What Is an Annuity?
An annuity is a financial vehicle that, if utilized correctly, provides you with a source of regular income that is often greater than what can be earned with a conventional savings portfolio.
The annuity investment process is simple: You pay cash to an insurance company that guarantees you will receive a specific amount of money each month for the rest of your life. The amount you receive will be greater than any interest rate you can earn in your bank.
The guarantee comes in the form of an annuity, which is basically a contract between you and the insurance company. The insurance company agrees to pay you a specified amount monthly, while you, in return, relinquish the possibility of withdrawing your money early.
While typical annuities are bought with a lump sum or several lump sums, you can also build an annuity with regular, monthly payments.
Ask yourself if you can imagine yourself taking ten thousand dollars from the bank to buy a car and not being able to use that money for anything else where as with an annuity you are guaranteed income for the rest of your life.
This is the same benefit of having a pension for life or knowing you will receive interest income on your bank deposits for the rest of your life.
So what are the pros of an annuity?
Development of a safety net. You know that you will have a guaranteed income for the rest of your life.
Types of Annuities
As people are living longer and healthier lives, many retirees and pre-retirees are staying in the workforce longer in order to continue growing their nest eggs. While working a little longer is an obvious solution, it sometimes means getting by without a steady source of income while remaining enrolled in a standard employer-sponsored retirement plan.
Taking a Distribution from Your Retirement Plan
While receiving a distribution from your retirement plan may come in handy, there are some drawbacks to leaving an employer before reaching full retirement age.
You will pay an additional 10% federal tax on the distribution if you are under age 59 1/2.
If you take a distribution before you reach age 59 1/2, you will also forfeit any chance to contribute additional funds to the 401(k).
When you take a distribution from your retirement plan, your employer can also withhold an additional 20% in income taxes.
In any case, you should always consult with your financial advisor or a tax expert before making any decisions.
Variable Annuities
Are annuities right for you? This is the question many investors ask before they invest.
Annuities are regulated financial products that combine life insurance with an investment component. Variable annuities can be invested in in a few different ways. The most common ways to invest in an annuity are:
Equity index annuities – an annuity that invests in indexes such as the S&P 500 or the NASDAQ.
Guaranteed annuities – an annuity that guarantees to at least to match fluctuations in a chosen index over specific periods. For example, an annuity might guarantee investment returns of at least 50% of the S&P over 5 years. The guaranteed index can be any index the insurance company chooses.
Fixed contract annuities – an annuity that has minimum guaranteed returns. For example, an annuity might guarantee investment returns of at least 1% over the previous 6 months over a 10 year period.
Variable annuities that invest in equity indexes have typically had much better return than other annuity investments. However, historically, equities have also had a higher level of risk. And some insurance companies are now claiming that the risks of equity index annuities are understated and are offering new products.
Fixed Annuities
Annuities are an investment product that has been around since the 1600s. Although they’ve been around for so long, many people today still don’t know what an annuity is or that they even exist. This isn’t because they’re too complicated for the average person to comprehend… it just means that very few financial advisors are willing to take the time to properly explain them.
Here are the basics of annuities:
In exchange for a lump sum payment known as a premium, an insurance company will make a series of payments when certain age milestones are met.
These payments can be fixed or variable, which makes it a type of contract (i.e. life insurance or a long term care policy).
Contrary to popular belief, an annuity is not a type of retirement account. It is an insurance product that is meant to provide an additional source of income once you retire.
You can purchase an annuity with a single lump sum, installments, or with an annuity loan.
The main benefit of an annuity is that it provides your money the best chance of lasting for the rest of your life.
You are guaranteed payments for life, regardless of whether investment returns are good or bad, as long as you follow the guidelines your annuity provider provides.
Immediate Annuities
Immediate annuities are one of the most popular vehicle for accessing retirement money. With an immediate annuity, you give money to an insurance company. They guarantee to pay you a monthly check.
Although the underlying investments for the company’s portfolio can go down, the amount you receive each month will not. An immediate annuity also protects you from market fluctuations because there is a set payout each month.
Another type of annuity is an immediate annuity with income, also known as an income annuity. If you’re financially secure about ten to twenty years from now, a deferred income annuity will guarantee a monthly income for you then.
When you sign up for an immediate annuity, you enter into a lifetime annuity. This means that the insurance provider will pay you each month until you die. If you pass away the day after your annuity begins, your beneficiary will get paid the same amount.
Each annuity provider has a minimum required age for an immediate annuity. Be sure you qualify before signing up.
Deferred Annuities
1st Tier Of the Pyramid
In the "third party" or "platform" sales model that has come to dominate the annuity business, you are an annuity buyer, not an annuity owner. You are a "customer" of the insurance company which acts as your fiduciary, under the constraints of which you have no choice but to purchase its product. When you buy its products, it profits from the difference between the higher price it charges you and the lower price it pays to those from whom it buys the investment income stream. Casualties of this practice include investor confidence in the financial industry, and more importantly, the economics of the annuity business.
Deferred annuities, the first tier of the annuity sales pyramid, are an excellent example. The investor buys an annuity with a promised death benefit, but an uncertain life income. To the insurer, the death benefit is profit, but the life income stream is a cost. It expects to "make profit" indirectly by investing the deferred annuity's cash surrender value in a separate account, as is carried over by the FSA. This automatically places all deferred annuity customers in the role as customers, as opposed to annuity owners.
Indexed Annuities
Vs. Fixed Annuities: Which is Right For Me?
