Contract Restrictions On Annuities Affect Them As An Investments Choice

Published: 17th August 2015
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Annuities are insurance products. They're a contract between an insurer and an annuitant. But contracts inevitably imply restrictions on both parties. So, beware of restrictions that make annuities different from other investments.

The essence of an insurance product is that the insurance company guarantees a result. For life insurance the guarantee is the death benefit. For an annuity the guarantee is to pay an annuitant a monthly payment for the remainder of his life.

To 'insure' such guaranteed payouts, an insurance company must restrict how it invests its funds so they're assured of being there when needed for their clients. These restrictions must be consistent with the mortality statistics of its client base which is the basis of insurance products. A lot of insurance company investments include premium long term bonds for which it can safely project fund income over substantial periods.

Considering these points, the issue is 'in what ways do these restrictions as applied to annuities effect it as an investment by you as the client - i.e. a buyer?'

*Liquidity risk to you as the client:

The first effect is the liquidity risk that investing in an annuity presents. If you buy a deferred annuity, your contributions to it are relatively illiquid if you want to back out of the contract. That's because you face surrender penalties for cashing in your deferred annuity too soon. These penalties tend to 'lock' you into the investment for a number of years. So before you commit your money, consider if your situation allows you to be locked into an investment for some time.

Once you've annuitized (i.e. begin receiving your monthly payments) your annuity, you can't cash it in to your insurance company. So make sure an annuitization is the way to go for you.

*Accumulation phase time of your deferred annuity:

Insurance companies suffer extra cost to 'insure' their products compared to other types of investments. This reduces their comparative net returns on their own investments low risk investments are typically associated with lower returns. This, along with the penalty fees imposed on early withdrawals, means that you really need about 15 years in the accumulation phase to achieve significant compounding benefits of your annuity investment.

One benefit of an insurance product is that earnings grow tax-deferred. This can somewhat offsets their lower earnings compared to annually taxable investment types that have higher earnings.

*Contract clauses can restrict your investment flexibility:

Contract clauses may vary with the particular insurance product you buy. Therefore, be sure to understand what each clause means so you don't incur a restriction you wouldn't normally expect.

As an example, your product may have a clause that allows the insurance company to alter your product for non-payment of premiums. As a hypothetical example, the company may purchase a reduced paid-up annuity for you for non-payments. Would that be acceptable to you?

*Taxation of your payments:

If you purchased your annuity with after-tax payments, your annuitized payments will be taxed only one way. And that is that each payment will contain a taxable portion and a non taxable portion; the former comes from those tax-deferred earnings that your investment will earn over time, while the latter represents a return of your 'after taxed' contributions. Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 1/2 are subject to a 10% penalty.


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