While annuities have been a main source of retirement income in America since the 1800s, they have evolved significantly in recent years to satisfy the more sophisticated goals of today’s investors. An aging population and increased longevity, persistently low interest rates, older-age health uncertainties, high volatility in financial markets, and the long-term repercussions of the Covid epidemic have all expedited this transformation.

It is not surprising that Americans, particularly those who are nearing retirement or have already retired, are looking for strategies to secure their retirement income.

To meet consumers’ rapidly changing needs, the annuity industry has quietly innovated, focusing even more on income protection products that provide customers with individualized, risk-responsive solutions that span retirements of 25 years or more. Simultaneously, the epidemic has spurred digital change within annuity firms, affecting how they interact with clients, improve operational efficiencies, and enhance overall digital capabilities.

The competitive landscape is changing significantly. Although annuity sales dipped around 10% in 2020 to roughly $220 billion, they have rebounded sharply in 2021.  Per the Secure Retirement Institute (SRI) total industry annuity sales were up an estimated 23% to $129 billion for the first six months of this year as variable annuity sales jumped 33% to $62.8 billion and fixed annuity gained 14.9% to $66.2 billion.  Demand for annuities is likely to steadily build given the growing interest in protected income, particularly as we move towards 2024 — the peak year for Baby Boomers turning 65.

Looking across the annuity industry, here are just a few examples of the innovation happening: 

RILA

There has been a significant shift from guaranteed living benefit riders on variable annuities toward Registered Index-Linked Annuities (RILAs) or structured annuities. RILAs can be thought of as a blend of a traditional variable annuity and fixed index-linked annuity. RILAs are SEC registered annuity products that offer the benefits of downside protection with upside growth potential.

They are essentially fixed indexed annuities with different crediting mechanisms that generate the return earned by the policyholders but are designed in a way that policyholders share some downside risk. Innovations include a variety of protection strategies, index allocation options, and crediting methods. More recently, living benefit riders have also been added.

Although RILAs have been around for a decade, sales have only recently begun a rapid ascent thanks to extensive product innovation. The RILA market grew 38% in 2020 to $24 Billion, representing 11% of total annuity sales and per the SRI has seen sales leap 105% YTD in 2021 to $19.3 billion. 

The most common RILA structure in the market is a ‘buffer’ product, but there are also floor-based designs. With buffer products, the insurance company often incurs the first 10% to 15% of equity market losses, but the policyholder bears the risk of losses beyond that point. With a floor product, the customer is protected from significant downside but often bears the first 10% to 15% of equity market losses. Both features have proved valuable in 2020, considering holders were partially protected from short-term losses and from the 30% equity market decline in March 2020. 

In-Plan Annuities

Due to the recent passing of the SECURE Act, plan sponsors are looking to address how 401(k) plans can be converted into protected lifetime income for employees in retirement, rather than just simply viewing 401(k)s as an accumulation tool.

Read Also: Comparing Variable Annuity Providers: What to Look For

The policy has eased the process of providing guaranteed income solutions inside of defined contribution plans, making it more likely for employer-sponsored plans to add insurance products and for advisors to have more opportunities to bring protected income solutions to their clients. These in-plan solutions could provide guaranteed income sleeves that are packaged into either a target date collective investment trust (CIT) or as a stand-alone election option in an employer 401K plan. 

While first generation product designs have seen minimal adoption among sponsors, companies are rapidly innovating products for this market today, looking to differentiate themselves and quickly capture market share. A number of asset managers have also recently been trying to enter this sector with managed payout funds that incorporate deferred income annuities (DIAs). The SECURE Act will continue playing a leading role in accelerating product development and adoption by plan sponsors, as well as heightening general awareness among consumers that these options now exist. 

Fee-based products

Reflecting the ongoing shift within the investment market from a traditional commission to a fee-based compensation system, there continues to be an increased focus on the fee-based market for annuities and building new products that are attractive to financial planners and their clients. Some platforms now offer lower-cost, no-load, fee-based investment-only variable annuities (IOVAs), traditional VAs with lifetime income benefits, and RILAs.  

