What Are Annuities?
Annuities are one of the most confusing ways to invest your money and if you don’t understand what are annuities and how annuities work then you’re not alone. That is the reason why I decided to create Annuities Explained which will help explain what are annuities and how they work, the various types of annuities, the pros and cons of annuities, and perhaps most importantly, how to buy annuities. I will try to go into further detail in future posts and I invite you to ask questions along the way. Annuities are an investment agreement between you, the investor, and a company that provides annuities which is typically an insurance company. In this agreement, you agree to give them a set amount of money either all at once or over time and they agree to pay you regular payments totaling the amount you invested plus an additional rate of return for a specified period. Typically annuities are used by investors to supplement retirement income every month.
How Annuities Work
The simplest way to explain how annuities work is to describe them as an investment security that you pay money into for a set period, and once you reach a certain date you start to receive regular payments for a set period, often for the rest of your life. Investors, especially those who are very risk averse, like annuities because they provide a steady stream of income, and unlike stocks, bonds, mutual funds, and other common investment options, annuities are guaranteed.
The amount of time you pay into the annuity can vary anywhere from a one-time payment (think lottery winner or someone who just received a big inheritance) to many smaller payments over a long period. This will vary largely on the amount of the annuity and when you intend to start receiving payments. For example, if you start paying into an annuity when you were in your 20s but don’t intend on taking payments until you retire, you will likely have many small payments, however, if you waited to start when you were in your late 50s, you will need to pay more each month over a shorter period. Annuities provide a nice supplement (or primary income), especially for those who think social security might not be enough for retirement.
Once you reach the date where you will start receiving annuity payments you will be paid a guaranteed amount of income every month until you die. Some annuities will also allow your spouse to receive payments after your death until they die, but terms can vary depending on where you purchase the annuity.
Typically the issuer will base the number of payments made on the average lifespan of someone in your position (which is calculated through extensive research on their part). If you live longer than the typical person then you will continue receiving payments for more than the annuity is worth, but conversely, if you die earlier you will receive less money overall. For example, if you pay $50,000 and the issuer estimates that you will live for 20 years you will get equal payments each month. If you live beyond 20 years then you keep receiving payments even if that exceeds your $50,000.
Some of you may read this and wonder why the issuer would do this, but even though you may live longer, on the whole, the average lifespan of the typical annuity holder will hold and they will likely come close to breaking even. They get their benefit largely from fees charged and of course, being able to invest money for a higher rate of return when the money isn’t being paid out.
Types Of Annuities
There are a lot of different types of annuities available and they can largely be adjusted to suit the buyer, but the two most common types of annuities are immediate annuities and deferred annuities.
To explain immediate annuities I will refer back to the example of the lottery winner. Let’s say you won $1 million and you received a lump sum. Instead of spending the money right away, you wanted to help ensure that it would last you for the rest of your life. If you put this money into an immediate annuity you would pay the issuer up front and they would provide you payments every month with a specified rate of return.
The most common type of annuity is a deferred annuity that provides a fixed rate of return on your investment. This amount will vary depending on which annuity company you work with and what the market conditions will bear. An example of this would be an individual who invests $100,000 in exchange for a 7% interest return. This investor would receive regular installments of principal and interest spread out monthly from his retirement until he dies
Immediate Annuities
Immediate annuities are a way to defer income taxes and to increase monthly income. These annuities are annuities funded with a large sum of money and available to be drawn on immediately. Immediate annuities are contracts between the insurance company that holds the funds and the owner who deposits the funds. Usually, these are funded from an IRA or 401(k) upon retirement for two reasons, to defer income taxes and to increase monthly income.
When the funds of an IRA or 401(k) are withdrawn from the plan and converted to funds available to the owner, income taxes are due on the full balance available. This additional income could move a holder into a higher income tax bracket and reduce the amount of money available for investment. By rolling these accounts into an immediate annuity, the only income tax due is the tax due on the payments received. This defers the balance of these taxes to a later date. Immediate annuities are therefore a wise tax savings strategy for many investors.
Immediate annuities allow for payments to start right away. Payments can be set up in several ways, depending on the holder’s desires. A financial advisor will outline all the choices and assist the investor in choosing the one that best fits the investor’s financial goals. Most holders take their payments monthly; however, quarterly, semi-annually, or annual payments can be requested. The payment received will depend upon the amount invested, in what time frame the owner wants to get the money, and the rate of return on the account.
