There are two main types of annuities; immediate or deferred. Immediate annuities provide income to you right away, whereas with a deferred annuity the contract spells out terms for you to receive the income at some point in the future.
Each type of annuity functions differently, and may or may not be an appropriate investment for you, depending on your personal circumstances.
- Immediate Annuities
Immediate annuities provide guaranteed income to you, usually on a monthly basis. You purchase this income by giving the insurance company a lump sum of money; in return they calculate how much monthly income they can provide to you based on the type of annuity (fixed, variable or inflation-indexed) and based on the term of the annuity that you choose (life-only, joint life, term certain). These types of annuities are effective at protecting against longevity risk; the risk of living beyond life expectancy. You can purchase an immediate annuity (or any type of annuity) with IRA/retirement money, or with non-retirement savings that you have. The link at the top of this paragraph will take you to more in-depth content about this type of annuity.
- Deferred Annuities
With deferred annuities, you deposit your funds with the insurance company by investing in either a fixed, variable, longevity, or equity indexed annuity, and the taxes on any investment gains are deferred until such time as you take a withdrawal. Written into your deferred annuity contract will be the option to turn your deferred annuity into an immediate annuity after a certain amount of time has passed; essentially you are letting your earnings defer until such time as you desire to turn the investment into a guaranteed stream of income. Deferred annuities can come with all sorts of features (at a cost) that provide specific types of death benefits and/or future income guarantees. These types of annuities can be effective at protecting against sequence risk (the risk of unknown future investment returns) as they create a certain outcome at a defined point in time on down the road. The link at the top of this paragraph will take you to more in-depth content about this type of annuity.
Advantages and disadvantages to a AnnuityAn annuity is a contract between the buyer and an insurance company. In general, the insurance company promises to do something with the buyer's money. This page should serve as a general overview of annuities. After you understand the concept you can look into the various annuity types.
Advantages of AnnuitiesAnnuities can be helpful in some situations. In general, some benefits are:
- Tax-deferred growth and compounding within the annuity contract
- Guaranteed rates of return on your dollars
- Guaranteed lifetime payments if you annuitize (in some cases you don't even have to annuitize in order to receive this benefit)
- Other features that may be important to you. These are various bells and whistles that do very specific things
Disadvantages of Annuities
- You have to pay for the guarantees somehow. If you don't need them, don't pay for them
- Some contracts have surrender periods that can tie up your money longer than you want
- IRS rules restrict how you take money out of an annuity. Distributions may be taxable and/or penalized
- Annuities can be overused in banks
The Variable AnnuityA variable annuity is an annuity with exposure to investments. If a fixed annuity pays a fixed rate of return, a variable annuity pays a variable rate of return. Before making a final decision for or against a variable annuity, you should understand how they work.
A variable annuity is an annuity with exposure to investments. If a fixed annuity pays a fixed rate of return, a variable annuity pays a variable rate of return. Before making a final decision for or against a variable annuity, you should understand how they work.
The Variable in Variable AnnuityA variable annuity is similar to plain-vanilla fixed annuities. You get some of the same features like tax-deferral, guarantees, and potential for lifetime payouts. What makes the variable annuity unique is the investments inside the annuity. You'll often have a choice of stock and bond mutual funds to put your money in.
This is where the term variable comes in (as in, your returns will vary with the returns of the investments). Fixed annuities offer a predetermined return. There's no way of knowing for sure what a variable annuity will return.
Why Would One Use a Variable Annuity?The first question to ask is if you should be using an annuity of any sort. Assuming you do, you need to pick between a fixed annuity and a variable annuity. There are some cases where you might pick the variable annuity. For example:
- You want the potential for more growth than a fixed annuity offers
- You can afford increased risk with your money
- You want some of the flexibility that newer variable annuity products offer
Fees in a Variable AnnuityThere's no such thing as a free lunch. You get some standard features, and you might add some bells and whistles (or 'riders'), but there's a cost. A variable annuity has the following costs:
- Mortality and Expense charges
- Administration charges
- Underlying investment charges
- Rider charges (if you select any optional riders)
At this point, I should point out that there is only one reason you should ever pay these charges: because you need to. I cannot overemphasize this. If you don't need the benefits unique to a variable annuity, don't use one. You can invest in mutual funds and pay a lot less. However, if you want the guarantees, for example, then the additional cost may be worth it.
