Annuities: Basic Training for a Complex Product
, by Rob Kaufman
Determining whether or not you should purchase an annuity can be a very frustrating process. Most annuities are complicated and convoluted products that oftentimes can only be figured out by financial professionals. Is this complexity intentional? That's a topic for another article.
For right now, the topic at hand is intended to provide you with a basic understanding of what an annuity is, the different types of annuities available and the pros and cons of owning an annuity. Hopefully, having access to this information will help you make the best decision as to whether or not owning an annuity is the right thing for you.
What is an Annuity?
An annuity is a contract between you and an insurance company. You can make either a lump sum payment or a series of payments in return for regular disbursements that begin immediately (immediate annuity) or at/on a future date (deferred annuity).
The main objective of an annuity is to provide you with a steady stream of income during retirement and, based on the annuity product you purchase, for the rest of your life. This income is possible because you are in a pool of other annuity holders. Some of these other annuity holders may pass away at a younger age and that, in effect, helps subsidize the income stream for annuity holders who live longer.
Annuities can be customized to meet specific needs and requirements. For example, you can choose when you want to start receiving your payments (annuitize). You can also choose the time period over which you'd like to receive those payments (i.e. 20 years, 25 years, until death, etc.). As you might expect, the longer your payment period, the lower the disbursements. However, knowing you have a lifetime of payments helps provide peace of mind that you won't outlast your assets.
Types of Annuities.
Are you still with us? If you are, know that things get a bit more complicated at this point, so you might want to read a little more slowly...
Fixed Annuity . This variety of product pays out a guaranteed amount based on the balance of your account. The conditions are determined when you purchase the annuity and do not change. Plus you have no involvement with how your annuity funds are invested by the insurer. The downside to a fixed annuity is a modest annual return.
Variable Annuity. This product provides potential for a higher return, with greater risk. You choose from a variety of mutual funds that provide your annuity's "subaccount" and your payments are based on the performance of these investments. The downside to a variable annuity is that there is greater risk due to your investments into markets that can often be volatile.
Indexed Annuity. The risk and potential reward of an Indexed Annuity falls somewhere between a Fixed and Variable Annuity. Your minimum payout is guaranteed although a portion of your disbursements is linked to the performance of the market index selected for your annuity. There's potential for higher earnings, but their fees are high and surrender charges (taking your money out early) could be astronomical.
Annuity Pros and Cons.
Okay, you're still here. That's good. We're past the more difficult part. Now we're onto some of the reasons an annuity might be good - or not - for you.
PRO #1: Peace of mind. You'll generate valuable income in retirement and, if you choose a lifetime annuity, you'll receive payments for the rest of your life.
PRO #2: Inflation Protection. Depending on the amount of your payments and disbursements, many annuities increase payouts to keep pace with inflation.
PRO #3: Time and Worry Savings. Since income is guaranteed, there's at least one less reason to worry about money when you retire. Also, managing your own investments takes a lot of time. With an annuity, you can spend more of your retirement enjoying yourself instead of trying to find the right investments.
CON #1: Surrender Fee. When you invest in the stock market, you can always take your money out of your account(s). With an annuity, it's not so easy. If you take your money out early, you'll have to pay a surrender fee (percentage of the annuity value) and that can turn out to be a hefty dollar amount.
CON #2: Annual Fee. Many Annuities, especially Variable Annuities, charge annual fees - sometimes between 2% - 3%. If your annuity is averaging 6% per year, but you're getting charged 3% annually, you might not be doing as well as you thought you were.
CON #3: Lost Financial Benefit. If you pass away a few years after purchasing a lifetime annuity, you would have gotten back very little for your initial investment. That's money that might've been given to your heirs but will remain with the insurance company.
It's important to remember that before making any commitment to an annuity (or annuities), get as much information as you can and speak with as many financial professionals and annuity experts as possible. Knowledge is power and the more you know, the better decision about annuities you can make.
What do myFICO customers say about annuities? Do a search for "annuities" at the myFICO forum and find out!