Annuities for Dummies

An annuity is a contract between an individual and an insurance company. The individual pays the insurance company money, either in a lump sum or regularly over time. The money is invested. When the individual retires, he or she begins receiving regular payments from the insurance company. The payments last for the rest of the individual’s life.

In a nutshell, that is how annuities work. Annuities have a reputation as complex and difficult financial instruments. As the preceding explanation shows, they are based on basic, fundamental principles. It is not necessary to be a financial expert in order to grasp these principles. Even dummies can do it.

Annuity Basics for Dummies

People recently retired or close to it sometimes want to provide a guaranteed source of income for the rest of their lives. If they don’t have enough money to do this immediately, they make plans to save the money gradually and grow it through investment. Since the idea behind this plan is to make themselves secure, it wouldn’t make sense for their investments to be very risky. Since they are close to retirement, they have little chance to make up for investment losses by earning more money, which is another reason not to take much investment risk.

The money they save and invest must last the rest of their lives, but they don’t know how long they will live. Insurance companies must take in money and invest it to get money to pay life insurance benefits. They are experts at estimating average life spans and timing investments to have money to pay benefits. Life insurance companies are the logical entities to estimate average life spans of, and pay benefits to, people who want income that will last for the rest of their lives.

Originally, the lifelong payment stream was called an annuity. Now the term annuity is applied to the contract between individual and insurance company. Inside the contract, the company spells out the terms in which it will fulfill its promise of guaranteed lifelong income to the annuity holder.

Fixed Annuities for Dummies

Holders of fixed-annuity contracts agree to make regular payments to the insurance company for a period of years. The insurance company accumulates these payments, which is why this time period is called the accumulation phase of the contract. The company credits the holder with interest, at a fixed rate stipulated in the contract. (That is where the “fixed” part of “fixed annuity” comes from.)

The company needs to estimate the benefits it will have to pay in the future and the money it has available for investment to fund those benefits. Withdrawals of money will worsen the accuracy of its estimates, so it needs to create disincentives for the annuity holder to withdraw their money. Surrender charges are that disincentive. They penalize a withdrawal by charging the holder a percentage of the money withdrawn. The duration of the surrender charges varies by company and by contract, ranging approximately from 4-15 years. The percentage amount might be close to 10 percent in the first year of the contract, falling drastically in subsequent years.

The annuity holder still has some scope for taking money out. Annuity contracts allow as much as 10% of the principal value to be withdrawn penalty-free, and sometimes annual interest credited can be withdrawn without penalty as well.

The general idea behind annuities is to time the accumulation period to end about the time that retirement begins. At that point, earned employment income isn’t coming in anymore, so it is time to stop saving and accumulating money and to start distributing the money that you have accumulated. Not surprisingly, this is called the distribution phase. The classical game plan is to distribute it in the form of regular, level payments that last for the remainder of the annuity holder’s life. The holder can also arrange to have distributions go to a surviving spouse for the rest of his or her life as well. Annuities that possess both an accumulation phase and a distribution phase are called deferred annuities because the payment stream is deferred until the sum of money necessary to support it accumulates.

The rate of return on the fixed annuity depends on the size of the regular payments that are made and on how long the annuity holder lives. The size of payment is agreed-upon in advance and specified in the contract, but nobody can predict exactly how long the holder will live. The insurance company will profit from holders who fail to reach their statistical life expectancy and lose from those who exceed it. On average, invested funds will be just sufficient to compensate annuity holders with money left over to pay the costs of administration and management.

Fixed annuities are conservative investments, like government bonds. They are suitable for older investors nearing or recently entered into retirement.  They are not suitable for young investors because their surrender charges make them relatively illiquid, yet their conservative rate of return makes them ill-suited to a growth-oriented portfolio. Young people need growth in investments and liquidity in their non-investment wealth holdings. Fixed annuities are not suitable for purchase by the truly elderly because surrender charges will penalize withdrawals for daily expenses or emergency purposes and because the holder may not outlive the duration of the surrender charges.

The annuity contract contains additional important information about the credited rate of interest, which may fall after the first year or two, and about the circumstances under which the annuity holder may cash out the annuity without penalty. It’s a good idea to ask the insurance company representative to answer any questions that arise and seek help from a qualified financial planner if help is needed in fitting annuities into a coherent financial plan.

Indexed Annuities for Dummies

Some people may want to get a larger payment during the distribution phase than that offered by a fixed annuity. One way to do this without greatly increasing investment risk is by purchasing an indexed annuity. Instead of allowing the insurance company to invest the payments they make and accepting the interest return with which the company credits them, these people may instead tie the investment return in their annuity accumulation account to the performance of a financial index, such as the Standard & Poor’s 500 index of stocks.

