What Is a Two-Tier Annuity?

An annuity is simply a contract between an insurance company and an investor in which the investor gives up a sum of money in exchange for the promise of a stream of income in the future. Most annuities impose a surrender charge for several years, during which the customer must pay a fee to surrender the annuity for cash. At the end of the surrender charge period, there is no charge from the insurance company, though the annuitant may have to pay taxes. A two-tier annuity, however, imposes an additional liquidity restriction: You cannot take a lump sum without giving up a substantial portion of your return. To get the full value out of your annuity, you must take the payout as an income stream, over a minimum number of years.

Because two-tier annuities have more restrictions on liquidity than traditional annuities, the insurance company can invest premiums more freely, in less liquid investments or in investments with longer time horizons, in pursuit of higher returns. All things being equal, a two-tier annuity should pay higher returns than an identical annuity without a requirement to take payouts as a stream of income. The two-tier structure also has an indirect benefit--it is less attractive to creditors who may otherwise move to seize your assets in a lawsuit.

The main disadvantage of two-tier annuities is that you lose access to your money for the duration of the income phase. You are essentially locked in from the time you purchase the contract through the deferral period, during which you cannot annuitize, or commence your income stream. You only get your money in annual or monthly payments, over a period of years. Some contracts tie up your money for as long as 20 years. If interest rates rise or another annuity company offers a better deal in the future, you will not be able to exchange your two-tier annuity for a new one. Also, because most of these products are fixed indexed annuities, they only capture part of the return of the stock market. Over long time horizons, you may be better off in a variable annuity or mutual fund, assuming stock returns are positive during that time.

Two-tier annuities may be appropriate under the following conditions: You have sufficient assets to generate an income throughout the deferral period, you know you will want the income during the income period, you want the benefit of tax-deferral, you are confident you have enough other assets to meet any emergencies that arise. In essence, when you purchase a two-tier annuity, you are locking yourself into a pension plan. You may consider a two-tier annuity to shield assets from the claims of creditors, making you a less tempting target for lawsuits.

Two-tier annuities are regulated primarily at the state level, by state insurance commissioners. Only licensed life insurance agents may sell annuities of any kind, and only life insurance companies can issue annuities of any kind. If the annuity is a variable annuity or has a risk of investment losses (rather than losses resulting from fees or surrender charges), the annuity must be registered as a security with the Securities Exchange Commission, and the salesperson must be a Registered Representative with the SEC. As of 2010, two-tier annuity sales have come under regulatory scrutiny in recent years because of sales to people whose situations are not suitable for two-tier annuities. Some institutions have prohibited their use within their 403b plans.