These annuities can be either a fixed annuity which is a fixed rate of interest on the funds left in the account or variable annuities where the return depends upon the investment in the stock market. With a variable rate, the investor accumulates the profits or losses of the investment. This is a somewhat more risky type of investment as compared to a fixed annuity. Different insurance companies have different interest rates, expenses, and fixed costs with these policies. It pays the holder to shop and compare different options before signing any contract. The contract will state all the terms of the agreement when the payments are to be made to the holder, the amount of the payment and for approximately how long these will continue, how the income on the plan is to be computed and accumulated, any charges to the account, what happens when the holder dies if any changes can be made to the agreement and how these changes can be made.
Immediate annuities are annuities funded with a large lump sum usually from a retirement account like an IRA or 401(k) and start making payments to the owner right away. There are wonderful boosts to many retirement plans by providing additional income for many years in a safe, secure way and conserving money by delaying payment of income taxes. If you are considering a retirement plan then you should consider immediate annuities.
Deferred Annuities
With all of the different kinds of investments out there, you may have heard of deferred annuities but were never really sure what they were. Deferred annuities can be a great way to put away money for the future, and you do not have to pay taxes on it until later in life. With these ways to save, you can earn much more on your principal than you would with a standard interest-bearing bank account.
Deferred annuities give you a contract with an insurance company that allows you to invest a little at a time for a prescribed number of years, and then at the end of that period you can either get a lump sum payment, or you can turn it over to an immediate annuity. There are penalties for early withdrawals which varies from company to company and they usually last only until your account has broken even, which also differs between investments.
You will be able to choose between a fixed and a variable deferred annuity. When it is called “fixed” it means that your profits are tied to the interest rate which though it goes up and down, does not fluctuate too violently. A deferred annuity is very low risk but with limited rewards. This is a great choice if you are planning your retirement on a fixed income as you will know approximately how much you will be getting at the end of it, give or take a little.
The variable type is tied to how the market behaves, and as we know, it can sometimes be quite volatile, sometimes to your advantage. It is a higher risk, but as with anything higher risk, it can also have higher payouts. You will have to do a little research on the market so you can decide what you think what you think your returns will be years down the line. This is a good option if you can afford to take a loss if it does not go so well; if you think that later on you might be strapped for cash, you could consider the other alternative.
Any qualified financial adviser can help you choose, not only between a fixed and variable annuity, but they will also give you their expertise on the market and their opinion on how it will perform over time. For a first-time investor, or one with little experience this might be the way to go. Find someone who you are comfortable with and know their fees upfront; it would do you much good if what you owed them outweighed your return.
Now that deferred annuities are not such a mystery anymore, you can start doing your research and finding the one that best fits your budget and your lifestyle. Investing in deferred annuities is a smart way to save for retirement, and it is always nice to know that there will be a little extra money for you when you get there.
Annuity Payment Types
The most common types of payment for annuities are fixed and variable annuities. Fixed annuities provide a guaranteed rate of return over a set period. For example, the issuer may guarantee that if you pay $100,000 into your annuity then you will be guaranteed a 5% return on that money (this assumption also assumes no fees or taxes). Fixed-rate retirement annuities are great for investors who are very risk-averse and/or are close to retirement and don’t want to lose their nest egg.
Variable annuities were introduced to help entice the investor who expects a higher rate of return on their investment and would otherwise invest in a diversified mutual fund or something similar. Variable annuities guarantee a lower rate of return but are tied to another security (often mutual funds) that will provide a higher rate of return when the market bears it. The benefit here is that if the market is booming, your money isn’t tied up in a low-yield investment.
Fixed Income Annuities
As investors are flailing around looking for both security and growth, one of the first vehicles that come to mind is fixed-income annuities. Although the emphasis on a fixed annuity is the preservation of capital, most boast some moderate growth due to the long investment horizon associated with annuities.
