An annuity is a powerful financial planning tool that when used for the right purpose, and in the right situation, can provide tremendous value to the annuity buyer. Annuities can add stability and security to an investor's portfolio when they are used in an efficient manner. Unfortunately, the vast majority of annuity buyers misallocate their resources when purchasing annuities and end up with an underperforming annuity that costs too much, pays too little, and is simply an inefficient use of their resources.
By definition, an annuity is a contract between you and a 3rd party (usually an insurance company) whereby in exchange for making a lump sum payment, the insurance company promises to do four things:
- Provide an income for a certain period of time,or for life
- Provide for accumulation, or asset growth
- Provide a death benefit
- Provide for long term care benefits
There are only two types of annuities: Fixed and Variable.
- Immediate annuities--start paying income right now (to start in less than one year)
- Deferred annuities--start paying an income later (anywhere from 1-50 years)
- Multi Year Guarantee Annuities (MYGAS)--pay a fixed interest rate each year for a certain period of time
- Indexed Annuities-increase in value depending on the performance of a baseline index like the S&P 500, Dow Jones, Gold, Real Estate, or even a negatively correlated index.
The key feature of fixed annuities is that the principal is FIXED--it is guaranteed by the insurance company. Gains are usually locked in each year, and you can mix and match different types of annuities to create a guaranteed income stream in retirement that is not influenced by interest rates, market fluctuations, or other typical market influences. These are good options for conservative individuals, and are not regulated as an investment, but an an insurance only product.
- With these types of annuities, the principal value "varies" based on the performance of the sub-account values that your money is allocated to. These are viewed as investments and are sold by individuals that are licensed to sell both investments and annuities. These are good for individuals that want upside appreciation, and can tolerate risk in their portfolio. This type of investment typically has higher fees and expenses because of the additional insurance costs that are prevalent because of the insurance component.
SHOULD YOU BUY AN ANNUITY?
- This depends on the problem that you are trying to solve. You money has a job to do, and you can choose to find the most efficient and effective way to get the job done, by allocating your scarce retirement resources in a comprehensive, coordinated plan that maximizes returns, reduces risks, and eliminates unnecessary fees, taxes, penalties, and surcharges, or not. This is where the misuse of annuities come into play.
- Insurance companies want you to believe that whatever your financial problem, whatever your worry, there is an annuity that can fix it, and that just isn't true. They are good solutions for some financial problems, but horrible solutions for other problems. Most investors haven't appropriately defined with their advisors what problem they are trying to solve, and therefore end up misallocating resources into an underperforming annuity and have been sold something without looking at the overall picture.
HOW DO I KNOW IF I NEED AN ANNUITY OR NOT?
- Define what problem you want your money to do for you (Income, growth, legacy, or long term care benefit.)
- Look at all of the available annuity options that can solve for those needs
- Look at annuity alternatives that do the same thing
- Determine how much money is required to solve the problem
- Compare fees, costs, expenses, taxes, performance, what-if scenarios
- Allocate resources accordingly
- Monitor your decision and make changes when necessary.
HOW CAN I GET HELP SELECTING AN THE RIGHT ANNUITY?
- You need to work with a professional. Someone who knows what you need, and can match you up with the right solution. In my firm, we like to look at prices and solutions from all available annuity providers, not just 2-3, and try to create the greatest benefit for you using the least amount of money.
An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future.
The goal of annuities is to provide a steady stream of income during retirement. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.
Many aspects of an annuity can be tailored to the specific needs of the recipient. In addition to choosing between a lump sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions - that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while those that start at a preset date in the future are called deferred annuities.
The duration of the disbursements can also vary. You can choose to receive payments for a specific period of time - for example, 25 years - or obtain them until your death. Of course, securing a lifetime of payments lowers the amount of each check, but it helps ensure that you don't outlive your assets.
Annuities come in three main varieties - fixed, variable and indexed - that each have their own level of risk and payout potential. Fixed annuities pay out a guaranteed amount based on the balance of your account. The downside of this predictability is a modest annual return, generally slightly higher than a CD.
You have the opportunity for a higher return, accompanied by greater risk, with a variable annuity. In this case, you pick from a menu of mutual funds that comprise your personal "subaccount." Here, your payments in retirement are based on the performance of investments in your subaccount.
Indexed annuities are somewhere in between when it comes to risk and potential reward. You receive a guaranteed minimum payout, although a portion of your disbursements is tied to the performance of a market index, such as the S&P 500.
Despite their potential for greater earnings, variable and indexed annuities are sometimes criticized for their fees and their relative complexity. For example, many annuitants find that they have to pay steep surrender charges if they try to get their money out within the first few years of the contract.
An important feature to consider with any annuity is its tax treatment. While your balance grows tax-free, disbursements are subject to income tax. Conversely, mutual funds that you hold for over a year are taxed at the long-term capital gains rate. And unlike 401(k) accounts, contributions to annuities don't reduce your taxable income. For this reason, some finance experts recommend annuities only after maximizing your contributions to pretax retirement accounts.