- What they are: Insurance products that provide a source of monthly, quarterly, annual or lump sum income during retirement.
- Pros: Tax-deferred growth of earnings; no annual contribution limit; steady income source during retirement.
- Cons: Notoriously high expenses; surrender charges; early withdrawal penalties; payments may be taxed as ordinary income; no additional death benefit.
- How to invest: Directly through insurance companies or through your broker.
An annuity is a contract between you and an insurance company that agrees to make periodic payments for a given period of time, or until a specified event occurs (for example, the death of the person who receives the payments). Whereas life insurance pays a benefit if an insured person dies, an annuity may make payments as long as an insured person lives. In this manner, annuities are often used to provide an income stream during retirement. You can "fund" an annuity all at once - known as a single premium - or you can pay over time. With an immediate annuity (also called an income annuity), fixed payments begin as soon as the investment is made. If you invest in a deferred annuity, the principal you invest grows for a specific period of time until you begin taking withdrawals - typically during retirement.
The owner of the contract is the person who purchases the annuity and who is entitled to make changes to the policy; the annuitant is the insured person; and the beneficiary is the person designated by the owner to receive whatever is left in the annuity after the annuitant dies. In many cases, the owner and the annuitant are the same person, and the beneficiary is a spouse or child. In other cases, the owner and the annuitant may be different people. The annuitant becomes significant if and when the contract is annuitized.
When a contract becomes annuitized, the annuitant receives a fixed monthly income from the insurance company (typically for life), while giving up any claim to receive a "lump sum" payment. The monthly income will be determined by the annuitant’s - and not the owner’s - age and life expectancy. For example, if a 40 year old woman purchases an annuity and designates her 70 year old father as the annuitant, he would qualify for larger monthly payments each month than his daughter would (because the insurance company would expect to make fewer payments to an older person).
Types of Annuities
There are three broad categories of annuities:
With fixed annuities, the insurance company pays a guaranteed (or fixed) rate of interest while the account is growing. Fixed contracts are similar in function to certificates of deposit (CDs). Fixed annuities can be life annuities or term certain annuities. Life annuities pay a set amount each period until the annuitant passes away. Term certain annuities, on the other hand, pay a set amount per period for a fixed term. Once the term has elapsed, the annuity is spent (even if the annuitant is still living).
With indexed annuities, the insurance company agrees to grow your investment by a specified annual interest rate or by a percentage of a particular index’s growth, such as the S&P 500 Composite Stock Price Index - whichever is greater. The indexed annuity’s participation rate determines how much gain in the index will be credited to the annuity. If there is 10% growth in the index, for example, and the participation rate is 80%, the annuity would be credited with 8% (80% of the 10% index growth).
Indexed annuities may also be bound by a cap rate - a limit to the amount of growth that can be credited in any given year. If a 7% cap rate were in effect for the previous example, for instance, the annuity would be credited only 7% instead of the 8% (less any fees).
Variable annuities allow you to invest in a variety of pooled investment accounts, called subaccounts, within a variable annuity. These products are frequently referred to as "mutual funds with an insurance wrapper." Investments range from very conservative (for example, a money-market subaccount) to very aggressive (such as an aggressive growth stock fund subaccount). You decide how to allocate the funds.
For example, if the insurance company offers two bond funds, a money market fund, and two stock funds, you could allocate 20% of the total contribution to each fund. Conversely, you could put the entire contribution into one subaccount; it is up to you. With variable annuities, the account value fluctuates in response to the markets and the particular subaccounts chosen. Variable annuities are considered securities, and are regulated by the Securities and Exchange Commission (SEC).
Note: Annuities are complicated products, and the advantages, disadvantages and tax treatments differ significantly between products. It is recommended that anyone interested in an annuity for retirement planning consult with a qualified professional prior to making any decisions.
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