The implication of this is that their credited interest return will fluctuate as the S&P fluctuates, instead of remaining fixed. These fluctuations will not be too drastic, though. The index itself is an average of performance by the 500 companies that comprise it. Index annuity contracts contain several features designed to decrease the effect of market fluctuations. The participation rate limits changes in the holder’s account to some fraction of changes in the index. The cap rate puts an upper limit on account fluctuations, while the lower limit is usually set at zero. The contract specifies the technique for calculating the index number itself, which may have the effect of moderating fluctuations still more. All of these features are set down in the indexed annuity contract, as well as a possible schedule of allowable penalty-free withdrawals.

The indexed annuity is also suitable for older investors at or nearing retirement. These people must want to have more money distributed to them and be willing to put up with fluctuations in their accumulation account in order to get it.

Variable Annuities for Dummies

Variable annuities expand on the principle of variability of investment return. The annuity holder assumes full responsibility for directing the investment performance of the annuity’s accumulation account. The insurance company provides the annuity holder with a menu of investment opportunities, ranging from money market funds to bond funds to funds that are essentially the same thing as mutual funds but are called “sub-accounts.” (They are called sub-accounts to avoid confusion with actual mutual funds.)

The purpose of giving the annuity holder more responsibility and more choices is to enable him or her to try to earn even larger investment returns than those associated with fixed and indexed annuities. This, in turn, would make it possible to enjoy even larger annuity payments in retirement. Investments in bond funds and stock mutual funds fluctuate in value; so does the accumulation account of a variable annuity. Variable annuity holders are given the opportunity to earn a larger return and in return must bear more risk.

Variable annuity investments can accumulate tax-deferred because they are life-insurance products. (One feature of a variable annuity is the option to designate a beneficiary for a death benefit that would, at a minimum, equal the value of contributions made to the annuity less any withdrawals made prior to the holder’s death.) The other side of this coin is that variable annuities have the same management-related expenses as mutual funds, plus insurance-related expenses that mutual funds don’t have. These relatively high expenses mean that other options for achieving tax deferral, such as contributions to qualified plans, should be exhausted before purchasing a variable annuity. These same high expenses, plus the higher level of risk and lack of liquidity imposed by surrender charges, make variable annuities unsuitable for the elderly.

Recently-developed variable annuity products advertise “living benefit” riders that guarantee sizable returns, minimum additions to income and minimum withdrawal levels regardless of actual market performance. A guarantee is only as good as what stands in back of it. Even dummies should know enough to make sure that the issuing insurance company is financially strong. At least four major rating agencies offer evaluations of all major insurance companies to allow the public to do just that.

Professionals and business owners who are threatened with loss of wealth from liability lawsuits benefit from variable annuity purchases. In many states, their life-insurance status shields these investments from attachment in litigation. The high expenses of variable annuities are simply the price paid for liability protection by this class of people.

As with other types of annuities, the variable annuity contract contains useful information that should not be overlooked. This includes possible limitations on the number of times the annuity holder is allowed to change the makeup of the investment portfolio, as well as state taxes on variable annuities passed along to the holder by the insurance company.

Immediate Annuities for Dummies

Originally, the word “annuity” referred only to a lifelong payment stream that was purchased for in one single, lump-sum payment to an insurance company. Today, this arrangement is called an immediate annuity because there is no accumulation period – the distributions begin soon after the immediate annuity is purchased. (Distribution payments may be made monthly, quarterly, semi-annually or annually; the distribution pattern chosen determined when the first payment is made.) The lump-sum purchase payment is invested. If the insurance company controls the investment, the immediate annuity is “fixed.” If the annuity holder controls it, the immediate annuity is “variable.”

Immediate annuities are very useful for people who already have the money necessary to provide for their lifetime stream of income. These annuities combine well with employer retirement plans in which either the employer or the employee can choose to invest a lump sum of savings into an immediate annuity at retirement. Government retirement systems in countries such as Chile have been privatized through the use of immediate annuities. In the United Kingdom, employees are required to purchase an annuity using the proceeds of lump-sum retirement payouts no later than age 75.

A Final Word to Financial Dummies

Uninformed investors often fall prey to bad annuities only to regret every having made the investment. Don’t be a dummy, check the annuity contract and compare multiple products before buying. Every state regulatory agency allows for a “free-look period,” during which a purchaser can reverse the purchase decision without penalty. In fact, the annuity contract contains all sorts of useful and interesting information, from the scope for surrendering the annuity for cash to the name of the issuing company.