Annuities are one of the most confusing ways to invest your money and if you don’t understand how annuities work then you’re not alone. That is the reason why I decided to create Annuities Explained which will help explain what annuities are and how they work, the various types of annuities, the pros and cons of annuities and perhaps most importantly, how to buy annuities. I will try to go in to further detail in future posts and I invite you to ask questions along the way.
How Annuities Work
The simplest way to explain how annuities work is to describe them as an investment security that you pay money in to for a set period of time, and once you reach a certain date you start to receive regular payments for a set period of time, often times for the rest of your life. Investors, especially those who are very risk averse, like annuities because they provide a steady stream of income and unlike stocks, bonds, mutual funds and other common investment options, annuities are guaranteed.
The amount of time you pay in to the annuity can vary anywhere from a onetime payment (think lottery winner or someone who just received a big inheritance) to many smaller payments over a long period of time. This will vary largely on the amount of the annuity and when you intend to start receiving payments. For example, if you start paying in to an annuity when you were in your 20s but don’t intend on taking payments until you retire, you will likely have many small payments, however if you waited to start when you were in your late 50s, you will need to pay more each month over a shorter period of time. Annuities provide a nice supplement (or primary income) especially for those who think social security might not be enough for retirement.
Once you reach the date where you will start receiving annuity payments you will be paid a guaranteed amount of income every month until you die. Some annuities will also allow your spouse to receive payments after your death until they die, but terms can vary depending on where you purchase the annuity.
Typically the issuer will base the number of payments made on the average lifespan of someone in your position (which is calculated through extensive research on their part). If you live longer than the typical person then you will continue receiving payments for more than the annuity is worth, but conversely if you die earlier you will receive less money overall. For example, if you pay in $50,000 and the issuer estimates that you will live for 20 years and you will get equal payments each month. If you live beyond 20 years then you keep receiving payments even if that exceeds your $50,000.
Some of you may read this and wonder why the issuer would do this, but even though you may live longer, on a whole the average lifespan of the typical annuity holder will hold true and they will likely come close to breaking even. They get their benefit largely from fees charged and of course being able to invest money for a higher rate of return when the money isn’t being paid out.
Types Of Annuities
There are a lot of different types of annuities available and they can largely be adjusted to suit the buyer, but the two most common types of annuities are immediate annuities and deferred annuities.
To explain immediate annuities I will refer back to the example of the lottery winner. Let’s say you won $1 million and you received a lump sum. Instead of spending the money right away you wanted to help ensure that it would last you for the rest of your life. If you put this money in to an immediate annuity you would pay the issuer up front and they would provide you payments every month with a specified rate of return.
Deferred annuities on the other hand are more common for the average investor. A deferred annuity as outlined above is one where you pay in over a period of time and then receive monthly annuity payments once you have reached a set time or dollar amount.
Annuity Payment Types
The most common types of payment for annuities are fixed and variable annuities. Fixed annuities provide a guaranteed rate of return over a set period of time. For example the issuer may guarantee that if you pay $100,000 in to your annuity then you will be guaranteed a 5% return on that money (this assumption also assumes no fees or taxes). Fixed rate retirement annuities are great for investors that are very risk averse and/or are close to retirement and don’t want to lose their nest egg.
Variable annuities were introduced to help entice the investor that expects a higher rate of return on their investment and would otherwise invest in a diversified mutual fund or something similar. Variable annuities guarantee a lower rate of return, but are tied to another security (often mutual funds) that will provide a higher rate of return when the market bears it. Obviously the benefit here is that if the market is booming, your money isn’t tied up in a low yield investment.
Annuities Pros and Cons
There are a lot of good and bad features of annuities. First of all there are tremendous tax benefits for investing in annuities. Specifically the money you invest in an annuity grows tax deferred until you eventually start your withdrawals.
Once you start your payments, only the gains you made on your annuity are taxed, and since many of us typically have lower income during retirement, they will be taxed at a much lower rate than it would have been during our working lifetime. Unlike IRAs and 401K programs, there is no limit to the amount of money you can contribute to an annuity (and the issuer would love for you to invest more I’m sure).
Another obvious benefit of guaranteed income annuities is the guaranteed payments that annuities provide. With all of the turbulence in the economy (especially in the last few years) a guaranteed rate of return from an annuity sounds pretty good to many investors whose faith was shaken from losses in the stock market.
Some of the disadvantages of annuities are that much like a certificate of deposit with your local bank, there are early withdrawal penalties if you are forced to cash in your annuity early. Typically these penalties are structured in such a way that they are high for the first few years and they slowly decrease over time. These penalties can be as high as 10% so clearly annuities aren’t for investors who need a lot of liquidity in their portfolio.
Another disadvantage of annuities is that fees typically higher than other investments. There are many annuities that have fees amounting to 2-3% or more, which compared to other investments with fees of 1% or lower, can really add up. Before purchasing any annuity, you need to be sure you have done your homework on all of these fees and be sure that the rate of return you are expecting makes up for any fees you will be charged over the life.
How to Buy an Annuity
So if you’ve read all of this and you want to know how to buy an annuity you’re in luck. There are hundreds (probably more like thousands) of annuity companies that sell annuities in all shapes and sizes. Typically any insurance company will offer some sort of annuity package, so if you already have an established relationship with one of them you should look in to their annuity options.
With the financial trouble in the market the last few years it is important to do some research in the company you are buying the annuity from. Since you are relying on them to provide a guaranteed income for the remainder of your life you want to make sure the company will be around that long. The good news is that companies that issue investment options like annuities are rated by companies like Moodys and Standard and Poors for their financial soundness and you can easily monitor any changes in their status. Also your state’s insurance department will monitor these companies and help prevent any potential problems before they happen. (The National Association of Insurance Commissioners – NAIC – provides a listing of insurance departments by state).
Are Annuities a Good Investment?
After reading this article you might be wondering if annuities are a good investment. Well that’s a question you will have to answer depending on your own personal circumstances, but there are definitely benefits. If you are a risk averse investor who is just looking to hold on to what you have then annuities might be right for you. If on the other hand you are looking to make a significant profit on your investments over time then you should definitely look elsewhere. To learn more or talk to an advisor for free, Click Here.