An annuity of any type is a contract between the investor and another entity, generally an insurance company. The guarantor provides an investment vehicle similar to a certificate of deposit. Fixed annuities pay a contractual fixed growth rate on the deposited funds. The critical advantages of fixed annuities versus other interest-bearing accounts come from the core advantage of any type of annuity: the monies grow tax-free, and many have low investment minimums. A standard starting point for an annuity is between $1,000 and $10,000. They have very similar withdrawal rules to Individual Retirement Accounts and 401K plans about withdrawal planning. An individual must be 59 ½ before starting to take the annuity or else pay a 10% tax penalty on the withdrawal.
As with any contract, it is critical to take the time to understand the fixed annuity details for the one you consider as an investment vehicle. All guaranteed annuities generally have a guaranteed minimum rate of 3% returns. Some have higher rates or bonus rate programs but it is critical to read the fine print on those types of interest rates. They are often not as advantageous to the investor in the long haul so much so in the near term. It is the exact opposite gimmick from a credit card introductory rate: for the annuity, the “catch” is a very high introductory rate and a lower-than-normal guaranteed rate in place of the credit card’s low introductory interest rate combined with a high post-new member rate.
The key to knowing whether annuities are right for you depends on your level of confidence that you will not need access to that money for at least the first five to ten years of the contract. Some annuities have significant early withdrawal fees, often in the range of 10%. As with any form of fund investing, it is critical to discover the fees upfront as those fees can quickly consume your returns on your investment. The best fixed-income annuities have low-cost ratios.
The difference between a fixed-income annuity and a retirement account is that the annuity at some point will move from the accumulation phase to the payout phase, in which your capital reserve transitions into some form of income. A fixed annuity refers to its method of growth. All annuities can select either a fixed or variable payout. At the point in time when you annuitize the money, the insurance company receives a lump sum in return for a guaranteed payout, generally calculated off life span actuarial tables. Variable annuities work largely the same way but may vary in actual amount based on market and investment performance.
Not all of the annuity must be annuitized at once. One way to hedge your bet about current interest rates is to transition your annuity in stages, allowing you to try and make one last effort to leverage the most out of your money.
Variable Annuities
Unlike their deferred annuity counterparts, variable annuities don’t have a locked-in rate of return but instead, give you a way to ride the market when times are good. The way it works is that the annuity performance is tied to some kind of investment security like stocks, bonds, or money market accounts very much like mutual funds do. When these investments go up you make money and when they go down you lose money.
Your investment starts when you first start your annuity contributions, and when you do you choose what type of investment you want these contributions to go toward. You could alternatively invest a percentage in each investment option. Depending on what annuity company you are doing business with you will have different options, but remember annuity fees will apply for each of these investments as well.
Retirement Annuities
There is always a lot of controversy over the topic of retirement annuities. Some people feel they are a favorable option for retirement savings while others only seem to have bad things to say about them. Retirement planning should be a vital issue in every person’s life. You want to be sure you can live comfortably and enjoy yourself after you retire and not be a burden to your family.
If you are someone who is presently in the process of trying to make their mind up on retirement annuities and learn more about them, there are a couple of important points to realize.
Although there is a great deal of negativity that surrounds annuities in the world of retirement savings, overall they are an ideal way to save for retirement. For one thing, they are tax deductible. That is a term that everyone loves to hear.
When choosing annuities make sure you choose the most flexible plan. There are fixed and variable annuities to pick from. With both of these, you get guaranteed rates of interest. If you are wary of the constantly fluctuating stock market the fixed-rate retirement annuities will be best for you. This ensures you stay at your initial rate and this will never change. Of course, the problem with the fixed rate is that if the market ever goes down you will not have the option of changing your rate of interest and possibly taking advantage of a better price which is a drawback.
With the variable option, you can switch as you please. The variable option is tax-deferred as well and has more growth potential than its fixed counterparts. The variable annuities allow periodic payments which can be a desirable feature to have included in your retirement plan. What this means is that if you happen to outlive your assets you will continue to receive payments. This is nice to know because it would be pretty unfortunate to live a long wonderful life only to find that your retirement payments have run out and you have nothing to live on.
The variable annuities also offer a death benefit. This way your beneficiary will be able to receive any amount of your asset left over if you die before you have started receiving payments. This is relieving because you will not have to worry about years of making payments toward your retirement savings being all for nothing.
The issue of annuities for retirement is one of obvious importance. Because it can be so difficult for most people to decide which type of annuities or other retirement savings they want to start, it is wise to seek advice from a financial adviser. Even after doing a bit of research on your own time, this will be a wise idea. They can sit and discuss your job and retirement planning options and make sure you decide on the right options for you and your life.
