Annuities for Dummies

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About a month ago I booked a flight to see one of my best friends. Considering that we’re still dealing with COVID-19, I decided to to purchase travel insurance. And, good thing I did. A couple of days before I was to take off, my friend and his family all tested positive. Thankfully, I was able to get my money back because of the insurance I had added-on to my trip.

Outside of travel insurance, many of us buy warranties for phones, appliances, or HVAC systems. After all, it’s worth the additional cost instead of completely replacing these items. And, in a way, annuities also offer guarantees—along with peace of mind.

At the same time, annuites can be complex. As a result, many people avoid them as much as possible. However, if you want a guaranteed retirement income help make your dream retirement a reality, then you should at least have a basic understanding of annuities to see if it aligns with your goals.

Annuities: Where Did They Come From and What Changes Have They Undergone?

Believe it or not, a very basic concept of annuites can be traced back to Ancient Rome. As part of a contract called an “annua,” Roman citizens would make an upfront payment in exchange for steady payments throughout their lives.

A variety of annuities are now available. And each offer different guarantees and savings features, which makes annuities more complicated than ever. In turn, this can make annuities difficllt to comprehend for the average person.

In spite of this, U.S. annuity sales were $62.3 billion in the third quarter, up 12 percent from third quarter 2020, reports LIMRA. And, over the past year, annuity sales grew 19 percent to an impressive $191.4 billion.

What Is an Annuity?

“The insurance companies that create annuities often make them seem like investments,” writes Ron Lieber in The New York Times. “But really they’re more like insurance.”

At their simplest, annuities provide a guarantee. “If you turn over some money, you’ll be guaranteed to get all that money back—plus usually a certain amount more,” explains Lieber. “Or you turn over some money and you’ll be guaranteed a regular check for a certain period.”

“Like insurance to stave off financial disaster, an annuity is something you purchase to guarantee that you won’t run out of money if you live a long time,” he emphasizes.

And, I don’t know about you. But, for me, it’s comforting to know that you will be taken care of. “After all, we don’t know how our investments will perform: This year may be the first in a while that your stock and bond index funds both lose money.”

A contract between an insurance company and you is known as an annuity. Your insurance company promises to make periodic payments to you in exchange for a single payment or periodic payments called premiums. The payments can be received right away or at a later date.

Annuity contracts can also be used as a means of saving for retirement. In addition, you may be able to use these contracts to supplement retirement income from a 401(k) or Social Security. Depending on the contract, you might be able to accomplish both outcomes.

Stock photo of a contract. energepic.com/Pexels

Types of Annuities

Just like there are all different type of pizza, there are also a variety of different annuities. But, the three main types of annuities are fixed annuities, variable annuities, and indexed annuities.

With that in mind, before selecting an annuity, be sure you know what the different kinds are, how they work, and the fees associated with. In addition to your annuity contract, riders may be available to give you extra flexibility. Keep in mind that you’ll probably have to pay more for a rider—just like how you would pay extra for toppings in your pizza.

Fixed Annuities

In general, a fixed annuity is easy to grasp since it’s the most straighforward. Rather than being tied to market rates, the insurance company promises you a fixed interest rate. For example, with a Due Fixed Annuity, you’ll get a 3 percent guaranteed interest rate on your money.

A fixed annuity can usually be classified into the following two types.

With a fixed immediate annuity, you must pay a lump sum in order to receive a fixed income stream, usually for a set period of time. Depending on your contract, the payment may last for life. And, payments usually start right away.

Similar to immediate fixed-income annuities, deferred annuities are influenced by time. Unlike immediate annuities, however, the income stream is delayed. As opposed to beginning immediately after you buy your annuity, it can take anywhere from months to years for you to receive payments. This is what’s called the accumulation period since your annuity is accumulating interest. During thisperiod, you may be able to make extra payments in order to increase your income in the future.

Variable Annuities

As opposed to fixed annuities, variable annuities are not as clear-cut. In fact, you may even consider these more of an investment product.

A variable annuity provides you with the option of selecting an array of investment options. Those subaccounts determine how much your contract will be worth. According to the performance of your investments, its value may rise or fall.

Most investments are made through mutual funds, which invest in stocks, bonds, and money markets. Combining these investments may also be possible.

Indexed Annuities

An index annuity is sort of a hybrid of a fixed and variable annuity. Indexed annuities offer protection against market drops, but they also don’t offer much benefit if the market rises.

Why? Well, you can receive guaranteed income through an indexed annuity. However, another portion of your income will be determined by the performance of an index, such as the S&P 500, which gives you the possibility of investment growth.

Why You Should Consider an Annuity

If you’re concerned about your retirement income, an annuity can provide a bit of peace of mind. The reason for this is that as an alternative to pensions and Social Security benefits, an annuity can provide you with a steady income during retirement.

In retirement, you might not have to worry about running out of money if you choose an annuity that provides payments for the rest of your life. The guarantees can give you some certainty about the amount of money you need to save for your ideal retirement since this money can cover daily expenses or emergencies. You can even leave your annuity to heirs or donate your annuity funds to your favorite charity.

Andrea Piacquadio/Pexels

What’s more, annuities grow tax-deferred. That means you don’t pay taxes upfront. Instead, you’ll pay taxes when you start receiving payments.

Why You Shouldn’t Get an Annuity

At the same time, not everyone needs an annuity. And, there are also risks involved.

