What Is An Annuity?

Annuities are widely promoted by financial institutions as a retirement planning tool. They are not always as simple as they sound, however, and they are not always the best choice for every investor. If you are considering investing in an annuity—or if someone else is trying to convince you that you need one—take care to understand the benefits, costs and risks before you invest.

Annuities are investments that you can use to turn savings into a dependable income stream for retirement or to provide financial support for your loved ones after your death. 

An annuity is a contract between you and a life insurance company. The contract requires you to save and invest money in the annuity now or on a regular basis until you reach retirement age.  Then the insurance company will pay you in regular installments for life, or for a defined term, when and if you decide to “annuitize” or start withdrawing your money in regular payments over time.  You can begin annuitizing, or withdrawing money out of the investment right away or at a later time.  If you are not taking income right away, your investment in the annuity will grow on a tax-deferred basis, meaning you do not have to pay income tax on the money that your investment earns.  You may also be able to withdraw your money in a lump sum after a period of years if you choose not to annuitize, depending on the terms of the contract.

Annuities are sometimes described as an investment program wrapped in an insurance policy, and that is essentially what they are.  You will pay a premium (annual fee) for the investment and the money beyond the premium price will be invested in the annuity will be invested either in fixed-rate assets (such as bonds or bond mutual funds) or variable-rate assets (such as stocks, stock mutual funds, or real estate).

Typically, an annuity will offer several different types of guarantee—or insurance—as part of its features. The most common guarantee is a death benefit, or a sum of money that will be paid to the person you name as your beneficiary in the event of your death.  This might be a defined amount, or it might be the net amount of the money you have saved through the annuity, minus any costs or fees.

Other guarantees might insure that:

  • the income from your annuity continues for a defined term or for as long as you or your survivors live (even if the amount of that income can change under certain conditions),
  • your survivors will get back at least the amount that you put in (otherwise known as your principal) even if the investments have not performed well
  • you will receive a minimum rate of return regardless of market conditions.

Annuities carry both benefits and risks.  The benefits are the guarantees and the investment choices.  The basic risk is that your money can be locked up for a long period of time, and you may have to pay big penalties if you need it sooner.

 

Only people who hold a license to sell insurance and mutual funds can legally sell annuities. These people may work for different financial institutions—banks, brokerage firms, financial planning companies—or they may be independent licensed financial advisors. 

Every annuity has a life insurance company behind it making the guarantees. Sometimes this insurance company is part of the company that is trying to sell you the product. Or it may just be paying a sales force to distribute its product.

Annuities are not insured by the Federal Deposit Insurance Company (FDIC) the way bank accounts are. It’s important to know that the life insurance company behind any annuity you are considering is financially healthy enough to stand behind its guarantees when it comes time for you to collect your money.

Life insurance companies are rated by three different agencies (A.M. Best, Moody’s and Standard & Poor’s) on the basis of financial strength, claims paying record and other management issues. While ratings can be complicated, the letter “A” is the thing to look for. The more “As” a company has, the more financially strong it is. AAA is the best rating. You can also check on the company and the person selling the annuity through your state insurance department.

There are many different kinds of annuities designed for investors:

  • of different ages
  • with different life goals,
  • with different investment needs and
  • in different tax brackets.

Most annuities available today have some combination of these features:

Single Premium or Flexible Premium

With a single premium annuity, you invest one large lump sum, perhaps money you have received through an inheritance, divorce or your employer’s retirement plan.  Flexible premiums mean you can pay smaller premium amounts in installments over a defined period of time.

Immediate or Deferred

With an immediate annuity, you convert your savings to income right away.  With a deferred annuity, you don’t start taking the income until some point in the future, such as retirement age.  With a deferred annuity, the underlying investments grow tax deferred (meaning the investment returns are not subject to income tax) until they are “annuitized” or converted to income. With an immediate annuity, there is no benefit of tax-deferred growth.

Variable-Rate or Fixed-Rate

These terms refer to how the money you save in the annuity is invested.

