Immediate vs. Deferred Annuities
The first basic distinction among annuities contracts is between immediate vs. deferred. As we have seen in the preceding blog post, all annuities are designed to be irrevocably converted into income at some point, by definition.
We might even say that deferred annuities—those that appear designed to grow like bank or investment accounts and offer some access to our principal—are simply waiting to grow up into immediate annuities, at which point our claim on principal goes poof, and we have only a stream of periodic checks where once was a mighty pool of liquidity. Once again, by contract and by design, a deferred annuity is an immediate annuity waiting to happen.
In a moment, we are going to pretend that there really is a distinction, but you MUST forever bear in mind that annuities are designed to ultimately convert liquid principal into income according to some contractual scheme. This is a fundamental characteristic of what annuities are. We’ll get into a bit more detail later, and for now will focus on the very basics. Ok, here we go.
Fixed annuity surrender value
The surrender value is the cash-out amount that you’d receive if you surrendered the contract and asked to move your money. The accumulation value is an amount that appears on your statements, as is what the contract is worth so long as you don’t ask for all your money. In some ways, it is a make-believe number, since the surrender value is all you have access to if you need more than just the interest and/or a small annual percentage of principal (usually 10%) of your money, which you can usually (but not always, check your contract) access free of surrender charges.
So, surrender value is equal to accumulation value minus applicable surrender charges and other fees and “haircuts.” A haircut, by the way, is an old securities term for taking a chunk out of value for some reason. They should have used “shave” instead.
Interest rates are usually a bit higher than banks, since they do not offer FDIC insurance, which means that the guarantee of principal and interest is basically an insurance company guarantee and dependent on the financial strength and goodwill of the insurance company. Access to principal is often restricted, through surrender charges, for two primary reasons.
First, in order to get a decent return (with a portion going to you), the insurance company will need to tie up the money for a longer period, and if they have to cash out of an investment in order to give you your money at an inopportune time, they will make you feel some of their pain.
The second reason is because of the commissions they had to pay in order for a salesperson to bring them the business: if they haven’t had enough time to make a profit on your money on top of the commission they had to pay to get it, well, again, that pain’s for you.
This annual interest rate will usually be somewhere between mid-term (2-5 years) CD rates, and the rates actually paid on good-quality corporate bonds, mortgages, and the other things that insurance companies will invest in with the money collected in annuity premiums.
Annuities market value adjustments – hidden risk that waters down guarantees
Market Value Adjustments (MVAs) are a kind of additional surrender charge that has nothing to do with commissions, and are a way that the insurance company sometimes uses to pass risk on to the purchasers of annuities. They’re kind of sneaky, and make fixed annuities with them act more like the SEC-regulated variable annuities that we’ll get into later (without the greater disclosure required of SEC-regulated products). They work like this: when interest rates go up, bond prices go down, which means if you cash in during a period of rising rates, the insurance company will get less for the bonds they put your money in.
With MVA annuities, you will then get less, on top of any commission-derived surrender charges.
Annuity bonus interest – how real is it?
Let’s talk about bonus interest for a moment. Bonus interest is an extra percentage that an annuity may credit to your premium when you buy and can look awfully good at first blush. For a “5% bonus” annuity on $100K, your initial “deposit” is considered to be $105K . . . and then you’ll “get” whatever annual interest the product pays credited to your accumulation value as the months roll on.
It is important to remember that we get little in life for free, especially from big financial institutions; when you get down to the nuts and bolts, the bonus is kind of nebulous.
It has to be; if the insurance company could conjure money out of the air, it surely would keep it for itself. Believe me, any bonus is reclaimed by the insurance company in higher charges and fees over the years that you keep it, or in stiffer surrender charges if you try to pull your cash before they have time to nibble it all back. If you think carefully on this, you will realize that it cannot be otherwise.
Remember the “too good to be true” axiom. Particularly troublesome is where these smoky bonuses are pitched to make up the surrender charges on products the salesperson wants you to replace with his annuity; since the bonus is a chimera, the hapless investor can be subjected to two surrender charges, when before the new commission (I mean the new annuity) there was only one.
Bonus interest in general, and on replacements in particular, has attracted a lot of unwanted attention to the insurance industry from the insurance and securities regulators.