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ANNUITIES/CDs REVIEW
Annuities and CDs serve many useful purposes,
but it’s good practice to review your annuity and
CD investments periodically to make sure they
are still serving their intended purposes.
What is a CD?
A Checking Deposit, or CD for short, is a long-term
deposit with a commercial bank. The bank offers a
higher interest rate because the depositor agrees to
leave the money with the bank for a specified period
of time. The rate of the CD is usually fixed over the
term of the CD and there is almost always an interest
penalty for cashing the CD in early. Typically, CD’s are
offered in terms of 3 months to 5 years, but they may
be found in many different length terms. A major
advantage of CD’s is that they can be FDIC insured.
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| What is an Annuity?
Annuities are insurance policy contracts which act as a tax blanket for investments. Annuities were the
very first retirement savings vehicles because interest earned inside an annuity is not taxed until it is
withdrawn. This type of tax treatment may sound familiar, as it is very similar to a 401(k) or IRA. Like other
retirement vehicles, annuity withdrawals have a 10% early distribution penalty, and when withdrawn are
taxed at ordinary income tax rates. The major difference between annuities and most retirement accounts,
like the 401(k) or IRA, is that contributions are not tax deductible for annuities. Usually it is more tax efficient
to max out retirement accounts at work and personal IRAs before investing in an annuity contract.
When an annuity is annuitized, the balance of the annuity becomes the property of the insurance company.
The insurance company then assumes the obligation to pay out a certain regular payment (usually monthly)
for the life annuitant. The annuity can also be structured to continue to pay a survivor if the annuitant dies
first. A very low percentage of annuities are actually annuitized. Immediate annuities, which are always
annuitized immediately, are available and generally have more favorable annuitization terms than a deferred
annuity which has been used to accumulate money over time.
Why use an Annuity?
Annuities can offer unique benefits which are only available from an insurance company. Some annuities
guarantee certain levels of withdrawal or investment returns. These guarantees are paid for through “policy
riders” and backed by the claims paying ability of the insurance company. The cost of these guarantees,
plus the administration and distribution costs of these policies make them very expensive investment vehicles.
In addition to high annual expenses, most annuities have surrender charges if you cancel the policy within a
certain timeframe, often 5-10yrs with up to 15% surrender charge penalties. You should carefully weigh the
advantages and disadvantages of purchasing an annuity. Annuities are almost always sold with commissions,
so a second opinion from a disinterested party is advisable.
What are the Types of Annuities?
There are three major types of annuities. They all share the same tax rules, but the investment portion of
the policy is different.
Fixed Annuity
Fixed annuities pay a fixed interest rate to policy holders. The insurance company is required to invest
policy reserves in very conservative investments such as high quality bonds and mortgages. The
insurance company deducts operating expenses, profit margin and agent commissions from total
investment returns. What is left over is what is paid to policyholders. The interest paid can vary from
year to year, depending on investment performance of the insurance company’s investments. Fixed
annuities are guaranteed to never lose money and most have a guaranteed minimum interest rate.
Equity Indexed Annuity
Equity Indexed Annuities (EIA) are technically classified as a type of fixed annuity. The idea is that the
policy is guaranteed never to lose value, but still has the potential to earn higher rates of interest through
a stock market index (like the S&P 500). The way the insurance company can offer this is by using a
portion of the policy premiums and purchasing zero-coupon bonds which mature at face value on a future
date. This guarantees that several years in the future the original premiums will remain when the
zero-coupon matures at full value. The remaining premium is invested in call options on the particular stock
market index that annuity tracks. If the index rises in value, the call option becomes worth more, which
allows the policyholders to receive higher interest than simply investing in a fixed annuity. If the index is the
same or declines during that time, the option contracts expire worthless and no interest is credited to
the policyholder.
The major criticism of EIA’s are that when looking at the historical stock market returns, over one-third (1/3)
of their return is attributable to dividends paid to shareholders. Call options do not receive dividends as
they do not own the security they are a derivative of. In addition to the lack of dividends, EIA’s almost
always contain additional interest crediting restrictions and rules which lower the potential interest earned in
the policy.
Interest calculations are usually reduced by two of the following three policy provisions:
• Participation Rate- Only a percentage of the index increase is credited. Typically 30-90%
• Interest Rate Cap- A limit is placed on how much interest can be credited per year. Typically 8-12%
• Spread- The interest credited is a set level below actual performance. Usually about 2%
As an example, a policy could credit interest to policyholders like this: S&P increases 24% in one year, the
policy is credited with 60% of the gain with a cap of 10% (.24 x .60 = 14.4% capped at 10%). The
policyholder would receive 10% interest crediting for that year. If they had owned the actual index, they
would have received a 24% return plus the dividends paid out that year. There has been close regulatory
scrutiny on EIA’s recently.
Variable Annuity
Variable annuities do not rely upon a declared interest rate of the insurance company, but rather use
sub-accounts which look and act very much like mutual funds. The investment returns in a variable annuity
are generated by the sub-accounts. The performance of sub-accounts is not guaranteed because they
participate directly in the stock market and other investments. Recently, variable annuities have begun to
offer guarantees not available with mutual funds alone. With the purchase of additional riders and accepting
a more limited control of the subaccount investments available, the policy can guarantee a certain
withdrawal rate or annuitization value, regardless of the investment performance of the sub-accounts.
These guarantees are paid for with the purchase of market hedging instruments by the insurance company
with the proceeds from the specific rider which offers the guarantee. In the wake of the 2008 financial crisis,
many insurance companies have had to reduce or eliminate these guarantees due to the increasing cost of
hedging strategies and potential miscalculations in the risk modeling of these policy riders.
Variable annuities have an expense ratio called “Mortality & Expense” or M&E. The M&E expense often is
1% or more per year. In addition to the M&E each sub-account also has an expense ratio, often 1% or
more. With administration fees and policy riders, these expenses can easily exceed 3% per year. With
annual expenses that high it is very difficult to earn even average market rates of return.
Your needs and life circumstance changes frequently, so if you have any annuities or CD’s in your portfolio,
contact us to request a complimentary consultation.
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Financial Life Advisors (FLA), a Registered Investment Adviser, and Jim Oliver & Associates, P.C. (JOA) are under common ownership and control. Team Oliver is used to describe collaborative services of both firms. Professional tax services are provided by JOA and investment advisory services are provided by FLA, each under separate agreements.
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Sign up here to schedule a
COMPLIMENTARY
consultation with a member
of Team Oliver.
Please bring a copy of last
year's income tax return.
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