Variable-rate annuities typically offer a choice of mutual funds, usually stock funds or combinations of stock and bond funds, whose returns will vary with the stock market.  You may be able to choose where you will invest your money from several different funds, or to allocate percentages of your money to different funds.  You may or may not be guaranteed a minimum rate of return on your investment.

Because at least part of your annuity’s return depends on stock market performance with a variable-rate annuity, it also has the increased earning potential.  However, in exchange for the potential of making more money you also take the risk that the value of your money could decline.  Over the long-term, the stock market generally rises, but in the short-term it can rise and fall, sometimes quite dramatically.  In general, variable-rate annuities are better for people who do not need their money for at least 10 years and can leave it invested even if the stock market loses value for a period of time.

With a fixed-rate annuity, your money is invested in bonds and other fixed income investments, and the rate of return or a minimum rate of return may be guaranteed by the life insurance company.  Fixed-rate annuities offer more earnings certainty, but less growth potential than variable-rate annuities.  Fixed-rate annuities are generally better than variable-rate annuities for people who need their money soon, and cannot or do not want, to take the risk that it could decline in value.

Let’s look at an example.  Joyce is 45 years old and just received a significant amount of money through an inheritance from her father.  She would like invest a portion of the inheritance in something that she can as supplemental income when she retires.  She doesn’t anticipate retiring for another 20 years so she doesn’t need to access the money right away.  A single-premium, deferred variable-rate annuity might be a good choice for Joyce.  If the value of the investments in the annuity decline because the stock market drops, she still has time to wait for the market to recover and the value to rise again.

In contrast, Tony is 65 and has chosen to take a lump sum from his retirement plan.  He will need income right away to supplement his pension, savings and Social Security.  For Tony it might make more sense to purchase single-premium, immediate fixed-rate annuity that pays out a set monthly amount beginning in the near future.  He needs a dependable amount of income right away and may not be able to afford to have its value fluctuate with the stock market.

Different Options When You Annuitize

With every annuity, you will likely reach a point—probably at retirement age or later—where you want to “annuitize” or begin taking income from your annuity.  Different contracts offer different options for you to receive your income.  You may be able to schedule your annuity payments:

  • On a set monthly, quarterly or annual schedule
  • As personal income or the rest of your life or for a defined number of years
  • As regular income or a lump sum to go to your surviving spouse or beneficiary if you should die before collecting your entire annuity.

The amount of income you will receive depends on:

  • the amount you put into the annuity,
  • the amount your annuity investments earned, and
  • the way you choose to take the income.

Some annuities may pay a fixed-rate of income; some may adjust the income you receive to keep in pace with inflation; and some annuity income may vary with how the annuity’s underlying investments increase or decrease in value.

 

Any investment choice depends on many factors including your personal circumstances, your age, the amount of risk you feel comfortable taking, the amount of time you have before you need the money, and your other assets, investments and financial realities. 

When you are young, it’s typically better to take advantage of other types of retirement savings programs such as 401(k) plans at your job and IRAs—which have more tax benefits—before you consider investing in annuities.  If you end up needing the money you have invested in an annuity before you reach age 59 1/2 you will probably have to pay some penalties for early withdrawals.

As retirement gets closer, annuities might seem more attractive because they offer the option to “annuitize” or convert your savings into regular income, which you will most likely need or want when you stop working.  You will need to decide if the benefits of an annuity outweigh their risks and fees.

There are some people who may find annuities attractive, including:

  1. Working people who are already making maximum contributions to their 401(k), IRA or other qualified tax-advantaged retirement plans but still have surplus cash they want to devote to saving for retirement.  Because annuity premiums are not tax-deductible, it’s usually better to take full advantage of these other options first.
  2. People who are confident they will not need access to their money for a long time or until they are ready to change their savings to regular income, usually at retirement age.  Many annuity contracts impose heavy penalties of for withdrawals taken in the early years of the contract, and an additional 10% tax penalty applies to withdrawals taken before age 59 1/2.
  3. People at or near retirement age that have a lump sum of money they want to, or need to, convert to predictable income over a period of years.  An annuity can make this process easier because an insurance company does all the calculations to determine how much income you can regularly receive while still having enough money to last in the annuity for as long as you need it.  The insurance company also usually guarantees the income for the term of the contract.

