An annuity is a part of a long-term financial plan that pays a predictable income. If you are caring for someone who has already retired, it’s possible they may have purchased an annuity to generate a stream of income in their retirement. In particular, if they had a pension at work, they may have converted the money to an annuity as part of their retirement planning.
Insurance companies and licensed agents and brokers sell annuities (also known as annuity contracts) to investors for lump sums, such as retirement pensions. In return, the insurer agrees to make consistent payments to the investor to begin immediately or at a later date. The payment guaranteed by the annuity contract protects against the possibility that the investor might live beyond their financial resources.
Annuities are intended to be long-term investment strategies. However, if this financial plan is no longer working, there may be options for exchanging these products that may better serve retirement needs.
Kinds of Annuities
There are different types of annuities available to individuals. Annuities can be fixed or variable, and they can be immediate or deferred.
With a fixed annuity, the insurance company guarantees the principal and a minimum rate of interest. The growth of the annuity’s value and the payments can be a fixed dollar amount or increase by a certain interest rate or formula. State insurance departments regulate fixed annuities.
In a variable annuity, money is invested in mutual funds that are only available to the insurance company’s annuity investors. The amount you will be paid depends on the funds’ performance, net of expenses. As with any mutual fund selection, be sure to pay close attention to fund management fees, investment performance and risk. State regulators, the Financial Insurance Industry Regulation Authority (FINRA) and the Securities and Exchange Commission (SEC) regulate variable annuities.
When insurance companies refer to immediate or deferred annuities, they mean the time when they start paying you. With an immediate annuity, payments begin right away, but with a deferred annuity, payments may be arranged to start much later.
The time period over which an annuity is scheduled to pay also differs. Some pay throughout your lifetime, while others (known as period certain) pay for a set length of time, regardless of how long you live. For example, with a pure lifetime annuity, payments stop when you die, even if you pass away shortly after the payouts begin. There is also an add-on option to guarantee your beneficiaries will continue receiving payments for a certain period after your passing, but this benefit can lower the payments you receive while alive.
A Better Exchange
If you own a deferred annuity that has not been annuitized and is no longer a good fit for your situation, you can exchange it for a better option rather than surrendering it altogether. A provision in the tax code known as a 1035 exchange allows you to swap an annuity contract for another without incurring taxes at the time on the gains.
Why would someone want to switch to a different annuity? New contracts may have more attractive features like better interest rates or investment options, but one of the biggest reasons is mounting expenses with a current contract. What might seem like small charges now can easily add up over time.
Consider this hypothetical illustration from Fidelity Investments:
The national industry average expense for tax-deferred variable annuities is 1.25% and Fidelity’s is 0.25%. If you invested $100,000 in a variable deferred annuity for 20 years at a hypothetical 6% rate of return, the account value of the higher-expense annuity would be $249,379, but the value of the lower-cost annuity would total $305,053—a difference of $55,674.
Because some annuities charge surrender fees, it pays to carefully weigh the pros and cons of an exchange. Surrender charges can be as much as 5% to 7% of the annuity in the first year and decline to zero over time. If the surrender period on your annuity has already elapsed, then you will not be subject to these fees when making the 1035 swap. Be aware that your “new” contract may involve yet another surrender period, so make sure you’re willing and able to make that commitment.
Keep in mind that the exchange of funds must occur directly between insurance companies, and the name of the annuitant must be the same on the “old” contract as the “new” one. However, the “new” company may allow you to change the name or add someone to the contract after the swap.
Consult with a Professional
Sometimes it can be hard to decipher the fine print of annuities. “It may not be worth the exchange in some cases,” says Tim Gannon, vice president of annuity products at Fidelity. That might be the case if the surrender charges are high or if the annuity’s death benefits are generous.
If you’re unsure about whether to keep or exchange an annuity, consult a reputable financial adviser, a tax professional, and possibly an elder law attorney before making a decision. These professionals can help ensure this move is the best fit for your financial situation now and into the future.