What You Need to Know About Annuities

As Americans continue to extend life expectancies more than ever before, there is a real concern that many people may actually outlive their income in their golden years.  Increasing costs for senior citizens on a fixed income are giving an entire generation of aging baby boomers cause for concern.

But there are steps a person can take to avoid that angst in later years.  Prudent financial planning and a disciplined approach to money issues can help set the table for a comfortable retirement.

To help accomplish that goal, one of the frequently used tools in a financial planning toolkit are annuities to meet the goal of long-term wealth accumulation.

Defining annuities

An annuity is a contract between an insurance company and an individual.  Under terms of the agreement, a person will pay premiums into an account on a regular basis over a specified period of time.  In exchange, the insurance company will pay the policy holder back a certain amount of money, on a periodic basis, for a specified amount of time.

Annuities are considered a safe and conservative investment vehicle for those who want to guarantee themselves a stream of income during their retirement years.

Although there are many kinds of offshoots, annuities fall into three basic categories:

Fixed annuities provide policy holders with a minimum rate of interest and a fixed amount of payments over a defined period of time.

Variable annuities give policy holders the option of directing their annuity payments to different kinds of investment options.  The payout a policy holder gets depends on how much they put in, what the rate of return is and what kind of expenses are involved.

Indexed annuities combine different features of insurance and security products.  A policy holder will receive a return based on a stock market index, such as the Standard & Poor’s 500 Index.

Annuities can be used in two primary ways by investors.

An immediate annuity allows a lump sum to be placed into an annuity account and then an investor can immediately begin receiving payments.  These payments can be a fixed amount, a variable amount and are tailored to best suit your situation.  People generally choose to set up this kind of annuity if they experience a large one-time lump sum payment in their lives, such as a significant inheritance, the sale of a business, or even winning the lottery.  They are a smart option for someone who wants to regulate and manage an income stream with a guaranteed allowance that can extend to the rest of their lives.

A deferred annuity meets the need for an investor to slowly accumulate wealth over their working life, which can then translate into an income stream during their retirement years.

Benefits and disadvantages

Annuities over investors several benefits and some provisions that are worth noting.

Tax sheltering.  Perhaps the biggest advantage to an annuity is that you pay no taxes on the income and investment gains of funds placed into an annuity during the accumulation phase of a deferred annuity.  You only pay taxes when you withdraw funds from the account, which typically takes place after you have experienced a significant drop in income after you have retired, meaning you’ll incur less of a tax bite.

If you contribute funds to an annuity through an IRA or a similar type of investment vehicle, you can also defer your taxable income equal to the amount you contribute, also giving you tax savings in your current year as well.

It’s important to note that if you do take an early withdrawal, you may incur a penalty and also be taxed on the withdrawal as ordinary income.  In addition, if you withdraw funds before age 59 ½  you could be subject to a 10% federal tax penalty as well.

Retirement income.  Annuities are one of the most conservative ways to ensure that you enjoy a stable and long-term stream of income to supplement your other forms of retirement income.

Depending on the terms of your annuity, you can work with an actuary at the insurance company who will help you figure out what your periodic payment should be based on the amount in your annuity and what current life expectancies are.  Another factor that is considered is whether or not there is a spousal provision in place.  This means in the event of the policy holder’s death, a spouse would continue to collect payments until they pass away.  Most annuitants choose this option.  Obviously, the longer you wait to start drawing from your annuity, the larger the payments will be.

Because it is impossible to predict an annuitant’s age of death, in some instances where a policy holder lives an exceptionally long life, they will receive significantly more than what they paid into it.  On the other hand, if they and their spouse pass away at a younger age, they may receive less than what they paid in.  This does not concern insurance companies because they base payments only on what the average life expectancy is for all of their policy holders.

Some policies do allow for a guaranteed number of payment years, which will be paid to an annuitant’s estate if both the policy holder and their spouse at an early age.  It should be noted that when provisions such as this, and others, are added, the more guarantees mean that monthly payments will be smaller overall.

Peace of mind.  Because annuities are considered a long-term stable investment, they are considered among the safest of all investment vehicles.  Annuities are generally issued by insurance companies, many of whom have been in business for decades and that have sizable holdings which translates into a significant protection for your personal account.

Risks, fees and charges.  The only downside on annuities can come when investing in a variable annuity, which is considered a security because it’s performance is tied to stock market indexes.  If the market does well, the potential to make additional money can turn into a smart decision.  But in periods when the market stutters and under performs, your investment return can suffer as well.  In some instances, an annuity investor may even experience a loss of their original capital.  As it is with all investments, there is a certain level of risk that needs to be understood before committing any funds.

Another way that your original investment may be at risk is if you withdraw funds too soon after you set up an annuity.  In some instances, insurance companies will impose a “surrender charge” which can be in place for the first six to eight years after you purchase an annuity.

In addition, most insurance companies will also impose certain fees when you invest in a variable annuity.  These may include:

  • Administrative fees. You will probably be charged a small amount for record keeping and administrative expenses.  This can either be a flat fee or a percentage of a policy holder’s account value
  • Underlying fund expenses. If an insurance company invests in a mutual fund on your behalf, there will be fees associated with that action.
  • Mortality and expense risk. This is the charge an insurance company tacks on to your account to cover the risk it assumes as part of an annuity contract.  It typically runs 1.25% of the value of an account.
  • These can be assessed if you withdraw funds before age 59 ½ and can run at 10%, payable to the IRS.