What are Annuities?
Annuities are an insurance product that you invest in that pays out income. If done strategically they can be a great part of your retirement strategy.
Here’s how they work: You make an investment in an annuity and it makes payments to you at a later date. This income payment can be received monthly, quarterly, annually or in a lump sum. The size of your payment is determined by the length of your payment period. You can opt to receive payments for a set number of year or for the rest of your life.
Annuities can be useful retirement planning tools but they should be researched thoroughly to determine if this type of investment is a good solution for you.
What are the different types of Annuities?
1. Fixed Annuities
Fixed annuities are the most straightforward to understand. A fixed annuity is a contract between you and the insurance company that guarantees the principal and the rate of return on your investment. Fixed annuities are low-risk investments that are unaffected by the stock market.
A fixed annuity can be either immediate or deferred. An immediate annuity allows you to start receiving payments the month after you open the annuity. Deferred annuities postpone the payout until a future date to allow time for growth of the principal.
The biggest benefit of fixed annuities is they provide better interest rates that remain the same for the length of the contract. They also provide lifetime payouts after retirement.
2. Indexed Annuities
Indexed Annuities are much more complex. They offer features of both index annuities and variable annuities and is tied to the stock market.
The interest rate on indexed annuities will vary throughout the contract. Indexed annuities usually offer a guaranteed minimum return even if the index it is tied to does poorly. However, if the index is performing well, you have the potential to earn much higher interest rates.
There are many intricate parts to an indexed annuity such as participation rate, cap rates, and high surrender charges. It is important that you thoroughly understand the product, its benefits and its limitations.
Questions to Ask Before Buying
Have I considered all of my options and done some comparison shopping?
Because annuities are long-term savings vehicles, you’ll want to make sure the company you pick will be around at least as long as you will. Different annuities offer a wide range of choices, prices, features and flexibility.
Is the rate on a fixed annuity too good to be true?
You want a competitive interest rate at renewal time. If the company is offering bonus rates (a higher interest rate for a set period of time) make sure the underlying interest rate and the company selling the annuity are financially viable. Once the bonus rate term expires, there is no guarantee going forward that renewal rates will be competitive. Be especially careful if you are exchanging annuities.
What are the annuity's surrender fees and how long are they in place?
If the surrender fee is high (typical fees are around 6-7% and decline over a period of approximately five to seven years), you could feel locked into a contract from which it will be costly to escape.
Will my ordinary income tax rate be greater than the current capital gains rate when I begin to take distributions?
If so, you may pay more in taxes by choosing annuities over another investment that would be taxed at the capital gains rate. Keep in mind, however, that your money in an annuity is accumulating on a tax-deferred basis. By selecting an annuity, you avoid paying yearly ordinary income tax on the earnings while your money compounds and grows.
What is the insurance company's rating?
While anyone who is properly licensed to sell insurance products (e.g., banks, brokers, agents) can sell annuities, the annuity contract is issued by an insurance company. So, you’ll want to consider the company’s rating. Is it financially secure, with a good claims paying record? While this is most important for fixed annuities, it is relevant to any guarantees (e.g., death benefit) in a variable annuity as well. Checking up on an insurance company is easy at your local library, or you can contact your state’s Department of Insurance. A.M. Best, Standard & Poor’s and Moody’s all rate the financial stability of insurance company general accounts. Morningstar and VARD’s evaluate and report information on variable contracts only. Variable annuities are rated by independent sources such as Lipper Analytical Services, VARD’s and Morningstar. It’s a good idea to choose an annuity from a company that gets high marks from at least two independent rating sources.
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