Guaranteed Income Annuities
Many older people plan to use their annuity for their regular income. After they retire, an individual has to use this particular form of income with great care. Guaranteed income annuities can serve to provide a base income for a person’s life after their retirement. As the name conveys, it is guaranteed, so you will not have to worry after you sign up for this investment in stock and share. Whatever the share market condition, you can expect the same level of cash income. You have to choose the products according to your own needs. This kind of product ensures the annuitant that they will always get their payment on time.
Guaranteed annuity incomes also possess some disadvantages, like its very rigid product of annuity. You cannot change the annuity when you wish; it is very inflexible. You get the fixed income for which you have agreed at the time of making the annuity, irrespective of drastic changes in the stock market and share market. You should seek the assistance of an independent financial advisor. He will direct you to select which annuity is best for you by keeping all of the safety factors in mind. You can quickly alter your annuity if your circumstances change within your life span.
Although the guaranteed annuities are bound with some limitations, it is a convenient way to turn your pension fund into a regular income for your usage. It means transferring your pension money into a regular base salary for the rest of your lifetime. Many people want to convert their pension fund into guaranteed annuity income to be on the financially safe side. It is one of the income methods for people who stop working due to their aging. Some people like to go for different annuity products to enjoy profits and to experience less risk.
A guaranteed annuity is a plan for people who earn pension funds and who wish to have some regular income through these funds. It provides a person with great security so that they can live a retirement life happily. Individuals who are less able to be flexible in life and are not interested in facing any financial risks often choose to select this product. The sensible people think that this is the best deal to get some regular kind of income with their pension funds. Many individuals wish to live their retired life in trouble so they transfer their entire pension fund into annuity income. In the golden years, every one of us wants to live a stress-free life with at least some limited income arriving regularly every month. So, if you are unsure of how to best select your annuity product, visit any independent financial advisor who may be able to help you by offering you sound financial advice. That way you can spend your remaining years happily without worrying about finances because you have chosen wisely by investing your funds into guaranteed annuities.
Pros and Cons of Variable Annuities
The obvious benefit of investing in a variable annuity instead of fixed income annuities is that you can benefit from the upswings in the market. Often guaranteed rates of return will be much lower than average investments so it can be frustrating to lose out on potential income.
You may be asking yourself why you should invest in a variable annuity rather than just investing in a mutual fund. The answer revolves around the tax benefits that annuities receive. Much like 401K’s and IRA’s annuities are tax deferred on the income portion of the investment (the money you invest is not taxed upon withdrawal), so if you were to invest in a mutual fund instead you would lose out on this benefit.
For those of you worried about losing money, some annuity companies provide a guaranteed minimum rate of return on your investment. Typically this rate of return will be lower than a fixed annuity with the same company but it’s nice to have a floor. Not all companies will provide this option though so you should be sure you are familiar with the terms before investing.
One of the cons of variable annuities is the fees that are charged. Typically annuity fees are higher than other types of investments so you want to make sure the rate of return you are getting is not diluted by these fees
There are a lot of good and bad features of annuities. Perhaps the biggest benefit of annuities is that they are tax-deferred. First of all, there are tremendous tax benefits for investing in annuities. Specifically, the money you invest in an annuity grows tax-deferred until you eventually start your withdrawals. What that means to you is that all the money you contribute and any gain you make on your investment is not taxable until you begin receiving payments. Once you receive payments only the gain on your money is taxed. It should be noted that the income is taxed at a regular tax rate, however, not at a capital gains rate like other investments.
Once you start your payments, only the gains you made on your annuity are taxed, and since many of us typically have lower income during retirement, they will be taxed at a much lower rate than they would have been during our working lifetime. Unlike IRAs and 401K programs, there is no limit to the amount of money you can contribute to an annuity (and the issuer would love for you to invest more I’m sure).
Another big benefit is that annuities are guaranteed as long as the company you dealt with stays in business. Not only are your payments guaranteed but you will continue to receive them until you pass away, regardless if that amount is more than you originally invested.
Another obvious benefit of guaranteed income annuities is the guaranteed payments that annuities provide. With all of the turbulence in the economy (especially in the last few years), a guaranteed rate of return from an annuity sounds pretty good to many investors whose faith was shaken by losses in the stock market.
