What is Annuity Principal?
One of the main concerns of many retirees is running out of money. In fact, this is the top concern for almost half of Americans.Thankfully, purchasing an annuity can prevent this from happening. How? By securing your investment and providing a guaranteed lifetime income stream.
- When you’ll start getting payments.
- Your annual withdrawal amount.
- What penalties apply when you withdraw your principal.
Your annuity principal is the money you pay when you buy it. Some of these payments are made in one lump sum. But most are made in a series of monthly contributions.
The annuity principal is invested for the annuitant. And because of this, it forms the basis of payments they start receiving after the first withdrawal.
Annuities 101
There are two kinds of annuities: immediate and deferred. Moreover, you can buy either a fixed, fixed indexed, or variable annuity with deferred annuities.Principals are affected differently by each of these options. As such, to protect your retirement investment. And to start, you need to understand how annuities treat the principal.
Owners of immediate annuities pay one lump sum to get a stream of income right away. It lasts a specified number of years or for the remainder of the annuitant’s life.
You can’t cancel or adjust an immediate annuity once bought. The reason? Payments begin as soon as the annuity is purchased. They can be paid monthly, quarterly, or yearly by annuity companies.
Therefore, the insurance company absorbs the principal paid into the contract to pay operating expenses and invest in maintaining the income for a long time to come.
Also known as a single-premium immediate annuity, this is usually purchased with a lump sum (premium). People who are retired or getting close to retirement typically buy this type of annuity.
The cash value of a deferred annuity grows over time. This is because whenever the owner pays premiums, the principal value increases, and the cash value increases. The reason is that they will have time to grow before you start getting paid.
If you liquidate an annuity, the principal amount is usually guaranteed. As such, any penalties or fees won’t affect the principal.
The same is not true, however, for variable annuities. In mutual fund sub-accounts, owners invest premiums. Due to the fact these accounts are unguaranteed, the principal fluctuates with each mutual fund change.
Some companies offer a Principal Deferred Annuity. The benefit of this plan is that you pay a lump sum or make regular installments over time. In exchange, you’ll receive a guaranteed income for a specific period of time or the rest of your lifetime. In addition, you won’t have to worry about market fluctuations with deferred income annuities.
- Fixed Annuities. You can’t lose either your principal or any interest you’ve accumulated if you buy a fixed annuity.
- Fixed Indexed Annuities. With a fixed indexed annuity, the insurance company guarantees your principal won’t be lost. Also, every year, on the anniversary of your purchase, your gains are locked in (known as an ANNUAL RESET), which becomes the starting point for the following year. You’re still going to get your interest because the index value is reset annually, so if the index drops in the future, it won’t affect your interest.
- Variable Annuities. The downside of variable annuities is that neither your principal nor investment gains are protected. In a variable annuity, your money is invested, such as in mutual funds. According to the performance of those investments, your annuity’s value changes.
Annuities are either qualified or non-qualified. But, what’s the difference?
Losing Your Principal
“It may be odd to think you could lose money with an annuity, considering that they’re marketed as special guaranteed investments specifically designed to protect us from that outcome,” writes Jordan Bishop in a previous Due article. “This is a rather common misconception, however, because not all annuities are the same, and not all of them come with the same level of principal protection.”Even so, annuities are generally considered to be safer than other types of investments for retirement. However, this depends on the type of annuity you purchase, the contract you enter, and the financial strength of the insurer issuing the annuity.
- You own a variable annuity. Deferred and immediate variable annuities don’t protect your principal and don’t guarantee how much you’ll be paid. However, since they invest your savings in stocks and bonds, they base the income on market performance.
- If you die sooner than expected, you can lose money on fixed income annuities. The principal for fixed-income annuities is calculated to last as long as the holder’s average life expectancy. So if you die early, then you’ll lose the unpaid portion.
- Inflation increases. Money today isn’t worth what it was ten, fifteen, or twenty years ago because inflation makes today’s money less valuable than it used to be.
- Early withdrawals. If you have a deferred annuity and tap into it before the surrender period, you’ll have to pay a surrender charge. In addition, if you do this before age 59 ½, the IRS will impose a 10 percent penalty.
- The insurance company goes under. If the insurance company goes bankrupt, you won’t get your money back.
Frequently Asked Questions
1. How much does an annuity cost?
The minimum to open a new contract is usually $5,000. But there are some annuities you can buy for $100 a month. And, unlike other retirement plans like 401(k)s and IRAs, there are no contribution limits.2. Is annuity income truly guaranteed?
“Annuities can offer many choices for guaranteed income,” notes Craig Hawley, head of Nationwide Advisory Solutions. Among these are “the simplicity of an immediate annuity to a range of different optional living benefit riders that are designed to protect portfolio assets or income payments when markets decline.”Depending on the investments, living benefits can provide a guaranteed income regardless of performance. A guarantee on the initial investment is another way to protect yourself against market risk besides getting a return on premium.
Because annuities are contracts with an insurance company, the payment guarantee is up to the insurance company. “Insurance companies are highly regulated, with strict requirements related to their investments and capital reserves,” adds Hawley.
“Their financial strength is regularly reviewed and rated by five independent firms: A.M. Best, Fitch, Kroll Bond Rating Agency (KBRA), Moody’s, and Standard & Poor’s, each with their own rating scale and rating standards.”
There are also Guaranty Associations in every state that protect policyholders if an insurance company goes belly-up.
3. How do guaranteed principal annuities work?
All your money is guaranteed to be repaid to you someday by the insurance company. You’ll get your money back if you invest in a variable annuity and lose money. Fixed annuities, however, work much better. This is because your account doesn’t fluctuate, so the insurance company just returns your money with a bit of interest.
4. What is annuitization?
“Annuitization is the process of turning a lump sum of money into a guaranteed stream of income payments for life,” explains Jordan Bishop in a previous Due article. “When you annuitize an annuity, you essentially convert your account balance into an income stream.” You can do this for a set period of time, like a decade or a lifetime.Annuities can be either immediate or deferred. “An immediate annuity pays out income right away, while a deferred annuity allows you to grow your account balance over time before receiving income payments,” he adds. “In other words, with a deferred annuity, you are deferring the income payments until a later date.”
“This may make you think: ‘Ok, so, that means that I can only annuitize deferred annuities because immediate annuities are “immediately” annuitized, right?'”
Even with immediate annuities, you can decide whether or not to annuitize. This is true even for “vanilla” annuities — those without contract riders. However, with deferred annuities, you have to choose what date you’re going to defer payments to.
5. What happens to the principal when you die?
Now we get to the question on everyone’s mind. What if I annuitize and die in a month? Does the annuity return any of the principal?- Simple lifetime payout. The payments end when you, the annuitant, die.
- Joint (and survivor) lifetime payout. So long as one of the people on the annuity is alive, the insurance company keeps paying. There is a possibility that the payment will decrease after the first death. In either case, the second person continues to receive payments until they pass.
- Lifetime payout with period certain. The scenarios above can be mitigated. How? by adding a “period certain” to your payout. That option guarantees payments for at least as long as the fixed period — of your lifetime. What if you die before the term ends. Your beneficiaries will get your principal back.
- Lifetime with a refund. There’s also a “refund” option. The insurance company pays your beneficiaries the remaining principal. But that means smaller payments.
- Period certain only. The payments end after a set number of years–even if you’re still alive. The insurer doesn’t base the payments on your life expectancy. As such, you’ll usually get your money back.
