One of the major objections consumers voice about deferred annuities is that consumers are concerned they can’t withdraw cash if they need it for emergencies.
In many ways, consumers want their annuity contract to function as a fully liquid checking-account-like instrument. You hear this time and time again. Although annuities are not designed to be fully liquid, they do possess significant cash liquidity power that needs to be better explained and understood.
When annuities were first brought to market, there were only two contractual ways to gain access to cash from the contract prior to the time when surrender charges on withdrawals were no longer applicable. These were either full surrender of the contract or electing full annuitization using one of the contractually provided options.
Over the years, the need to provide consumers with more ways to gain access to their cash without any surrender charges became increasingly important to potential annuity buyers. Insurance carriers responded with continued product innovation to make this a reality.
Deferred annuities are designed primarily as tax-advantaged, supplemental retirement income products. In addition to full surrender and annuitization, today’s deferred annuity products offer a number of options for limited, penalty-free liquidity. The exact liquidity options depend on the deferred annuity contract purchased. These options can include:
Partial annuitization. In some cases, the owner of a deferred annuity contract may need cash and may wish to apply only a portion of the annuity contract’s cash value (rather than the entire cash value) to produce a series of annuity payments under the contract, while leaving the contract’s remaining cash value in the deferral or accumulation stage. For example, the owner’s current financial need may be for annuity payments that are less than the payments the contract’s full cash value would produce, or the owner may wish to “ladder” or “stagger” annuity payments to take advantage of future changes in annuity purchase rates.
Prior to 2011, there was no specific rule in the tax code regarding such “partial annuitizations” of nonqualified annuity contracts. Starting in 2011, however, the tax code provided that partial annuitizations of nonqualified annuities are treated the same as other annuitizations, as long as the resulting annuity payments are made for a period of at least 10 years or over the life or lives of one or more individuals. In such cases, the annuitized and nonannuitized portions of the contract are treated as separate contracts and the after-tax investment in the contract is allocated pro rata between them for purposes of applying the rules governing the taxation of distributions.
- Free partial withdrawals. This option allows the contract’s owner to take up to a certain percentage (e.g., 10%) of the contract’s value or to withdrawal any interest earned each year without surrender charges. Certain contracts allow the owner to accumulate free withdrawals not taken up to certain limits. For example, if the 10% free withdrawal were not taken for three years, 30% of the contract could be taken. Some carriers cap such a feature at a maximum 50% of the contract’s value.
Systematic withdrawals. This option allows the contract’s owner to request automatic withdrawals of a certain percentage of the annuity’s value each year (e.g., 5%) until the contract value is reduced to zero.
Terminal illness. This option allows the contract owner to gain access, usually without incurring surrender charges, to most or all of the contract’s value if they have been diagnosed with an illness that will result in their death within a certain timeframe –usually 12 months to two years.
Nursing home confinement. This option allows the contract owner to gain access, without incurring surrender charges, to most or all of the contract’s value if the owner has been confined to a nursing home because of illness or incapacitation.
Long-term care. This option allows the contract owner to gain access to the contract’s value, without surrender charges, either in a lump sum or by requesting a monthly payout to pay the costs of a long-term care event.
Income riders. These riders, which are subject to an additional annual charge, trigger the payment of a certain percentage of the contract’s value (e.g., 5%) for life upon reaching a certain age. This payment stream can be stopped at any time and restarted by the contract holder and is different from annuitizing the contract in that it can be controlled by the owner. Income riders offer buyers great flexibility over when and for how long to take annuity cash payments.
Deferred annuity contracts are not checking accounts, but they do offer contract owners a number of options to gain access to cash. Deferred annuities are medium- to long-term contracts, but they have limited access to liquidity available through the options described above.
Consumers should use only a portion of their liquid net worth to purchase an annuity. They should keep a reserve of cash on hand to cover financial emergencies, including out-of-pocket costs of uncovered medical bills, large home repairs and other unexpected living expenses.
Harry N. Stout has been the president of Fidelity & Guaranty Life, deputy chief executive of Old Mutual Financial Network, and managing director of Insurance Insight Group. He is host of the “FinancialVerse” podcast and author ofThe FinancialVerse personal finance booksand ofToday’s Annuities — A Tool to Create Protected Lifetime Income. He may be contacted at [email protected].