An annuity is an agreement that investors make with an insurance company. The (Investor) customer gives the insurance company a sum of money, either as a lump sum or in installments. The insurance company invests the funds and agrees to make payments over a determined period of time. In simple terms, you give money, in promise of future monthly income that will be paid out for a defined period of time.
Unlike other insurance contracts, the payments don’t depend on the customer undergoing an accident or suffering a unfortunate event in order to receive a payment. Instead of filing a claim, the customer determines the conditions under which they’ll receive their payouts.
Whether you have a retirement plan or not, there are a lot of concerns that not to be addressed. According to a SimplyWise Retirement Confidence Index, the number one fear for retirement is that Social Security will dry up in their lifetime.
But, that’s not all. The unexpected death of a spouse, rising cost of medical expenses, investments not keeping up are also worrisome. And, as if that’s not enough to keep you awake at night, almost half of Americans cite running out of money as their chief retirement concern.
While there isn’t a one-size-fits-all solution, one of the best ideas to ease your anxiety over retirement is through an annuity. In simplest terms, this is an insurance product that promises you an income throughout retirement — which, by the way, a guaranteed is something that 71% of workers want.
An annuity might sound too good to be true. But, it could be a powerful component of one’s retirement portfolio. The problem, despite the fact that annuities have been around for centuries, these financial products are often misunderstood and misused. So, to clear the air and help you make a more informed decision, we’ve put together this invaluable guide.
What will you find? In our annuity guide, we’ll define what annuities are, the different types, and the pros and cons. We’ve also included the five questions to ask prior to purchasing an annuity, as well as a glossary index.
So, without further ado, let’s dig deeper into the world of annuities.
As we already mentioned, an annuity is an insurance product. But, that was a barebones definition. More specifically, an annuity is actually a contract between you and an insurance company. In exchange for a lump-sum payment or a series of payments, you’ll receive a guaranteed lifetime income.
When do you receive these payments? That depends. Usually, you have two options either immediately or sometime in the future. Whatever you chose, the goal of an annuity is to provide you with a steady income after you leave the workforce.
Similar to more popular and well-known retirement plans think a 401(k), contributions can only be withdrawn after the age of 59 ½. If you do make an early withdrawal you will have to pay a penalty — in most cases this a 10% early withdrawal penalty tax.
However, if you don’t touch your annuity, it will accrue on a tax-deferred basis. And, unlike your 401(k) or IRA, there aren’t contribution limits. That means you can invest however much you want. You’ll then earn a percentage on everything that you deposit — with Due the calculation is simple you’ll get 3% a month on your money.
In addition to guaranteed lifetime income, another appealing aspect about annuities is how customizable they are. Again, you have the choice to make a lump sum or series of payments to an insurer. You even have the ability to determine when you’ll start receiving payments, aka annuitize your payments.
Even the duration of disbursements can be tailored to your retirement goals. For example, you can receive payments for a specific timeframe, like 25 years, or until your pass away. And, if you still have some money left over, you can pass that on to a beneficiary through a death benefit rider.
Why do people buy annuities?
There are a lot of reasons why people have and will continue to, purchase annuities. This is especially true if you’re on the verge of retirement, like being one year out. Mainly, to generate long-term income to supplement other sources, such as a 401(k) or Social Security.
At the same time, annuities can be beneficial to investors of all ages. Why? Because they come packed with the following advantages;
- Protection and growth. An annuity allows you to grow your money, without the risk of losing your tail.
- Long-term security. In addition to being a supplemental retirement income, some insurers are offering a long-term care annuity to cover these future expenses.
- Tax-deferral. This means that you don’t have to worry about taxes until you receive annuity payments. In the meantime, enjoy your significant money growth.
- Principal protection. No matter what, an annuity ensures that you’ll get a return.
- Probate-free estate distribution. You can avoid probate and a cash inheritance to beneficiaries. If you don’t have any beneficiaries, the annuity balance can be included with your estate.
- Inflation adjustments. As long as you have an inflation-protected annuity (IPA) you’ll be guaranteed a real rate of return that’s either at or above inflation level,
- Death benefits for heirs. Since annuities permit a death benefit rider, you can pass your annuity balance on to an heir or spouse.
Also, research has found that retirees who have a guaranteed income are happier and live longer than those who don’t.
What an annuity isn’t.
Annuities are contracts between you and an insurance company. Most agents try to make them sound better than they really are.
