Annuities: How to Find the Right One for You

What was once a simple idea has become more complicated

Annuities are one way to generate a lifetime income, save for retirement without the worry of market risk, and leave something to your family or favorite charity after you die. However, as with many financial products, what was once a simple idea has become complicated.

There are three main types of annuities—fixed, variable, and indexed. This article will focus on what to look for in each type of annuity, as well as what questions to ask before you invest.

Key Takeaways

  • There are three kinds of annuities: fixed, variable, and indexed.
  • Fixed annuities are risk-free and pay a fixed amount either in a one-time, lump-sum payment or on a monthly, quarterly, or annual basis.
  • Variable annuities can rise or fall in value depending on the interest rate, but any earnings grow tax-deferred.
  • Indexed annuities are tied to the performance of an index, such as the S&P 500, and provide you with a return based on that performance, though not to fall beneath a certain minimum.

A Little Background on Annuities

An annuity is an investment product sold by insurance companies or other financial institutions to hold and grow funds. The annuity is essentially a written contract between you and the firm. When you annuitize, you invest a certain amount with the company and then accept a payout stream that can begin immediately or in the future. The payouts can be for life or a certain number of years. Annuities are mainly used to provide steady income during retirement.

Fixed Annuities

A fixed annuity promises that you’ll earn a stated interest rate on your money, resulting in the same payout year after year. This type of investment is risk-free. The insurance company assumes all the risk and guarantees that you’ll make the stated interest rate. Fixed annuities are not tied to the stock market in any way. There are two subcategories of fixed annuities:

1. Immediate Annuities

An immediate annuity, also called a single premium annuity, is when you make a lump-sum, one-time payment, and then a short time later you start receiving monthly, quarterly, or yearly annuity payments. These payments can be for life or for a specified number of years. Generally, you buy this type of annuity when you are about to retire or are already retired and want to generate a safe, consistent income no matter what.

2. Deferred Annuities

You purchase a deferred annuity when you want to save money on a tax-deferred basis and, at some point in the future, use the money that is invested for your ultimate goals. Some people use deferred annuities as a way to build for retirement, knowing that they will be receiving a guaranteed return no matter what. When you start receiving payouts, you’ll owe taxes on the earnings that you made in the annuity.

Generally, you can withdraw up to 10% a year from a fixed annuity without having to pay an early withdrawal penalty. You can easily convert money from a deferred annuity to an immediate annuity. You also can leave the money to a loved one or favorite charity free of estate taxes.

Also, annuities have a free-look period, the length of which varies by state. If you don’t like what the annuity contract says or simply change your mind, you can return the annuity to the insurance company and receive a full refund.

Variable Annuities

With a variable annuity, you can make either a lump-sum payment or a series of payments. The company agrees to make consistent payments to you immediately or at some date in the future. Variable annuities combine the elements of mutual funds, life insurance, and tax-deferred retirement savings plans. When you invest in a variable annuity, you can select a variety of mutual funds in which to invest. A variable annuity has two phases:

The Accumulation Phase

During the accumulation phase, you are paying money into the annuity and have a variety of investment options, ranging from a balanced fund (a type of mutual fund that holds preferred stocks, bonds, and common stock to obtain income and growth) to money market funds and international funds. The money that you put in the investment options will increase or decrease depending on the funds’ performances.

The best information you can get about the variable annuity’s investment options is in the prospectus. This will describe the risks, volatility, and whether the fund contributes to the diversification of the investments in the annuity.

The Payout Phase

During the payout phase, you start to receive payments. These payments can be one lump sum, or you can have them sent out to you on a regular basis (monthly, quarterly, or annually) for a certain number of years or a lifetime. These payments are guaranteed by the insurance company.

As the name implies, with a variable annuity the interest rate on your money is going to vary, depending on the performance of the funds in which you invest. You can benefit from bull markets but also suffer from downturns when the bears start roaring.

