Understanding Annuities? Fixed, Indexed, Variable?
Annuities have become a very important part of many investors’ financial portfolio. There are many types of annuities with different levels of risks and returns on investments. In addition, annuities have many features that are similar to life insurance, thus giving an investor the desired diversification and benefits. Before making this type of investment however, you should consult with a financial advisor. An advisor will help frame your financial goals and values and determine how your financial portfolio is performing before diving into to this type of investment. Annuities are very complicated, with a variety of risks, fees and details to consider, so it’s important to get the best possible advice out there before making any decisions.
Questions you should ask your financial advisor before investing in annuities:
- What is the cost of the contract?
- Is the cost paid in one lump sum or payments?
- What is the minimum interest rate?
- Is there an interest rate cap on my contract?
- Is the interest compounded?
- What are the surrender charges?
- How long is the surrender period?
- What is the term of the contract?
- Is there an administration fee?
- Is there a participation rate? If so, how long?
- What economic indexing is used for the indexed annuities?
- Can I make partial withdrawals of the principal and if so, are there additional charges or loss of interest?
- What is the vesting rate if my contract includes vesting
Some key terms of annuities:
- Annuitant– the investor of an annuity is considered an annuitant. The annuitant agrees to a contract with a life insurance company to receive periodic payments in exchange for an investment of a single large sum or payments in regular intervals.
- Accumulation Period– the duration of the time an annuitant invest into an annuity. The greater the contributions are into an annuity, and the longer the length of the accumulation period, the greater your cash flow will be when it is rolled over to the annuitization phase. Essentially, if an investor pays into their annuity during their entire work life their annuity will have a substantial sum accumulated when the annuitization period begins.
- Annuitization Period– The annuitization period is after the accumulation period and it begins when the annuitant starts to receive payments of interest earned. It can be quite substantial if the investor chose to have their annuity deferred and has paid contributions throughout their work life.
- Immediate– The annuitization period begins immediately after the investor contributes a large lump sum into an annuity.
- Deferred– The investor chooses to save and defer their contributions into an annuity. In addition, it refers to the investment gains are tax deferred until the investor withdraws the money.
Fixed Annuities
Fixed annuities are typically considered a safe long term investment. It is an agreement between you and a life insurance company and can be purchased with one single large payment or several partial payments. The agreement implies that the insurance company will pay you a fixed rate of interest for a set period of time, although the rate can change there is also a minimum interest rate that protects your investment. A fixed annuity can be paid out immediately (fixed immediate annuity) or deferred (fixed deferred annuity).
Indexed Annuities
Indexed annuities allows the investor to participate in the market fluctuations by having the interest rate tied to economic performance. An indexed annuity is very similar to a fixed annuity in nature. It’s return on investment and risks are best for a medium to long term type of investment.
There are many factors that determine the interest rate of an index annuity and the rate fluctuates day by day. In addition, the return on investment can be either immediate or deferred.
Immediate Annuities
A classification of annuity that describes how the disbursements or distributions are paid out. With this type of investment the distributions start immediately after the contract between the annuitant and the insurance company is created and paid with one lump sum.
Life Annuities
A classification of annuity describing the type of pay out the annuitant receives. This contract of the annuity is paid into with one single large payment, therefore it creates monthly cash flow until the annuitant expires. After expiration any value left in the investment reverts back to the life insurance company.
Deferred Annuities
A classification of annuity that describes how the contract between the annuitant and the life insurance company is created and paid into as well as how the disbursements or distributions are paid out. Deferred annuities have an “accumulation period” and pay out of distributions begins after the accumulation period concludes. The interest earned are also tax deferred.
Investors who wish to save for their retirement usually choose the deferred type of annuity. This allows the investor to pay for the contract in payments rather than one lump sum, thus giving the investor the ability to use their assets for other things.
Variable Annuities
A variable annuity is contract between you and a life insurance company and purchased with a lump sum payment or several partial payments. The annuity is then spread out into different sub-accounts that can include: mutual funds, stocks and bonds, or money market accounts. As the name implies, the rate is variable and dependent upon the performance of the investments that you choose.
Variable annuities are long term investments that can generate monthly cash flow once the payout phase begins, and the payout phase is dependent upon the structure which can be immediate or deferred.
When should an annuity be used in your portfolio? When is an annuity the right decision? Those are big questions and probably what lead you to looking for answers today. When does an annuity make sense? Whether you are investing in a variable annuity or a fixed annuity certain conditions should always be met.
While the processes of all annuities work on the same basic concept there are some major differences. Before we look at the the conditions a very basic understanding of the two major differences will help. A variable annuity is invested in the market. Technically, it’s not but for all intents and purposes it works exactly the same. You can and will very likely lose money as the market goes down. Your investment principal balance is at risk or market fluctuations.
With downside risk there is also a higher potential for gain. Contrast that idea with the fixed annuity either fixed indexed or traditional fixed. They will either pay a certain rate of return or a variable rate of return with one difference from the variable annuity, no downside risk. Neither of these are considered market investments. Just keep in mind that there are two major kinds of annuities, fixed and variable.
First, annuities are long term investments. They are not short term investments. Think of them as part of your permanent investment portfolio. They are also designed to provide income at a future date. If you are not using an annuity for income at a future date you should use a different investment.
Second, you should never use your emergency money for annuity investments. Annuities are not as liquid as other investments so they should not be considered for emergencies until all other options are exhausted. Most experts agree that 3-6 months of emergency money will suffice.
Third, study the benefits. Annuities have amazing benefits. First and foremost they are tax deferred. You are only taxed on earnings that you take out and not on your principal unless your annuity is a rollover from your employer. And with annuity laddering strategies you can sometimes even double your income from your IRAs and other retirement investments.
The other amazing benefits all have a lot of details so be careful. If an advisor tells you that your income is state guaranteed, ask how. Some of the benefits have fees associated with them. Always make sure you understand each benefit completely. Case in point, one very popular benefit increases your principal by a certain percentage rate each year no matter what the market does. The catch is that the amazing guaranteed rate is not available as a lump sum withdrawal. It must be taken out over many years. This is one reason that annuities have a bad reputation. It is a fantastic benefit for income needs but useless if you need a lump sum in a certain amount of years.
And last but not least you should always work with a competent advisor to make sure an annuity is right for you and your exact financial situation. There are so many annuities available now that you can usually find one that fits your specific needs. Learn how annuities work and you could find the best investment you will ever own.
