When you purchase a deferred annuity, you must decide how you will make your premium payments: would you prefer to pay the full amount up front, or make a series of payments over time?
With deferred annuities, you can choose between a single premium or a flexible premium. Each has unique benefits and drawbacks, so you may want to consult with a financial advisor to determine which premium option makes the most sense for you and your goals.
How Do Annuity Premiums Work?
Annuities are insurance products, and as with other types of insurance, when you buy an annuity you must pay for the insurance it provides to you — that is, the insurance against outliving your retirement savings. This payment is called a premium, and you can pay it all at once or as a series of installments, or payments, over time.
According to the Insurance Information Institute, people often fund their single premium deferred annuities with money from a different qualified account, such as a 401(k) plan or IRA or from the sale of an appreciated asset.
Flexible-premium deferred annuities are funded with a series of smaller payments, which can be set up as automatic transfers or paid directly by the annuity owner at his or her own discretion. This is a helpful option for people who may not have a large sum of money to contribute right away but can afford smaller payments spread out over a longer period of time.
The flexible premium option is available only for annuities with deferred income start dates. Immediate annuities, which are also known as income annuities and include single premium immediate annuities (SPIAs) and deferred income annuities, don’t have an accumulation phase. However, when you buy a deferred income annuity (DIA), you select the income start date at the time the contract is issued and may make additional premium payments as allowed by your annuity contract.
Where Do My Premiums Go?
Insurance companies invest your premiums in interest-bearing accounts.
Fixed annuity premiums are pooled and invested in the underlying portfolio for the insurance company’s general account. The insurance company uses the return on their investments to pay income benefits and cover operational expenses.
Variable premiums go into subaccounts that the annuitant selects, and if a fixed option is available, the annuitant may allocate a portion of the premiums to the carrier’s general account. The insurer credits the interest to the contract in accordance with the contract terms and uses its portion of the returns from these investments to finance its operations.
Pros and Cons of Single Premium Deferred Annuities
SPDAs are ideal for some, but they may pose challenges for others. Do you have a large sum of money that you can contribute now, or might you need access to that money in the short term?
According to Mark Cavalieri, associate director of multi-year guaranteed annuity sales for Senior Market Sales, a full-service insurance marketing organization, SPDAs are significantly more popular than their flexible-premium counterparts among today’s soon-to-be retirees. Many people approaching retirement have savings to use as a lump-sum premium payment or money from a qualified retirement plan that they wish to rollover into an annuity their premium from a 401(k) plan or pension.
- Principal protection
- Your original contribution can be protected from losses, unlike investments made directly in the stock market.
- Optimizing compound interest
- More funds in the annuity equates to higher potential compounding gains.
Pros: Single Premium Deferred Annuities
- Potential surrender charges
- The larger the premium payment, the more money you’ll have tied up in the contract. If you encounter a pressing financial obligation that requires you to withdraw funds during the surrender period, you will have to pay surrender charges.
- Lack of capital for other investments
- This is referred to as “opportunity cost.” Your funds are held in the annuity, so they do not have the opportunity to potentially grow with other products or accounts.
Cons: Single Premium Deferred Annuities
Many SPDAs have a minimum premium, and they provide higher payments with a longer accumulation phase — or a longer period during which the lump sum premium can earn interest.
Pros and Cons of Flexible Premium Deferred Annuities
Flexible premium deferred annuities may suit you if you prefer to divvy up your premium payments into smaller amounts. Cavalieri told Annuity.org that most providers require an initial premium of at least $2,000 for a flexible premium annuity, so there is often an established financial responsibility prior to the scheduled payments.
- Less capital tied up
- Smaller payments made over time mean more money at your disposal for immediate needs.
- More time to pay
- If you do not have the full premium amount, you can make payments over time for the product best suited to you.
- Control over premium payment structure
- You set the schedule based on your income and comfort level.
Pros: Flexible Premium Deferred Annuities
- Less interest accrued and loss of compounding benefits
- With less money in the annuity, you miss the compounding interest that accompanies a larger sum premium.
- Maximum premium amounts
- Like single premium annuities, flexible premium annuities may impose a maximum premium amount.
Cons: Flexible Premium Deferred Annuities
Cavalieri, who is a life underwriter training council fellow, explained, “Today, the number of single premium annuity products far outnumber the ones with flexible premiums.”
Are My Premiums Protected?
Only fixed annuities and specific indexed annuities offer risk protection for premiums. Other annuity product premiums may be subject to losses. For example, variable annuities do not have premium protection as they are linked to stock market performance, but they can have higher earning potential as a result.
According to Forbes, “The obsession with markets is understandable, but it distracts retirement savers from what they should really be worrying about: outliving their money.”
Guaranteed income for life and premium protection are two advantages of owning an annuity product, and they are among the four primary reasons to buy an annuity.
Although there are varying levels of risk with any financial product, annuities are often safer options than most equities.
In addition, your premiums may be protected from creditors in the event that your insurance company becomes insolvent.
Annuities are not backed by the federal government. State guaranty associations exist to protect annuity owners if their insurance companies fail to pay income benefits.
Which Should I Choose: Flexible Premium or Single Premium?
Your time horizon and risk tolerance should influence your decision regarding premium options.
As Cavalieri explained, if someone has a lump sum and a diversified portfolio, single premium annuity products tend to be better options with broader features.
Conversely, flexible premiums can be suitable for conservative savers who may not have a lump sum saved but want a low-risk product with a guarantee of lifetime income.
An annuity owner’s circumstances can change, but it is important to make an informed decision about your annuity product’s terms before signing the contract.
Tax penalties and surrender charges for early withdrawals are considerations common to both single and flexible premiums. It can be costly to change annuity products or contract terms, but you may be permitted to exchange your current contract for a more suitable option under the 1035 annuity exchange rule, as long as you meet certain criteria.
The right premium choice depends on your goals and current financial limitations. Reputable annuity providers and your financial advisor can guide you toward the right solution for you.