To begin with, your annuity payments are dependent on your insurance company’s ability to pay them. You might not receive the income you were counting on if your annuity company goes out of business, leaving you in a difficult financial position. But, if the insurer does go out of business, you might be able to get some relief from a state-based insurance guaranty association.

Even though annuities may seem like an easy way to provide income in retirement, they can be expensive. Among the many fees associated with annuities are surrender charges, insurance fees, investment management fees, rider fees, and contract fees.

Aside from the fee issue, an annuity may not provide the same returns that other types of investments provide. By taking the future income security over some potential upside, you give up some upside. The result of this could be that you will have a lower retirement income than you could have had by investing elsewhere.

A Checklist for Annuities

In order to find the best annuity, you will need to know your retirement goals and how much of your budget you can devote to those goals. And, since annuities can be complicated, it might be helpful to work with a licensed agent who can better explain how annuities can fit into your bigger picture.

When you decide to shop for an annuity, you will want to ask yourself these questions:

Do you have a diverse retirement income comprised of guaranteed or non-guaranteed income?

Have you maxed out your other retirement contributions, like your 401(k)?

Would an annuity help strengthen your retirement plan?

When you retire, how much money will you have saved for emergencies or medical expenses? And, will this be enough to cover these expenses?

How will taxes influence your retirement income?

Glossary of Key Annuities Terms

Accumulation Period

This refers to the time period during which the annuitant makes payments and accumulates assets.

Annuitant

In most cases, the annuity contract owner.

Annuitization

The process of converting the accumulated value of the annuity contract into a stream of payments which can last for as long as the annuitant is alive or for a certain period of time.

Beneficiary

If the contract owner or annuitant passes away, this person will receive any remaining payments.

Contract Owner

An individual who pays the contract’s premium.

In addition to making withdrawals, investing, changing beneficiaries, and surrendering the contract, the owner can convert the deferred contract into an immediate income stream. And, it’s possible for two people to jointly own an annuity contract.

Deferred Annuity

An annuity with a postponed payout phase. You can pay for a deferred annuity contract with a single premium, multiple premiums or regular contributions depending on your financial situation.

Fixed Annuity

The contract owner receives a guaranteed rate of interest throughout the accumulation phase of a deferred annuity.

Free-Look Period

The number of days after the issue of a new contract during which the owner can cancel it.

Immediate Annuity

Single premium contract that pays out within one to 13 months after purchase.

Indexed Annuity

A type of annuity in which gains are linked indirectly to market indexet index, such as the S&P 500, but that also puts a limit on losses due to poor market performance.

Stock indices are displayed on a screen at New York Stock Exchange in New York, on Feb. 25, 2020. Scott Heins/Getty Images

Payout Phase

The time during which interest or income is paid out from the accumulated funds in either a deferred or immediate annuity.

Premiums

Payments made into annuity contracts.

Surrender Charge

If a contract owner withdraws from the contract before the surrender period ends, they are liable for the penalty fee.

Variable Annuity

Based on the portfolio performance of the underlying subaccounts, this is an annuity with varying contract value or income payments.

Annuity FAQs

1. Is an Annuity Right for You?

You may be a good candidate for annuities if:

You cannot cover your regular expenses because your Social Security and/or pension benefits aren’t enough.

In order to prepare for retirement, you have already started saving.

Health-wise, you are in excellent shape and hope to live a long time.

Retirement is something you want to be more certain about.

Annuities, however, are not designed to be your sole retirement nest egg, since they do not provide all of your retirement needs. Furthermore, they generally aren’t indexed for inflation, and they don’t provide high stocks market returns.

2. Which Annuity Is Right for Me?

Honestly, this question is impossible to answer. But, you should do as much research as you can to increase your annuity knowledge. And, you should definitely schedule an appointment with a trusted trusted financial advisor to assist.

You should, however, start by identifying your financial goals. When buying an annuity, you should only do so if your IRA, 401(k), or 403(b) have been fully funded or are planning to be fully funded in the future. An annuity, on the other hand, can provide significant benefits if you have already made these investments and still have funds available to invest.

Once you’ve determined what you want, it’s time to find a financial advisor to help you figure out which of the many options is right for you. You may want to reach out directly to the insurance company if you have ideas regarding a particular product after your research.

3. What Are the Fees Associated With Purchasing an Annuity?

There are two parts to this question.

The first is, “Do I have to compensate the financial advisor?“ No, the insurance company will pay them.

Second, what are the costs associated with purchasing an annuity? Unfortunately, the answer to that is not so straightforward.

Often, fees and/or associated costs do come with annuity products, but with the help of your advisor you can minimize and even eliminate these costs.

Consider, for example, purchasing an annuity that will cover your spouse or significant other after your death. There may be a fee associated with this, or your monthly income may be reduced. If this suits your plans, your advisor may advise you to purchase life insurance to ensure your loved ones will be taken care of if you pass away. As a result, you may receive greater monthly payments or lower fees.

4. Are There Penalties for Early Sales or Withdrawals?

Aside from insurance companies, you can also purchase annuities from mutual fund companies, brokerage houses, and banks. So, in the event that you sell your annuity or withdraw funds before payout begins, the company your bought the annuity may impose surrender charges. Suffice to say, your investment could be significantly impacted by this.

5. What Happens to My Annuity When I Die?

If there are any remaining payments they will be distributed to beneficiaries either as a lump sum or as a stream of payments after death. To avoid the surrender of assets to a financial institution following the death of an owner, it is important to specify a beneficiary in the annuity contract terms.

By John Rampton