 

The costs of owning an annuity can include:

  • annual fees for the insurance company’s guarantees and administrative services
  • annual or periodic management fee charged by the mutual funds or other underlying investments and
  • the sales commission paid to the salesperson.

These fees will usually be quoted as a percentage of the total amount you invest in the annuity.  Some fees will be deducted before your money is invested; others will be deducted from your account on a regular ongoing basis.  You should ask for a detailed list of these costs, and anyone selling you an annuity should be willing to provide it.

If the annuity has a guaranteed death benefit, the insurance cost will likely be higher for an older person.  This is because life insurance companies price their guarantees based on a person’s statistical life expectancy.  Life insurance gets more expensive with age.

Annuities are considered long-term investments and there are usually stiff penalties for withdrawals in the first five to seven years of the contract.  You may not see any benefits from the investment returns earned during that period.  Annuities commonly impose “surrender charges” on people who decide to cancel their contracts in the early years.  These charges can range from five to seven percent of the annuity value and decline over time to zero in year five or seven.   Some contracts allow owners to withdraw up to 10% of their principal each year without penalty after a certain number of years, or they might waive withdrawal penalties if the case of serious illness.

The risks of owning annuities include:

  • The possibility that you will need the money sooner than planned and will have to pay a penalty if you have to withdraw your money before the annuity term.
  • The risk that the investments made for variable-rate annuity do not perform as well as intended, leaving you with less income than you originally planned on.
  • The risk that the insurance company behind the annuity runs into financial trouble and does not fulfill its guarantee when the time comes for you to collect your money.

 

Questions You Should Consider With Annuities

 

  • Does buying an annuity fit in well with my overall retirement savings plan that includes IRAs and employer-sponsored 401(k) plans first?
  • Am I maximizing my contributions to other tax-free retirement investment options first? Unless you have a special need that only an annuity can fill, such as a death benefit or immediate income, you are likely to get more tax advantages at a lower cost by making tax-deductible contributions to these other plans.
  • Am I missing the full advantage of an annuity’s tax-deferred investment returns by investing in an annuity through an IRA or other account that already lets you defer income tax on the investment returns in the account? It’s usually better to invest in an annuity outside of an IRA to get the most benefit from both the annuity and the IRA.
  • Do I understand all the costs and risks of the annuity I am considering, including all the fees and possible penalties involved in the annuity itself, as well as any risk in the underlying investments?
  • Do I know specifically what is – and what is not – guaranteed under the annuity contract?
  • Have I considered that it might be more cost-effective to purchase life insurance and invest in mutual funds separately rather than “bundling” the combination in an annuity? This could be especially true if you are young and healthy.
  • What isthe rating of the life insurance company behind the annuity?
  • Is the person selling me this annuity legally licensed to do so?
  • Do I understand how I will get my money out of the annuity as well as how I will put it in?
  • What will my choices be when I reach retirement age? How much income can I expect to receive?
  • If I decide not to annuitize, can I get my money back in a lump sum? Will there be any penalties?
  • What happens if I die before or after I annuitize? What will my beneficiaries receive?
  • Am I entitled to a “free look” period? Some states require companies to allow you to review an annity contract for 10 days before you invest.

 

 

 

Why You Need To Read Your Retirement Account Statements

With the wild fluctuations in the financial markets Americans are, understandably, nervous to see how their own investments have fared. What do you do when your retirement or brokerage account statements come in the mail?  While it can be tempting to file them away or even toss them out, it’s actually pretty important that you open them up, review them to know what’s happening to your money and ask a few questions to see if you can, or should be, making different decisions.

Ensure Accurate Information
When you open your statement first review it to make sure that your basic information is correct; that is, your name, address, broker or management firm’s name, etc. While you’re reviewing the document check to see if there is online access information in case you want to keep track of how your portfolio or account is doing electronically.