Enhanced Critical Illness Riders

Among the most significant challenges faced by retirees is preserving income over a timespan that can easily exceed 25-30 years, while managing against the unpredictability of older-age health. In the past, traditional long-term care and critical illness products were one way to manage this risk, but the availability of long-term care products has diminished considerably.

This decline in availability and lack of diversity in features presents an inherent financial risk when it comes to older age health. To address this, insurance carriers have begun to introduce accelerated family or beneficiary-benefit options on life insurance policies, which has started to expand into annuities.

Deferred Income Annuities – Qualified Longevity Annuity Contracts (QLACs)

DIAs are poised to make a comeback: they’re increasingly being packaged in insurance solutions, either by being linked to fixed indexed annuities or included as part of defined contribution plans. DIAs are simple, transparent, and easy to understand. Essentially, they are the opposite side of the coin with respect to life insurance. Life insurance protects against the risk of premature death, while DIAs provide insurance against the “risk” of extended longevity.

They are typically purchased at or just prior to retirement, with guaranteed lifetime income payments contractually agreed to commence sometime in the future, often at ages 80 – 85.  In many ways, annuities with lifetime income benefits can operate in a similar fashion to DIAs for consumers purchasing with the expectation of converting them into protected lifetime income in the future. Newer ideas for DIAs include more flexibility around the funding of the product, changing income start dates and return of premium, as well as the ability to accelerate benefits.

For nearly 200 years, annuities have evolved to meet the changing needs of Americans, as well as the shifting dynamics of the marketplace. Several of the annuities described above did not exist, at least not in their current form, just a few years ago—evidence that few, if any, other financial products have undergone a greater innovation. 

Which Features are Provided by Annuities?

Annuities are financial products intended to enhance retirement security. An annuity is an agreement for one person or organization to pay another a series of payments. Usually the term “annuity” relates to a contract between an individual and a life insurance company.

There are many categories of annuities. They can be classified by:

• Nature of the underlying investment – fixed or variable
• Primary purpose – accumulation or pay-out (deferred or immediate)
• Nature of payout commitment – fixed period, fixed amount or lifetime
• Tax status – qualified or nonqualified
• Premium payment arrangement – single premium or flexible premium

An annuity can be classified in several of these categories at once. For example, an individual might buy a nonqualified single premium deferred variable annuity.

In general, annuities have the following features.

1. Tax deferral on investment earnings

Many investments are taxed year by year, but the investment earnings—capital gains and investment income—in annuities aren’t taxable until the investor withdraws money. This tax deferral is also true of 401(k) s and IRAs; however, unlike these products, there are no limits on the amount one can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for 401(k)s and IRAs.

2. Protection from creditors

People who own an immediate annuity (that is, who are receiving money from an insurance company), are afforded some protection from creditors. Generally, the most that creditors can access is the payments as they are made, since the money the annuity owner gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities.

3. An array of investment options

Many annuity companies offer a variety of investment options. For example, individuals can invest in a fixed annuity that credits a specified interest rate, similar to a bank Certificate of Deposit (CD). If they buy a variable annuity, their money can be invested in stocks, bonds or mutual funds. In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point.

4. Taxfree transfers among investment options

In contrast to mutual funds and other investments made with aftertax money, with annuities there are no tax consequences if owners change how their funds are invested. This can be particularly valuable if they are using a strategy called “rebalancing,” which is recommended by many financial advisors. Under rebalancing, investors shift their investments periodically to return them to the proportions that represent the risk/return combination most appropriate for the investor’s situation.

5. Lifetime income

A lifetime immediate annuity converts an investment into a stream of payments that last until the annuity owner dies. In concept, the payments come from three “pockets”: The original investment, investment earnings and money from a pool of people in the investor’s group who do not live as long as actuarial tables forecast. The pooling is unique to annuities, and it’s what enables annuity companies to be able to guarantee a lifetime income.

6. Benefits to heirs

There is a common apprehension that if an individual starts an immediate lifetime annuity and dies soon after that, the insurance company keeps all of the investment in the annuity. To prevent this situation individuals can buy a “guaranteed period” with the immediate annuity.

A guaranteed period commits the insurance company to continue payments after the owner dies to one or more designated beneficiaries; the payments continue to the end of the stated guaranteed period—usually 10 or 20 years (measured from when the owner started receiving the annuity payments). Moreover, annuity benefits that pass to beneficiaries don’t go through probate and aren’t governed by the annuity owner’s will.

