Many questions and misinformation exist regarding annuities. Even annuity owners may not fully understand what type of account into which they are invested. Though modern annuity contracts can be very complex, the nuts and bolts of all annuities are similar. Regardless of exposure to annuity contracts or investment strategies, there is an important distinction to make between annuity types and how they work. By uncovering income needs, risk tolerance, and information about assets and investment strategy, a financial professional can help families choose whether an annuity makes sense and how to customize the contract for them.
An Annuity is a Contract
Annuities are not bank accounts. An annuity of any type is a contract with an insurance company to hold and distribute money. Each annuity contract establishes a ‘separate account’ in which to hold the agreed upon investment vehicles the owner selects. Besides the insurance company, there can be multiple parties involved in an annuity contract. The account owner funds and owns the account, making decisions about investment choices and riders as well as choosing beneficiaries.
An individual or an entity such as a business may be the account owner. The ‘annuitant’ (must be a person and is typically the owner) is the person whose life will be the basis for calculating income options. In some circumstances there may be a second annuitant, a spouse for example that may also receive income after the passing of the primary annuitant.
FDIC and IRS Considerations
Annuities do not carry FDIC, even if they are purchased through a bank. Investors exceeding FDIC limits will appreciate added protections by diversifying between both banks and insurance companies. The insurance companies themselves provide the protection and guarantees for annuity contracts.
The IRS allows for tax deferral of interest and account growth within annuity accounts. This means that the taxes on interest and investment growth will be paid when those dollars are withdrawn. Families can save money by deferring such taxes to a later date when income tax rates may be lower.
There is such a thing as an ‘annuity IRA’, which is an annuity contract under IRA guidelines from the IRS. This seems like a redundant effort since both offer tax deferral. The exception that may make this scenario suitable is that the owner needs to take advantage of the riders and guarantees available only in annuity contracts.
How the Annuity Works
The first step after choosing a suitable annuity contract and company is to fund the account. A lump sum or schedule of deposits are made to the insurance company, which in turn invests the money in a separate account with the agreed upon securities. As time passes, the investments will change in value and interest payments will be paid into the account. Additionally, mortality and administrative fees will be deducted quarterly to maintain the account and underlying expenses.
While the insurance company is the custodian of your money, there is access to the funds. Though restrictions apply to withdrawals within the first few years, annuity owners always have access to their funds. The restricted time frame is known as the ‘surrender period’, typically including the first five to seven years. Commonly mistaken as an ‘early withdrawal penalty’, the insurance company charges a percentage of the withdrawal as a fee (CDSC or contingent deferred sales charge) to compensate for the risk they have been subjected to.
Eventually, an income stream will be triggered by the annuity owner and payments will begin flowing as instructed. Payments can be set for a specified period of time; ‘ten year certain’ for example provides equal payments over ten years. There are a number of options for payout schedules.
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A Lifetime of Reliable Income
Another option for payout is ‘lifetime’ payments, which are based on one or two annuitants’ life expectancy. Actuaries determine how long they expect them to live, how much the account may grow during that time, and then provide equal payments for the duration of one or both lives.
There is a risk involved for both parties under these circumstances, which is why annuities must be offered by insurance companies. The annuity owner takes the risk of forfeiting the investment principal and getting back less than invested in the event they perish before enough years of payments go by. The insurance company takes the risk that annuitants will live longer than expected and more money will be paid out than are taken in.
Modern annuity contracts offer an innovative alternative to annuitizing with a lifetime payout. There is now an option to receive guaranteed lifetime income without annuitizing the contract. There are some restrictions, for example withdrawals are limited to a percentage of the account value (usually around 5-7%) each year. Also, there may be guidelines for the risk level allowed in the separate account.
Why Invest in Annuities?
Annuities are used as a component of many portfolios because of their versatility and the protections they offer. In an investment world full of different risks, sound investors look to reduce and hedge against as many risk sources as possible. The modern annuity features and riders can offer guarantees and protection against many of the risks threatening retirement lifestyle.
The fundamental use of annuities is creating a lifetime stream of income, which is insurance against outliving assets. With riders like spousal protection, modern annuities can provide protection for the remaining spouse as well. For those seeking to protect their money but who also need growth potential, annuities with guaranteed growth built in can offer ‘downside protection’. This means the account can go up and is insured against going down for the cost of such rider.
Families that want to build in future income reliability can utilize an annuity to provide a reliable source of retirement income to supplement other sources. By redirecting a portion of a portfolio into an annuity and taking advantage of guaranteed growth riders, a family can count on a certain monthly income. This helps with retirement planning and gives peace of mind to families approaching retirement age.
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