Some of the disadvantages of annuities are that much like a certificate of deposit with your local bank, there are early withdrawal penalties if you are forced to cash in your annuity early. Typically these penalties are structured in such a way that they are high for the first few years and they slowly decrease over time. These penalties can be as high as 10% so clearly annuities aren’t for investors who need a lot of liquidity in their portfolio.
Another disadvantage of annuities is that fees are typically higher than other investments. Many annuities have fees amounting to 2-3% or more, which compared to other investments with fees of 1% or lower, can add up. Before purchasing any annuity, you need to be sure you have done your homework on all of these fees and be sure that the rate of return you are expecting makes up for any fees you will be charged over the life.
Lastly, the obvious con is that you can lose money in a market downturn. Just like stocks, bonds, and mutual funds, variable annuities can and do lose money so never invest more than you can afford to lose. If you are risk averse a guaranteed annuity may be a better fit for your portfolio.
Tax Advantages of Annuities
Annuities have a very good tax advantage for most investors. When you buy an annuity your money is invested tax deferred until you begin withdrawing your funds. Once you start receiving annuity payments only the portion of your investment that was gained is taxable, and quite often when you retire you are sitting in a lower tax bracket than you were during your working life. There is also an advantage to deferring tax with the time value of money which in short states that money paid out today is worth more than money paid out in the future.
Guaranteed Rate Of Return
Typically fixed annuities offer a guaranteed rate of return. The amount of that return depends on the agreement with the issuer, but since it is guaranteed it is usually lower than stock market investments or mutual funds, but the allure of a guaranteed investment return is desirable for many investors, especially when planning retirement investments. Variable annuities also typically offer a guaranteed rate of return as a floor but mix in some investments based on stocks, index funds, or mutual funds so you have an opportunity to improve that return, but have the guaranteed rate of return to fall back on should the investment portion of your annuities not fare so well.
No Maximum Investment For Annuities
Unlike 401k and IRA accounts, there is no maximum investment amount for annuities. So what that means is if you are looking to invest as much money as possible in a tax-deferred investment then annuities might be right for you.
Disadvantages of Annuities
While I feel that annuities are a good investment, especially for the risk-averse, there are a few disadvantages of annuities that may prevent the typical investor from sinking their money into a fixed or variable annuity. Let’s take a look.
Annuities Are Not Very Liquid
For investors who have money to stick away that they know they will never need annuities makes sense, but if you think that you may need your investment income for some other purpose then you may want to stay away from annuities. Most annuities have a penalty percentage if you withdraw your funds early and this penalty can be as high as 10% in the first year (the rate usually declines after a few years). You can sell your annuities on the secondary market, but there may be transfer fees involved so be sure to read any fees paperwork carefully.
Annuity Fees
In addition to the early withdrawal penalty, the regular annuity fees tied to annuities can be higher than normal retirement investments. Since annuities are often offered by insurance companies, they don’t have the economies of scale that investment companies have so to make up for this they have to charge their customers more. Often fees can eat away at your annuity yield adding up to 2-3% or more with some annuities.
Bottom line, annuities have their pros and cons and it depends on what type of investor you are. For the typical investor, it is recommended that you max out your IRA and 401K plans before considering an annuity, unless of course you have a large amount of money to invest, then an immediate annuity is what you need. Regardless be sure you read and understand all the pros and cons of annuities before investing.
We all know that annuities can be a good investment for the right investor, but one of the things that separates them from other investments is that annuity fees can be particularly high in comparison, depending on the annuity companies and types of annuities you invest in.
One of the more common annuity fees is the Mortality and Expense (M&E) fee. An M&E charge is a mix of expenses ranging from insurance to administrative fees that are applied to the annuities (particularly variable annuities). According to the National Association for Variable Annuities (NAVA), the average M&E fee is around 1.15% or 115 basis points.
Another common expense associated with annuities is the surrender fee. In simplest terms, a surrender fee is an amount of money that you have to pay for cashing in your annuity before a set period. Typically the fee decreases over time until it eventually fades out to nothing. Generally, a surrender fee between 6-7% is very common and may decrease by around 1% each year. The reason for this fee is that the annuity companies are making money on the investment that you paid in and when you cash in early the company loses the ability to invest that money elsewhere. They make back some of this investment by charging a surrender fee.