Investing in an annuity should never be done without a great deal of thought and analysis. Annuities are mainly sold with the promise of a safe, stable investment in exchange for a smaller than average expected return. This reflects the need to consider interest rates as current interest rates are quite low. Annuities can be a good alternative for the fixed rate bonds, CDs, and savings accounts that are riskier. Fixed rate income vehicles are still probably the best bet for most investors, but annuities do have an appeal, particularly for investors who are overly concerned with losing principal.
Annuities are really a bet against the market, as your profits will be directly related to the performance of the market. In addition, if interest rates increase, the value of your annuity decreases. Here are some of the pros and cons you need to think about before investing.
Pros:
Annuities come with a set interest rate. As a result, you have a guaranteed rate of return and your retirement income is known at the time of purchase. Your rates will never change although the rate can be increased by the insurance company if rates rise.
Annuities are long-term investments. You can invest in an annuity and have a guaranteed rate of return for 15, 20, 25 years or even longer if the surrender charges are low.
Longevity Annuities
If one person in a married couple is likely to outlive the other, it may make sense for the couple to enter into a contract with an insurance company to provide financial support for the longer-living spouse. This kind of contract was originally called a joint and survivor contract but is now frequently referred to as a longevity annuity.
Many annuities are designed to cover a series of payments until the lifetime of one of the beneficiaries (the annuitant). A joint and last survivor annuity, on the other hand, only provides payments for a predetermined period of time. After that period (called the joint lifetime), payments cease and, if the annuitants are both still living, the payments will remain available for the survivor.
With this kind of plan, the insurance company guarantees that an annuitant will receive at least the amount of the annuity payments. In many cases, these types of annuities can be a good option for retirement planning if one partner is older and is likely to outlive the other.
Hefty Fees and Expenses
The biggest drawback to an annuity is the high fees associated with them. Not only do annuities cost more than a standard investment today, but the cost will likely rise over time. While annuities come in several different types, they all have two factors that affect your cost. The first is the annuity's expense ratio, which is the annual fee charged by the insurer. This is similar to a mutual fund, which also charges an annual fee. The second factor is the "surrender charge" – if you withdraw funds from the annuity before a certain period of time has passed, you'll pay a penalty. This cost was famously criticized by Warren Buffett when he compared annuities to investment vehicles "sold by a relentless stream of hucksters – too often, salespeople who are little more than snake-oil peddlers."
Annuities also have two types of costs that can be both significant and easily overlooked: mortality and expense credits. Mortality costs are associated with the decreased expected lifespan of smokers. If you are a smoker, the cost of an annuity will be higher than if you are a non-smoker. Also, be aware that you can't purchase a higher than average cost annuity.
Do Annuities Make Sense for Retirement Savers?
Annuities as a whole are a tricky subject. There are some benefits to them, but it is all about understanding those benefits.
There are two sides to everything, and annuities are no different. In this guide we’ll be going over the dark and light side of annuities. So keep reading to find out more.
Savings Compounded
One of the biggest benefits to using an annuity is the value that it will add to your savings. Due to the tax advantages of an annuity, a lot of money can be put in and then the compound interest can build up over time. This will help you have more money saved for your future.
Insurance Benefits
One of a lot of the benefits of an annuity is the insurance aspect to it. If prices go up, there is a possibility of a lower interest rate. However, that doesn’t mean what you’ve invested is lost. This is because with an annuity you will always get a guaranteed interest rate.
Annuities in Retirement Accounts
If an investment’s return of principal is guaranteed, then it is a type of annuity.
Buying annuities with retirement funds is self-defeating. When you purchase an annuity you are giving up the chance to have higher returns by keeping your money in the market longer. You are also giving up the opportunity to use the money for other things when you are older.
If you choose to withdraw money from a retirement account to pay for an annuity, you lose the advantage of tax deferral. You will also lose any possible advantage of doing a backdoor Roth IRA.
You can, however, withdraw money from a retirement account in order to purchase an immediate single payment deferred annuity, which is a type of annuity that will not receive tax treatments.
Annuities in General
Annuities are life insurance policies that come as an investment. The premiums paid into the policy are invested and the resulting earnings are paid to the annuitant from day one.
The benefits of annuities are that they provide a guaranteed lifetime income, death benefit, and are fully guaranteed by the insurance company.
Generally, annuities are fixed premium or variable rate annuities.
Options for Beneficiaries
Say you have a 401(k) or other retirement account, would you consider leaving it to your beneficiaries? That’s what many people do with annuities, and why they are used as vehicles for transferring hard-earned savings after death. Your money can provide a stream of income throughout your grandchildren’s lifetimes.
But before you transfer what you’ve carefully built up, understand all of the options for doing so and choose one which is right for your beneficiaries.
At death, the money is given directly to the beneficiaries as an inheritance generally between two and five years later if there is no joint beneficiary.
The money is held in trust for the benefit of the designated beneficiaries, whether they’re young or old, blood or even non-blood family members.
If you have no beneficiaries designated, or if you designate one but they die before you do, the money is paid to the second beneficiary.
If there is no second beneficiary the money is paid to your estate.
If you designate none of the aforementioned beneficiaries, the money is invested in the annuity provider’s general account.
If you name both a primary beneficiary, who is expected to live to receive the money, and another beneficiary who is expected to live only as long as the primary beneficiary, the second beneficiary receives only the annuity income.
Summary
Annuities can provide a valuable addition to your retirement plan, but you also need to know what risks they involve and when it is not a wise choice to use them.
An annuity is a contract between you and an insurance company, in which you agree to pay a certain amount of money to the company to receive a guaranteed income stream. These broad strokes can appear quite self-explanatory, but that doesn’t make annuities any less complicated than they really are.