youre 85. Yes. However, this depends on the annuity company and tax allows. Generally speaking though, during the accumulation phase you may be able to make lump-sum or monthly contributions. Following the accumulation phase, the payout phase begins. If you dont defer the annuity indefinitely, you have three different payout options;  One, taxable lump-sum payment  Systematic withdrawals where taxable withdrawals are periodically made. Whatever remaining funds you have will continue to earn interest  Annuization issues a regular series of payments every month, quarter, or year for a specified period of time  often until the owners death. A deferred annuity provides for an initial waiting period before the contract can be annuitized (usually between one and five years), and during that period the contracts cash value generally remains liquid and available (albeit potentially subject to surrender charges), write Robert Bloink and William H. Byrnes. Beyond the initial waiting period, the contract may be annuitized, though the choice remains in the hands of the annuity policy owner, at least until the contracts maximum maturity age (at which point it must be annuitized).  By contrast, a longevity annuity generally provides no access to the funds during the deferral period, and does not allow the contract to be annuitized until the owner reaches a certain age (usually around eighty-five), they add. If you die before payments have begun, your spouse or beneficiary may continue the contract. That means they take it over and let the annuity continue to grow. If payments have begun, the beneficiary will receive the payments until the end of the guaranteed period. If you have a life-only contract, meaning that there isnt a guaranteed payout period, payments will stop upon your death. appeared first on Due.