With variable annuities, investment expense fees are quite common considering that they are tied into stocks, bonds, or money market funds. When you buy and/or sell these investment securities you will usually be charged an investment expense fee for these transactions, very much like you would with a mutual fund. Investment expense fees are much less common in the guaranteed annuity but some annuity companies still charge it.
Administrative and Management Fees are common across all types of annuities and are charged by the annuity companies themselves for the administration and management of your annuities. These fees could be in the 0.82% range based on an NAVA report. Depending on what your other investment options you may be paying more for your annuities than you would with another investment option.
Overall annuity fees are something that you need to keep an eye on and you need to factor in when you are considering returns. Not all companies charge the same fees so shopping around is a must here, and be sure you fully understand the terms and read the fine print before investing.
How to Buy an Annuity
So if you’ve read all of this and you want to know how to buy an annuity you’re in luck. There are hundreds (probably more like thousands) of annuity companies that sell annuities in all shapes and sizes. Typically any insurance company will offer some sort of annuity package, so if you already have an established relationship with one of them you should look into their annuity options.
With the financial trouble in the market over the last few years it is important to do some research on the company you are buying the annuity. Since you are relying on them to provide a guaranteed income for the remainder of your life you want to make sure the company will be around that long. The good news is that companies that issue investment options like annuities are rated by companies like Moodys and Standard and Poors for their financial soundness and you can easily monitor any changes in their status. Also, your state’s insurance department will monitor these companies and help prevent any potential problems before they happen. (The National Association of Insurance Commissioners – NAIC – provides a listing of insurance departments by state).
When Should You Buy An Annuity?
Where annuities are concerned, many individuals who are not knowledgeable of this type of retirement investment will naturally have lots of questions. What is the difference between an annuity and some other type of retirement investment? Now that there are traditional and Roth IRAs as well as 401(k) plans, do annuities still make good sense? These are two of the primary questions but another one is “When should I purchase annuities?”
You can compare the answer to this in a similar fashion concerning the issue of when you should or shouldn’t buy stocks. You need the wisdom that only comes from doing some serious research about annuities so that you can determine when the time is right to purchase them based on your financial expectations for retirement. There are several types of annuities such as:
- fixed annuities
- immediate annuities
- indexed and/or CD annuities
- variable annuities
So you should educate yourself as to the different types available, not only to figure out which one will be appropriate for you but to decide on when you should purchase them.
Typically, the time for purchasing annuities comes about when an investor begins to focus more on income and safety during their retirement years versus growth or earnings yield. The window of opportunity normally occurs about 10 to 15 years before when you are planning on retiring. That window widens at the time you retire and then begins to steadily close thereafter.
When is the best time to buy?
Even though this is a generalization where annuities are concerned, you should still familiarize yourself with the different types listed above. As was previously mentioned, the time to purchase any of these annuities will depend on timing. Here is what we are talking about where timing and type of annuity is concerned:
Fixed annuities – since these are typically a form of fixed income investment, surrender fees will be a standard feature of these annuities, especially when they are the deferred fixed types. Characteristically, you want to purchase these 10 to 15 years before when you plan to retire.
Immediate annuities – as the name implies, the time to purchase these is now. In other words, the time to purchase immediate annuities is during the months surrounding your pending retirement.
Indexed and/or CD annuities – typically, these are purchased at any time during a person’s financial life cycle. However, they are best suited for long-term investing so you should consider getting started with these years ahead of the standard retirement age. These annuities allow the investor to enjoy the gains that occur in the stock market without suffering from losing cycles.
Variable annuities – these are an excellent choice for gaining tax deferrals outside of another retirement plan such as a 401(k) plan or IRA. These types of annuities are not normally a good fit for younger investors as they benefit those individuals who are closer to retirement age. Variable annuities help the investor to preserve these tax deferral options.
Are Annuities a Good Investment?
After reading this article you might be wondering if annuities are a good investment. Well, that’s a question you will have to answer depending on your circumstances, but there are benefits. If you are a risk-averse investor who is just looking to hold on to what you have then annuities might be right for you. If on the other hand, you are looking to make a significant profit on your investments over time then you should look elsewhere. To learn more or talk to an advisor for free, Click Here.