What are the positives and negatives of annuities?

Fixed annuities pay a fixed rate of return on the premium. The most popular type of fixed annuity is called an immediate fixed annuity. Immediate fixed annuities are funded with a single premium. They are usually purchased with cash from a savings account, the death benefit from a life insurance policy or the after-tax dollars that remain after the sale of commercial or residential property or real estate. As more people in the United States are living longer and have participated in employer sponsored retirement savings plans, a large number of immediate fixed annuities are now funded with the proceeds of mandatory retirement distributions that must take place after age 59 ½ but no later than age 70 ½.

With immediate fixed annuities, the payouts that are distributed by the life insurance company begin within 12 months of the contract purchase date.

Fixed Annuities + and –

Other sources of retirement income such as dividends may also provide a steady stream of income, but none will be guaranteed the way annuity payouts are. Immediate fixed annuities, on the other hand, ensure that an investor will receive payouts for as long as he or she lives. Even if he or she lives for 20, 30 or more years, the payouts are guaranteed. For retirees with few resources, fixed annuities can make a huge difference.

The amount guaranteed does not fluctuate based on the ups and downs of the equity, bond, credit or currency markets. Regardless of what happens in the world economically, owners of immediate fixed annuities are guaranteed to receive the payout in the amount set forth in the contract.

This fixed amount, however, is sometimes not as beneficial as one would think. If an annuitant is receiving guaranteed payouts in a fixed amount, in later years he or she may not be receiving enough to cover the increase in the cost of goods due to inflation. In other words, $400 per month 16 years from now won’t buy the same amount of gas, cereal or shampoo as $400 per month today will buy.

Inflation is the single greatest threat to a fixed annuity. For this reason, most insurance companies offer what is known as a COLA (cost of living adjustment) rider. The COLA rider is purchased separately, but allows for an increase in the payout each year based on the rate of inflation.

Another risk of immediate fixed annuities is if the annuitant dies before he or she has received back in payouts what he or she paid as the premium. However, most insurance companies now offer a guarantee of the paid premium. If an annuitant purchased a fixed annuity in the amount of $300,000 but dies after having received $100,000 in payouts, his or her beneficiary receives the balance of $200,000.

Another option that allows for the return of premium to the beneficiary is called “period certain”. With this option, the beneficiary receives payouts for the remaining years on the contract. If the period is 15 years but the annuitant dies in year 13, the beneficiary receives payouts for 2 years.

What are Variable Annuities?

Variable annuities can be immediate annuities are most often purchased for deferred growth as part of a qualified retirement savings plan. There are two phases to a deferred annuity: The accumulation phase and the distribution phase.

The Accumulation Phase

During the time of the accumulation phase, the annuity owner makes payments to the account. The money paid is held in a special investment account and invested at the direction of the owner. He or she can normally choose among a number of funds ranging from conservative to aggressive. The annuity owner can choose to put 100% of the premium in a single fund or he or she can split the premium among several funds.  Deferred annuities compound tax-deferred. The entire account, the premium and the earnings, grow tax-free until the distributions start.

The Distribution Phase

When the annuity owner starts the distribution phase, he or she is said to “annuitize” the contract. He or she can choose between taking payouts as one single distribution, or to receive payouts for a specific amount of time or for life. If the annuitant chooses to take payouts for 20 years, the payouts will more than likely be higher than if he or she chooses to receive them for life.

Variable Annuities Pros and Cons

Unless the product purchased was a no-load annuity, the insurance company will charge a “surrender charge” if any money is taken out of the account within the first few years of the contract. The surrender charge is typically a percentage of the amount withdrawn. It is used to pay the balance of the commission owed to the agent who wrote the contract. The surrender charge is typically reduced over time. For example, it might be 7% in the first year and 6% in the second year. After year eight it might disappear completely.

A tax-deferred account, particularly one that is started early in one’s career, can grow quite large over the years. When cash is not removed from the account to pay taxes, as it is with an after-tax savings account or mutual fund, it grows faster. Further, a tax-deferred account almost always reduces current tax year liability if it is part of a qualified retirement or pension account.

Unlike several other investment and financial products, a variable annuity contains a death benefit feature. This is very much like a standard insurance policy in which the death benefit is paid to the beneficiary upon the death of the policy owner. When he or she purchases a variable annuity, the investor can name a beneficiary who will receive the premiums that he or she has paid in over the years if he or she should die before the payouts begin. The amount paid to a beneficiary will vary by depending on the insurance company and the type of contract, but in most cases, the money will be returned to the beneficiary.