Over the weekend I jumped in the car and went for a leisurely drive. During my ride, Tom Petty’s “The Waiting” came on. While belting out “Yeah, the waiting is the hardest part,” I became curious. Why do we struggle so much with waiting?
“In the United States, we absolutely think of our time as an individual—and 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 time—time being used wisely, time being used well—waiting is contrary to all of that.”
“If you make me wait, you’re 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 don’t 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 aren’t 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.”
“They’re usually marketed as safe investments, with guaranteed income, when you’re ready,” he adds. “Most buyers never see the truth. It’s buried in huge, complex, jargon-filled contracts that normal folks can’t understand without a dictionary, gallons of coffee, and a claimant’s 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 that’s 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, it’s anticipated that over the coming years, deferred annuities are forecast to have the largest annuity growth rates.
What is a Deferred Annuity and How Does it Work?
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, that’s 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 you’ll 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, it’s 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 you’ve 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, you’ll 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 ½.
Types of Deferred Annuities
If you’re 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 there’s 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 you’ve 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, that’s the risk you assume with variable annuities. In exchange for more growth potential, you more actually lose the money that you’ve initially invested.
Fixed Deferred Annuities
On the flip side, there’s a fixed deferred annuity. It’s arguably the safest annuity option since it works like a CD. By that I mean, that you’re guaranteed a minimum interest rate your funds will earn. As such, you’ll 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. That’s 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 it’s tanking, your earnings will also plummet.
Does that remind you of a variable annuity? It should. However, unlike a variable annuity, index annuities also have a minimum guaranteed return. Moreover, there’s a set limit on the highest possible gains, as well as the highest possible loss.
Index deferred annuities can get complicated. Overall though, there’s more safety and predictability than a variable annuity, but your growth potential isn’t as much as a fixed annuity.
Annuity Types by Term
Term Deferred Annuities
What is a term deferred annuity? It’s simply an annuity that converts your balance into a series of payments. For example, you can set it up where you’ll 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, you’ll stop receiving payments. This is true even if you’re still alive and kicking.
Lifetime Deferred Annuities
As the name implies, with a lifetime deferred annuity you’ll receive recurring payments for your entire life. What’s 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 hasn’t been recouped.
There is a way to get around this limitation — at least partially. And that’s 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. The reason? This money hasn’t 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, there’s 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 won’t be taxed until they’re withdrawn. Also, if you make contributions with after-tax money, there’s no additional income tax liability.
- Unlimited contributions. Speaking of contributions, there isn’t a limit on how much you can contribute to the principal amount. That’s 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.
- Range of benefits. Survivor’s 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. Here’s 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 aren’t careful, some of these can be rather substantial.
- Complexity. As with most annuities, a deferred annuity contract can be long and complex. If you don’t clearly understand what’s 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 weren’t enough, you may face a 10 percent early withdrawal penalty from the IRS.
- Illiquid. Perhaps the biggest knock against deferred annuities is that it’s difficult, if not impossible, to access your money. Even if you can anticipate a surrender fee.
Is a Deferred Annuity Right For You?
Let’s be real, a deferred annuity isn’t for everyone.
For example, if you’re already in retirement and need money within the next year or two for medical expenses, an immediate annuity makes more sense. But, what if you’re several years away from retirement and in good health? A deferred annuity could be a way to supplement your post-career income,
If that’s not helpful, you can answer the following two questions;
- What do you want your money to CONTRACTUALLY do?
- When do you want those CONTRACTUAL guarantees to start?
If you choose to go forward with a deferred annuity, always make sure that you clearly understand what’s spelled out in the contract. If you don’t, always ask or work with a trusted financial advisor.
Deferred Annuity FAQs
How long can payments be delayed?
It depends on the term of the contract. For example, you could “defer” the annuity indefinitely. That wouldn’t 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 you’re 85.
Can you add funds during the accumulation phase?
Short answer? 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.
How do withdraws work with a deferred annuity?
Following the accumulation phase, the payout phase begins. If you don’t 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 owner’s death.
What’s the difference between deferred and longevity annuities?
“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 contract’s 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 contract’s 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. “In other words, many taxpayers purchase traditional deferred annuity products with a view toward waiting until old age to begin annuity payouts, but they always have the option of beginning payouts at an earlier date.”
“With a longevity annuity, there is generally no choice, but this also allows for larger payments for those who do survive to the starting period; as a result, for those who survive, longevity annuities typically provide for a larger payout (often, much larger) than traditional deferred annuity products.”
What happens to my deferred annuity when I die?
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 isn’t a guaranteed payout period, payments will stop upon your death.