Even so, variable annuities generally provide guarantees that you can’t get with other investments. For a fee you can add a death benefit feature, for example. Let’s say that you invest $125,000 into a variable annuity. A while later the value of the mutual funds held in the annuity declines to $95,000. If you had put this money into an ordinary mutual fund, you would be down $30,000. But with a variable annuity, your beneficiaries will still get $125,000 if you die.

In some products, if the market value rises to $150,000, your beneficiaries could get a “stepped-up” death benefit of $150,000.

Indexed Annuities

With an indexed annuity, you can make a one-time payment or a series of payments. The company will credit you the return that is calculated by the changes on a certain index, such as the S&P 500. It will also guarantee you a minimum return, though these minimums can vary from one company to the next. Some of the benefits of an indexed annuity may include:

  • You can use the funds to build up money on a tax-deferred basis (where you pay the taxes once you withdraw the money).
  • You can withdraw up to 10% a year of the original amount you invested without penalty.
  • You can add a death benefit where, if you die early, the annuity will go to your beneficiary and avoid probate altogether.
  • You can also pull out up to 100% of the annuity without penalty if you are forced to go into a nursing home.

Annuities can come with high fees, so make sure you know the cumulative cost before deciding whether to buy one or not.

Before You Purchase an Annuity

There are several questions that you should ask yourself and an insurance agent to gain a greater understanding of any annuity you are considering.

Ask yourself:

  • What am I going to use this annuity for? If you are retired or nearing retirement and need a consistent income, you may want to consider a fixed annuity. If you are building up for retirement, you may want to consider a variable annuity or an indexed annuity. If you are going to be leaving your annuity to your children or grandchildren, you may want to take a look at a variable annuity with a death benefit.
  • Am I going to need the money right away? What you really need to know is whether you will need the money in over the next two to five years. This is an important factor to consider when you have surrender fees that can affect the principal amount if you take the funds out early.

Ask your insurance agent or financial advisor:

  • What is the minimum guaranteed return? A guaranteed minimum return is a stated return that you will make no matter what. In the case of fixed annuities, the minimum guaranteed return is obvious. However, companies also frequently offer a minimum return on variable and indexed annuities. This will allow you to see what you will make yearly in a worst-case scenario.
  • What are the initial and annual fees paid to the insurance company? In some cases there are fees paid yearly to the company, and there could also be upfront fees that the company will charge. This information is usually found in the prospectus. Beware of too many fees. High charges will significantly reduce your benefit.
  • What are the surrender fees if I get out early? Many annuities have a surrender period during which an investor can't withdraw funds without paying a penalty. The surrender fee is a cost to you that is paid if you withdraw your funds early. These fees vary from company to company. As a general rule, the longer you hold the annuity, the lower the surrender fees are. In some cases these fees disappear completely after a certain number of years.
  • What different types of death benefits are available to me? A death benefit is provided to your beneficiaries if you die. This is a stated amount. In some variable annuities you can have a “stepped-up” death benefit (an increase in the benefits that results from a rise in the overall portfolio).
  • What waivers are available if I need the money right away? A waiver is used when you may need the money for an emergency, such as a medical condition or if you have to go into a nursing home. Many annuities will waive the surrender fee if you need the money for a situation such as this. Before you buy the annuity, you need to find out what types of waivers are available.

The Bottom Line

Each type of annuity has its own advantages and disadvantages. One of the major benefits of an annuity is that it allows you to build up money for retirement, so that when you do close that office door, you can take a lump-sum payment or create a consistent income that can last for either a certain number of years or life.

You are also able to build up money on a tax-deferred basis. Some of the drawbacks of investing in annuities include high fees, such as surrender fees if you need the money early and up-front and annual fees that may apply. It pays to take your time examining the different types of annuities in order to determine which will work for your situation.

Article Sources
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  2. U.S. Securities and Exchange Commission. "Variable Annuities—Free Look Period."

  3. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," Pages 3-7.

  4. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," Pages 8-9.

  5. U.S. Securities and Exchange Commission. "Updated Investor Bulletin: Indexed Annuities."

  6. Internal Revenue Service. "Retirement Topics—Death."

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