Annuities have been getting a lot of scrutiny in the press lately. Financial advisors and insurance agents are receiving a lot of these complaints. There are so many options when it comes to annuities that people tend to trust salesmen a little too much without doing their homework first. There are several different types of annuities and all of which have different variables on rate of return, tax consequences, and payout. The following will give an overall summary of the various types of annuities and the pros and cons of each.
First, an annuity is a contract between a client and the insurance company. This agreement is to supply income for a specified period of time or for a lifetime of an individual. The annuity can be purchased using a single lump-sum payment or smaller incremental payments. The income benefit for the annuity can be immediate or can be deferred until retirement. The main purpose of this vehicle is to create a self pension and provide an income long term.
One of the main problems in society today is the fact that people are living longer and creating the chance of outliving their assets. This will be an ongoing problem in the next 20+ years when it is believed that social security may dwindle away. Another large problem is that companies are moving further away from pensions and moving more towards 401K's and IRA's. This is giving more of the retirement investing to the employee and taking the burden off of the employer.
There are several different types of annuity contracts; there are immediate annuities, fixed annuities, indexed annuities, and variable annuities. Immediate annuities are the one financial product that can allow you to liquidate your principal yet be guaranteed not to run out of cash flow, no matter how long you live. This is because insurance companies pool the longevity risk across a large number of annuity owners, ensuring that there is adequate money to pay those who live a long time.
Fixed annuities are comparable to bank CD's and offer a fixed percentage of return often much higher than interest rates of bank CD's. Indexed annuities are designed to have a safety of principal similar to CD's, money market funds, and savings accounts. They are often linked to an index and guarantee a minimum rate of return but put a ceiling on a maximum. Variable annuities allow investors to allocate their money into the stock market through mutual funds with an insurance wrapper on it. It allows people to pay more fees for the insurance on the principle but allows them to participate in some of the excitement of the stock market.
Variable annuities are similar to many types of retirement accounts. They offer the benefit of tax deferred growth which is similar to IRA's and other retirement accounts. There are two different tax consequences based on the type of money used for the product. There are qualified accounts which are taxed similarly to 401K's and IRA's and there are non-qualified accounts which are taxed similarly to Roth IRA's and mutual funds. Withdrawals from deferred annuities are taxed on an interest-first basis, and subject to a 10% early withdrawal penalty when taken prior to age 59 1/2. Withdraws from a qualified account must begin before 70 1/2.
There are several options or "riders" that an individual can put on his policy to make it a more attractive investment. One of the more popular additions is the Guaranteed Minimum Income Benefit (GMIB) rider. This puts a floor to the amount of money an investor can make so that it will not dip into the principal if the stock market is performing poorly while allowing for the investor to capture an upswing in the market. An example would be a minimum of 5% with no maximum that could be achieved. So if the market went down 20% the worst an investor can do is a positive 5%. Another popular rider is a Guaranteed Minimum Withdraw Benefit (GMWB). This benefit allows the owner of the contract to take withdrawals for a guaranteed minimum period of time. This type of benefit guarantees you your money back unless you have positive investment results.
There are several negatives to annuity contracts as well. There are surrender periods that lock in the investment for a specified period of time. An annuity is not a liquid investment. In addition to that one of the risks that an investor takes is mortality risk. This is a risk an owner takes by signing certain annuity contracts. This means that the client may deposit $100,000 to get paid an income for 10 years and they die prior to 10 years. The money invested in certain contracts is forfeited.
Annuities are a good investment but it depends on if it is applicable to an investor's situation and risk tolerance. It is a long term investment that has relatively high fees, a period of surrender that must be satisfied, and not always a good return on investment. It allows for tax deferred growth, a minimum benefit with certain riders, and security allowing an investor to not outlive their assets.
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