Annuities can be a confusing for the investor and there are lots of different types available and the features and crediting rates within the annuities change constantly. There is always lots of talk about annuities within the space of financial planning and lots of disagreement on how and when an annuity is worth it. In this insight article we will go through the basics of an annuity and help you make a better-informed decision.
What is an annuity.
A fixed sum of money paid to someone each year, typically for the rest of their life* A form of insurance or investment entitling the investor to a series of annual sums*
The concept as you can see from the above definition is simple and basically in a life-only annuity the consumer would give a lump sum to the insurance company, and they would in exchange pay smaller amount back to the consumer every year until the consumer dies. That situation could be a good or a bad investment for the consumer depending on how long they end up living. If the person who bought the annuity lives past their life expectancy, they end up with getting paid more than they paid into the contract and vice versa if they die prior to life expectancy.
But today there are many more types of annuities and they have gotten complex and confusing for the average consumer. Variable annuities, fixed annuities, indexed annuities, deferred annuities, immediate annuities are just a sample of the many types that are available in the market. And there are many ways to choose your payout option. There is a life only option, there are period certain options where you get payment guaranteed for the period and then after that until you die. There are also scenarios where you can add a 2nd life to the payout schedule.
A fixed annuity is an insurance contract between the buyer and the insurance company where the insurance company promised to pay the contact owner a specified rate of return on the contribution for a specific period Fixed guaranteed rate of interest on the account owner’s dollar contribution Similar in concept to a CD that banks often issue Interest rate may only be locked in for a specified period of time and then it changes after that Contract is only as strong as the company backing the promise The earnings in a fixed annuity are tax deferred until the owner begins receiving income from the annuity.
Another type of annuity is a variable annuity. This type of annuity is very different from the fixed annuity as the money deposited by the investor is placed into subaccounts that gets invested in mutual funds that often hold stocks, bonds, commodities, and other types of investments. The variable annuity normally will not have any type of guarantee on the invested money although they sometimes have riders that can be purchased to limit downside. But in most variable annuities your account value will vary with how the market performs and you will ride it up or down. You may hear about guarantees inside variable annuities but those are normally on the death benefit of the product. So, the dollars that is invested may drop due to a market downturn but often at the death of owner the beneficiary can get back the full amount that was initially invested. There are expenses built into these products to cover for the risk that the insurance company takes on (Mortality and Expense charges). These expenses are on top of the fund fees and any other rider fee that may be part of the overall annuity. The variable annuity world is very complicated, and each company and each contract use different names for their riders and some sound good and some are good but make sure you understand the fees, the structure and how the contract works before you jump into one of these with your hard-earned money.
Fixed indexed annuity
A popular variety of the annuity is referred to as “fixed indexed annuity.” It is frequently sold as having the best of both worlds. Often, a fixed index annuity will have some type of guarantee against losing principal while you are living, along with the ability to tie in the returns to the performance of a market index. The guarantees can and are often applied to the account value, but these guarantees can also be applied to the income features so here it is important to look at the details of the contract. The cash out or “surrender value” is the sum the insurance company will pay you if you close your account and it is often the lowest number you see on the statement because the insurer will take their expenses out— (commissions to the financial salesperson—before giving you back your money. Agents will often tell potential buyers that these expenses are paid by the insurance company and that no money will come out of pocket for the buyer but that can be a little misleading since there often are lengthy surrender periods and penalties for cashing our “too early” The “account value” is the value that they credit to your returns to. As you hold on to the contract over time the surrender charges will go down according to a set pre-determined schedule. The structure is like this because the insurer wants to hold the money long enough to recover the costs that they had to obtain you as a customer. One more number that you may see on your contract statement is the “income value or income for life number.” This number is used to determine what lifetime income the company will pay out when you opt to start taking income. Very often the “income number” is much higher than the account value number but keep in mind that the “income account value” number is not a true value that you can withdraw and spend.
Annuities are complicated and can be advertised and promoted in many ways. Before you jump into these products make sure you clearly understand the contract and understand how the different values that they present work. Often, they are promoted as high return with no risk and shown to build wealth with minimal risk. Make sure you use common sense and think over what you really are locking your money into. Annuities can be used in certain situations and were originally designed against living too long. Today though they are often advertised as a perfect wealth accumulation tool where you can minimize risk and get market returns. Do your homework, understand the contract, know the fees, and surrender charges. You have spent years accumulating wealth so make sure you feel comfortable where you leave it.
Annuities generally contain fees and charges which include, but are not limited to, surrender charges, administrative fees and for optional contract riders and benefits. Withdrawals and death benefits are subject to income tax. If withdrawals and other distributions are received prior to age 59 1/2, a 10% penalty may apply. Annuities typically carry surrender charges for several years that may be assessed against withdrawals. All guarantees of an Annuity are backed by the claims paying ability of the issuing insurer.
*Definition from oxford languages