Before You Buy a Variable AnnuityBefore you buy a variable annuity you should make sure it's the right thing for you. Know what you're getting into. In particular find out why an advisor is recommending a variable annuity as opposed to mutual funds. Sometimes there's a good reason, sometimes not.
Take the prospectus home and read it carefully. This is the best source of important information about a variable annuity. It should detail all of the expenses, riders, and surrender features of the contract. If you don't know how the product works, ask somebody you trust.
A variable annuity is a lot like a Rube Goldberg machine. Several moving parts have to work together for a successful outcome. If one of them fails, the whole thing fails.
What Happens When You Annuitize?When you annuitize, you tell the insurance company to start paying you.
When you make the choice to annuitize, you also decide how the payments should be structured. For example, you can choose a variety of options including:
- Lifetime payments
- Life with period certain
- Joint and last survivor
- Period certain
This is typically an irrevocable decision - once you annuitize, you can't go back. This is because the insurance company has to take steps to guarantee you the annuitized payments. Should You Annuitize?
Remember that annuitizing is just an option. Most annuity holders never annuitize. Instead, people tend to use an annuity for a while and then take the money elsewhere. The main reason to actually annuitize is that you want the guaranteed payments.
What is a AnnuitantThe annuitant is important because of a few characteristics. The main one is the annuitant's date of birth (because this determines the annuitant's age).
The annuitant's age will affect how an annuity contract acts. For example, you might be looking at a lifetime payout from an annuity. The insurance company looks at statistics on life expectancy and then determines how much each payment should be.
If the annuitant is relatively young, then each payment will be smaller. This is because smaller payments will last longer than larger payments. Of course, the insurance company sometimes guarantees to continue payments for the entire life of the annuitant - even if it's unusually long - but the insurance company tries to limit its risk by looking at statistics.
Another important characteristic is the annuitant's sex. Because women tend to live longer than men, the insurance company has to budget for different lifespans depending on the annuitant's sex.
Annuity Surrender PeriodA surrender period is how long you must wait before taking money out of an annuity without penalty. An annuity might not have a surrender period, or it may last for more than 10 years. You can take money out before the surrender period, but you'll generally pay a percentage of the amount you withdraw.
Annuity BasicsSurrender periods allow the insurance company to guarantee that you'll keep your money with them. They're similar to CD penalties, where you promise to leave your money at the bank for as long as the CD lasts.
How CD Penalties WorkGenerally, longer surrender periods give you better benefits. The insurance company knows you're not going to snatch your money out of your account, so they can do more with it behind the scenes. Surrender periods may be any number of years (0, 4, 7, or more are commonly used).
For example, the insurance company may give you a higher guaranteed interest rate with a longer surrender period, or they may offer guarantees that last longer. Depending on your needs and expectations about interest rates, the guarantees may or may not be useful.
Some products with the longest surrender periods do not benefit you at all. Instead, they're abusive and provide larger commissions for salespeople (a salesperson deserves to earn a living, but some annuities pay enormous commissions). If you see a surrender period longer than 7 years, ask about shorter surrender schedules and see what the tradeoffs are.
Don't use an annuity with a surrender period you're not comfortable with. You'll lose money, and you can always find annuities with surrender periods aligned with your goals.
Dodging the Surrender ChargeIf you need money but you're not out of the surrender period, you may have some options. Check with the insurance company and see if you can:
- Take out 10% of the initial premium (or any "free money")
- Take out any earnings
- Qualify for a waiver given your circumstances (such as terminal illness or nursing home needs)
- Annuitize the contract