Check the Total Account Value and Individual Investment Vehicles’ Performance
Next you might want to scan ahead to see what your total account value is. If your retirement fund, pension or personal savings are invested to any degree in stock and equities you can probably expect to see a fairly significant drop in your account balance. That’s due to all of the major benchmarks – such as the S&P 500, Nasdaq and Dow Jones – dropping significantly in value in 2008 and into 2009. Remember, though, that your account statement is a snapshot of your account’s value at one specific point in time. The market is continually changing and in the long-term your investment or retirement account will both rise and decrease in value over time. Ignoring the reality of how your funds are faring now won’t change anything.  In fact, knowing more information about your investments than just the current value can help you make informed decisions going forward.

After you look at the total account value you may want to review the individual investments  that make up your account – i.e. the mutual funds, stocks and bonds your money is invested in. The statement should list the types of investments, how much money you have invested in that particular type of asset, the value of the investment as of the statement date, and the investment gain or loss. As you review the summary you may note questions you have about a particular fund, stock or bond’s performance that you want to discuss with your broker or financial advisor. For example you may want to ask if the investment’s performance is due to the current market fluctuations or if there are different, underlying reasons for the change in value. That may stimulate a conversation between you and your broker or financial advisor about other possible investments that are in line with your portfolio objectives that would be worth considering and, if so, what the cost and tax implications would be for changing your current investments.

Verify Account Activity
Take a few moments to go through the statement and verify the activity on your account. For example:

  • were you aware of all the transactions that are listed on the statement?
  • was the beginning balance from the last statement date correct?
  • are any deposit and withdrawal amounts correct?
  • are the listed account transaction amounts and sizes correct?
  • were you aware of the expenses incurred and how much you are being charged for services rendered?

Correcting Discrepancies
If something does not look right – for example if you don’t remember authorizing a buy or sell order that appears on your statement – contact your broker and ask him/her to explain the transaction, and provide supporting documentation. If you don’t get the information you need from your broker, write the firm’s management and request an immediate response. It is important to report inaccuracies as quickly as possible. Depending on the type of error, if you don’t note a discrepancy request action, you could possibly forego your ability to take legal action down the road.

Response Required?
Next, check to see if there is anything that requires your response. Did your broker include a buy or sell recommendation that requires your consideration and any action from you, if you are planning to respond, such as a signature?  Or, for example, is there a proxy voting statement?

Evaluate Your Portfolio Allocation
Take some time to review your current portfolio allocation – how your money is distributed or diversified among different types of investments such as cash, equities, mutual funds, fixed income securities, annuities and alternative investments. Ask yourself and your broker if your current portfolio is still in line with your financial needs and goals.

Act on Knowledge, Not Fear
Ignoring your account statements may help you avoid temporary fear and anxiety in volatile financial markets, however not reading them can prevent you from making choices that, in the long run, could benefit you. Open that account statement when it comes in the mail, dig deeper to understand how your investments are performing and use that knowledge to ask questions and potentially make decisions that help you get closer to your financial goals.

The key to a sound saving and investing plan is to not react out of panic when things change. Yes, significant changes like losing a job or being diagnosed with a costly illness or enormous drops in the financial markets will have an impact on your finances. But don’t allow the emotion of those changes drive you to make perhaps illogical, fear-driven choices that could create more personal financial pain over the long-run.

Instead view this as a time to methodically review where you are, go through your statements and revisit your initial assumptions, reconsider your personal budget and look for different ways to make new choices that will help you in the long-run rather than satisfying your emotional need to do something in the short-run in response to fear. You don’t need to panic or spend hours of every day listening to the financial news. This is not the time to strike out on your own and try your hand at day trading or trying to time the markets because you’re convinced you “couldn’t do any worse.”  Instead schedule time to talk with your financial advisor or broker. Review your investment time horizon, re-evaluate your financial objectives and re-visit your previous assumptions. Moving past the emotion of the moment and instead dealing with the facts and figures in front of you help position you to make more rational choices. You may realize that there is still time to recapture some of the losses you’ve incurred. Or you may be able to write some of those losses off your taxes and realize a financial benefit that way. You may realize it’s time to change some of the assumptions you were working from and make some different investment choices.

The key is to keep an eye on your investment time horizon and make sound investment choices based on that, not simply potential return; work with a credible, experienced and reputable financial professional, and make choices rooted in knowledge not fear to see your financial plan succeed in the long run.