Types of Annuities

Fixed annuities

In a fixed annuity, the insurance company guarantees the principal and a minimum rate of interest. In other words, the money in a fixed annuity will grow and will not drop in value. The growth of the annuity’s value and/or the benefits paid may be fixed at a dollar amount or by an interest rate, or may grow by a specified formula. The growth of the annuity’s value and/or the benefits paid does not depend directly or entirely on the performance of the investments the insurance company makes to support the annuity.

Some fixed annuities credit a higher interest rate than the minimum, via a policy dividend that may be declared by the company’s board of directors, if the company’s actual investment, expense and mortality experience is more favorable than was expected. Fixed annuities are regulated by state insurance departments.

An equity indexed annuity is a type of fixed annuity, but looks like a hybrid. It credits a minimum rate of interest, just as a fixed annuity does, but its value is also based on the performance of a specified stock index—usually computed as a fraction of that index’s total return.

A market-value adjusted annuity is one that combines two desirable features— the ability to select and fix the time period and interest rate over which the annuity will grow, and the flexibility to withdraw money from the annuity before the end of the time period selected. This withdrawal flexibility is achieved by adjusting the annuity’s value, up or down, to reflect the change in the general level of interest rates from the start of the selected time period to the time of withdrawal.

Variable annuities

Money in a variable annuity is invested in a fund—like a mutual fund but one open only to investors in the insurance company’s variable life insurance and variable annuities. The fund has a particular investment objective, and the value of the money in a variable annuity—and the amount of money to be paid out—is determined by the investment performance (net of expenses) of that fund.

Most variable annuities are structured to offer investors many different fund alternatives. Variable annuities are regulated by state insurance departments and the federal Securities and Exchange Commission.

The following annuities are available in fixed or variable form:

1. Deferred annuities A deferred annuity is designed to collect premiums and accrue investment income over an extended period for payout at a later time—for example, when an individual retires. Deferred annuities, also referred to as investment annuities, are available in fixed or variable forms.

2. Immediate annuities An immediate annuity is designed to start paying an income one time period after the immediate annuity is bought. The time period depends on how often the income is to be paid. For example, if the income is monthly, the first payment comes one month after the immediate annuity is bought. Immediate annuities are also available in fixed or variable forms

3. Fixed period annuities A fixed period annuity pays an income for a specified period of time, such as ten years. The amount that is paid doesn’t depend on the age (or continued life) of the person who buys the annuity; the payments depend instead on the amount paid into the annuity, the length of the payout period, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the payout period.

4. Lifetime annuities A lifetime annuity provides income for the remaining life of a person (called the “annuitant”). A variation of lifetime annuities continues income until the second one of two annuitants dies. No other type of financial product can promise to do this. The amount that is paid depends on the age of the annuitant (or ages, if it’s a two-life annuity), the amount paid into the annuity, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the expected payout period.

5. Qualified annuities A qualified annuity is one used to invest and disburse money in a tax-favored retirement plan, such as an IRA or Keogh plan or plans governed by Internal Revenue Code sections 401(k), 403(b) or 457. Under the terms of the plan, money paid into the annuity is not included in taxable income for the year in which it is paid. All other tax provisions that apply to nonqualified annuities also apply to qualified annuities.

6. Nonqualified annuities A nonqualified annuity is one purchased separately from, or “outside of,” a taxfavored retirement plan. Investment earnings of all annuities, qualified and nonqualified, are tax-deferred until they are withdrawn; at that point they are treated as taxable income (regardless of whether they came from selling capital at a gain or from dividends).

7. Single premium annuities A single premium annuity is an annuity funded by a single payment. The payment might be invested for growth for a long period of time—a single premium deferred annuity—or invested for a short time, after which the payout begins—a single premium immediate annuity. Single premium annuities are often funded by rollovers or from the sale of an appreciated asset.

8. Flexible premium annuities A flexible premium annuity is an annuity that is intended to be funded by a series of payments. Flexible premium annuities are only deferred annuities; that is, they are designed to have a significant period of payments into the annuity plus investment growth before any money is withdrawn from them.