Moreover, annuities are not any of the following;
- Ownership of shares of any individual stock, index fund, or mutual fund
- A bond or a certificate of deposit (CD)
- Insured by the FDIC, such as a bank CD or a checking or savings account. In fact, annuities are not regulated by any federal government agency or even guaranteed by a bank or credit union for that matter. Instead, annuity guarantees are backed by issuing insurance company’s financial strength.
- Available for “instant access.” That means you just can’t make a withdrawal as easily as you can with a checking or savings account. While it is possible to cash out your annuity, it takes several days and you may have to pay a penalty. As such, consider an annuity as a part of your long-term retirement plan.
What’s the difference between annuities and life insurance?
Since both annuities and life insurance are issued through insurance companies, some might believe that they’re one-in-the-same. In reality, they serve different purposes.
“Life insurance plans provide income for your dependents if you die sooner than expected,” explains Janet Hunt for The Balance. “Most life insurance plans can be divided into either term-life or whole life insurance.”
As a general rule of thumb, a term life insurance policy spans 10, 20, or more years. A “whole life insurance policy is for the entire life of the policyholder,” adds Hunt. “Some term life insurance policies offer the option to be converted into a whole life insurance policy when the term expires.”
“Many life insurance policies do offer cash value and income-earning options as well as other living benefits like a critical care coverage option,” she states. But, “this is not the main function of a life insurance policy. Its main function is to care for your dependents after your death and pay for end-of-life/final expenses.”
Another key difference? Pays are issued when you die and are in a single sum, as opposed to a series of recurring payments.
As mentioned several times above, annuities will provide you with a recurring income throughout retirement. The main purpose? To guarantee that you have an income in case you outlive your savings, exceed your expected lifespan, or run out of other retirement income streams.
Unlike life insurance, payouts begin when you retire from your job, typically at age 65. You’ll then receive monthly payments each month for the remainder of your life. However, theres’ also the option to choose to receive one lump sum.
Both have their advantages and disadvantages. However, life insurance is best suited for those who want to pass something along to their family to ensure that they aren’t struggling to make ends meet. If you’re concerned about your own financial future, annuities may be the better fit.
Cash now or cash later?
Another misconception about annuities is that there is only one type. For years, this was the case with immediate annuities. In fact, up until the 1950s, this was the only annuity option.
As the name implies, this is when you would receive payments right away. Usually, these are bought by older people or those who are close to retirement. Why? These annuities begin paying out within one to twelve months of the investment.
When you think about it, they’re kind of like a bizarro life insurance policy. With life insurance, you make a series of payments so that there your beneficiary will receive a one-time payment. On the flip side, you’re paying the lump sum upfront in order to receive regular payments.
But, what if you’re younger or don’t need an additional income stream right now? There’s also a deferred annuity.
Also known as a longevity annuity, you’ll delay your recurring payments to a future date. In some cases, you might be able to push annuity payments back to 30 years down the road. In the meantime, your investment will grow at a tax-deferred rate.
Furthermore, you have the option to receive recurring payments or a lump sum when it’s time to cash in. Deferred annuities also come equipped with a death benefit.
Are there different types of annuities?
Although annuities come in the above two basic configurations, they also come in several different forms. Usually, they are classified by the following three factors;
- Financial structure
- When payments begin
- How long the payment last
How do you know which type will be best for your retirement? That ultimately depends on your specific retirement plans and what obstacles you foresee, such as long-term care. But, to help you figure this out, here are your different options;
- Fixed annuities are your simplest and most straightforward option. You may make payments to an insurance company and they promise a minimum rate of interest and a fixed amount of periodic payments. These types are regulated by state insurance commissioners.
- Variable annuities are a more flexible income option. Here the insurance company places your money into different investment options. In most cases, this would be mutual funds. You might make more money with these types, but there’s also more of a risk since your return is based on market performance. The SEC regulates variable annuities.
- Indexed annuities are also known as hybrid or equity-indexed. They’re similar to fixed annuities. But, they also offer an interest rate that’s greater than a stock market index return, such as the Dow Jones Industrial Average or S&P 500.
Because this is a lot of information to consume, we will take a closer look at the different types of annuities in other chapters. We just wanted to introduce them to you for the time being.
Let’s talk about annuity fees.
“Nothing is free. Everything has to be paid for. For every profit in one thing, payment in some other thing.” — Ted Hughes
Unfortunately, all annuities have commission fees. For the uninitiated, this is how the broker puts bread on their table. They earn money by selling your annuity.
Here’s why this gets tricky. In most annuity contracts, you won’t see this included. But, they are built-in and can be anywhere from 1% to 10% of the total contract value. It boils down to what type of annuity you have.
