Annuity owners have sometimes been characterized as cautious, conservative, risk averse and, in some cases unsophisticated, yet they may very well have the last laugh once all of the benefits of annuity ownership are realized. Frankly, there is no other investment vehicle that provides as many benefits in one wrapper as does the annuity, which is something that annuity owners must know and their critics don’t.
How do Annuity Owners Benefit?
In one study done on annuity owners, it was found that 85% invest in annuities for their tax benefits. Under the tax code, annuities are considered to be life insurance contracts and are afforded many of the same tax advantages. Cash values are not currently taxed which allows accumulated earnings to grow faster.
Over a long period of time, this produces a significant advantage over taxable equivalents such as CDs. For an individual who pays state and federal taxes at a combined rate of 50%, a CD would have to yield 6% in order to achieve the same after-tax return of an annuity that yields 3%.
Another primary reason annuities are purchased is the safety of principal the offer. Annuities provide for a guarantee of principal that is backed by the annuity provider which is a life insurance company. Although they are not protected with federal government insurance such as FDIC, which covers savings deposits and CDs, they are backed by the assets of the insurer which have to maintain a certain ratio of assets and liabilities to ensure that all of their obligations can be paid.
This would make the financial strength and credit worthiness of the insurer a primary factor when selecting an annuity provider. Also, life insurance companies are regulated by the states, wherein most participate in a state guarantee fund that does provide a security net in the event an insurer is unable to meet all of its obligations.
Guaranteed Lifetime Income
This is, perhaps, the one key feature that separates annuities from any other investment vehicle. Annuity owners buy annuities for the security they provide in guaranteeing a stream of income that can’t be outlived. Based on the age and life expectancy of an individual and the amount of lump sum investment, a life insurer determines an income payout that is to be made for as long as the individual lives. The insurance aspect of an annuity is that, if an individual outlives his or her life expectancy, the insurer is obligated to continue payments.
Some annuities come with options that enhance the benefit by providing an inflation factor to the payments. Additionally, an option can be purchased that guarantees that the payments will continue to a named beneficiary in the event the annuitant dies.
Annuity owners looking for tax deferral, lifetime income, and safety of principal don’t necessarily have to sacrifice any advantage on interest earnings. Fixed annuities offer a fixed interest rate that is guaranteed for a period of a year up to 10 years in some cases. Generally, annuity yields track the yields of other fixed rate investments such as CDs.
The rates on annuities tend to be higher than their fixed rate equivalents largely because the life insurers are able to invest their assets for a longer term and for higher yields than banks which must be able to meet shorter term obligations. Like bank CDs, annuity owners can earn higher rates when making larger deposits and/or committing to a longer rate period.
Although annuities should be considered as long term investments, they do provide some flexibility in terms of the annuity owner’s access to funds. Most annuities provide for fund withdrawals without a charge if it is no more than 10% of the total accumulated value. For withdrawals in excess of 10% there would be a withdrawal charge.
After a period of time, somewhere between 5 and ten years, the withdrawal charge disappears. Any withdrawals would be subject to ordinary income taxes and, possibly and early withdrawal penalty levied by the IRS.
Annuity owners have the flexibility to change their situation if they find that the annuity they purchased is not performing well. If rates fall and an annuity rate drops too low, annuity owners can exchange their annuity with one that pays a better rate. This is allowed under the tax code as a 1035 exchange.
Because annuities are contracts, the proceeds that become available when the owner dies, pass to the beneficiaries outside of probate. This is a key feature for annuity owners who are concerned with keeping their estate settlement costs low and minimizing court delays in the distribution of their assets.
Annuity owners tend to own many different types of assets, as they should, in order to achieve the greatest amount of diversification. It’s the annuity, however, that tends to be cornerstone of their portfolio primarily because of its versatility as an investment vehicle. Even a mix of investments cannot provide the complete package of benefits available from a single annuity. But then, what do annuity owners know?