- Single-premium immediate annuities often have attached a 1% to 3% commission.
- Deferred income annuities usually fall somewhere between 2% to 4%.
- A commission on a 10-year fixed annuity often can range from 6% to 8%.
But, wait. There are more fees you should be aware of, such as;
- Riders are customized features that you can tack on. Some of the most common examples include death benefits or minimum payouts. Typically, each rider can set you back between 0.25% and 1% a year.
- Administrative fees are what you’re charged to manage your annuity, usually somewhere in the ballpark of 0.3% of your annuity contract’s value. However, you could be charged a flat fee that’s around $30 a year.
- Mortality expense risk charges are equal to a certain percentage of your account value, typically about 1.25% annually. This covers the risk that the insurance company has taken to sell you an annuity contract.
- Underlying fund expenses take care of any costs that are associated with the administration of underlying mutual fund investments.
- Surrender charges and tax penalties can kick in if you sell or withdraw your annuity too early or before you reach a certain age, usually 59 ½.
What are the disadvantages of annuities?
So far, you might have noticed that we are kinda fans of annuities. But, that doesn’t mean that they’re flawless. In fact, they have plenty of drawbacks.
For starters, you might be sacrificing liquidity for a lifetime of financial security. What does that mean? Well, because annuities are long-term lifetime contracts they’re considered illiquid. As such, annuities can not be easily converted into cold, hard cash.
Why’s that an important consideration? Well, if you’re on a tight budget and need quick access to cash for an emergency, an annuity is counterproductive. What’s more, if you have a serious health condition that may shorten your lifespan and you have medical bills, an annuity shouldn’t be a priority. Other common concerns involving annuities include:
- Pricey commissions and fees
- The complexity of the annuity structure
- Conservative returns, when compared to other investments
- Loss of potential returns from other investments, aka “opportunity cost.”
Opportunity cost is actually a disadvantage that many people cite when it comes to annuities. To be fair, this is a valid concern for younger investors you have the ability to bounce back from market losses. As such, they may want to take a high risk, high reward approach.
How to buy and sell annuities.
As I’m sure you know by now, but insurance companies sell annuities. The thing is, so do brokerage firms and mutual fund companies. Even local and national banks sell annuities.
Regardless of where you actually purchase an annuity, always thoroughly read and understand the annuity contract. At the minimum, pay attention to the fees attached. They should be clearly stated and transparent.
Another area to focus on is the mutual find prospectus. You only have to worry about this if you’re invested in a variable annuity. If so, request all the mutual fund options you have at your disposal and determine the right amount of money you can allocate. Also, if you invest in a variable annuity via a 401(k) or IRA, there aren’t any additional tax advantages.
Most importantly, if you sell or withdraw money from a variable annuity not too long after you bought it, expect a “surrender charge” from the insurance company. This will reduce the value, as well as the return, on your investment. In most circumstances, the surrender period is six to eight years after you buy the annuity. too soon after your purchase, the insurance company will impose a “surrender charge.” This is a type of sales charge that applies in the “surrender period,” typically six to eight years after you buy the annuity. Surrender charges will reduce the value of — and the return on — your investment.
Reducing risk and fraud.
The easiest way to avoid risk? Annutize gradually. As opposed to making your investment in a lump sum, you would put maybe half in and add the rest later. For example, putting $60,000 towards an annuity instead of $120,000.
Why would go this route? First, it gives you access to more interest rates. Second, it buys you time to calculate how much you actually need in an annuity.
Also, because annuities aren’t protected by federal entities, you need to factor in the financial strength of the insurer. It’s also advised that you only work with insurers who are highly rated d by A.M. Best, Fitch Moody’s, and Standard & Poor’s. And, to further migrate this risk, spread your annuity funds across different insurers.
- What Is an Annuity?
- The Difference Immediate Annuities and Deferred Annuities
- How does an annuity work?
- The Benefits of a Deferred Annuity
- The Benefits of an Immediate Payment Annuity
- What Is a Variable Annuity?
- What Is a Fixed Index Annuity?
- What Is an Indexed Annuity?
- A Brief History of Annuities
- Will Annuities Recover?
- Money for Today or the Rest of Your Life?
- Are There Any Other Types of Annuities?
- Become Familiar With Annuity Fees
- What Are Your Payout Options?
- Weighing the Pros and Cons of Annuities
- Is An Annuity Right For You?
- How To Measure Your Annuity
- Understanding Annuity Formulas
- Annuity Calculators
- Questions To Ask Before Buying An Annuity
- Annuity Glossary Index