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Annuities Pros and Cons

Pros and Cons of Fixed Annuities

by Annuities Explained on April 28, 2010

In the United States, annuities apply to those funds that are given to a life insurance company and which mature or grow on a tax-deferred basis. Eventually, these funds will be distributed back to the investor in a variety of ways. An annuity contract’s defining characteristic is the fact that it holds the option for a guarantee of the income that will eventually be distributed until the account holder passes away.

Additionally, it can go to all persons listed in the contract should there be more than one account holder. However, the majority of annuity account holders prefer to let the funds accumulate and then have them distributed in a lump-sum payment and not utilizing the “guaranteed-income-for-life” features of the contracts. In the US, annuities are defined by the IRS and the individual state governments regulate them.

Advantages and disadvantages of fixed annuities

Before discussing the pros and cons of fixed annuities, there are certain key terms that most annuities contain that you want to become familiar with. These include:

Annuitant (also referred to as Contract Owner)
annuitize
Beneficiary
Deferred Annuities vs. Immediate Annuities
premium
surrender period
Variable Annuity

When you have time, make sure you learn what these are. Now for the pros and cons of fixed annuities.

Annuities can be financially beneficial in a number of situations and provide the following benefits to the account holder:

guaranteed lifetime payments – provided you annuitize those payments although that isn’t always a requirement
guaranteed rates of return on your funds – a primary feature
tax-deferred growth – probably the most critical feature along with the compounding of funds within the annuity contract

Just be aware of the fact that those guarantees are only as good as the insurance company giving them. What this basically means is that if by some strange circumstances the insurance company fails, those guarantees are worthless. It stands to reason then that you should only deal with the strongest of insurance companies on the market.

Naturally, you can’t discuss the pros without covering the downside. The following are considered to be the primary disadvantages of fixed annuities:

IRS rules which govern annuities – these are basically restrictions as to the way in which you withdraw the funds of the annuity. Distributions may be either penalized, taxable, or oftentimes both.
overuse by banks – banks and other similar financial institutions tend to push annuities off on their demand account holders.
paying for the annuities – you have to pay for these somehow. So if you decide that you won’t need them, you shouldn’t pay for them
surrender periods – found in some contracts, surrender periods can tie your funds up much longer than you can wait should you want to start withdrawing them.

With the above in mind, you should be able to determine how a fixed annuity would impact your financial situation and help you make your decision to pay for one or not. Just remember that they are ideal for some individuals but not for others.

Pros and Cons of Indexed Annuities

by Annuities Explained on April 28, 2010

Indexed annuities are a class of annuities wherein the returns on them are yielded on your contributions and are based on specific equity-based indexes. They are typically purchased from insurance companies and are similar to other types of annuities. The payout conditions and terms depend on how they are defined in the annuity contract. Additionally, there will usually be provisions for a guaranteed rate of return issued by the insurance company that you purchase the annuity from.

Even if the index of the stock performs poorly, the annuitant’s level of risk of loss is somewhat limited. However, it is also common (occasionally) that the annuitant’s yields may be lower than what was initially expected. This is primarily due to the fact that the combination of “caps” on the maximum amount of earned interest and deductions that are classified as being fee-related. As with other annuities, you want to do your homework and determine whether or not indexed annuities will benefit your financial situation or not.

Advantages and disadvantages

Annual reset – the earned interest is annually guaranteed or “locked in”, while the value of the index is typically “reset” at year’s end. Normally, any future decreases in that index value does not affect the earned interest. Therefore, the indexed annuity that employs the annually resetting method might credit more interest to those annuities that employ other methods. This applies to fluctuations in the value of the index, both down and up, usually during the annuity’s terms. This type of method is more likely to provide access to interest which is indexed-linked before the end of the term compared to other methods.

Conversely, the participation rate (what you pay into the annuity) may fluctuate annually and is typically lower than the rates of other methods for indexing. Usually, these annual reset methods might employ a cap or an averaging to the limit of the total annual earned interest.

High-water mark – usually the highest value of the index on the anniversary of the contract’s term is how the interest is calculated and arrived at. It may credit a higher rate of interest than other indexing methods if that index attains a higher value earlier or in the middle of the contract’s term. Then, at the end of the term, it drops off.

The downside is that earned interest is calculated at the end of the contract’s term. However, with some annuities, you may not receive interest that is index-linked for that term should you surrender that annuity prior to the end of its term.

Point-to-point – since the earned interest is not calculated prior to the end of the contract’s term, an indexed annuity usually permits a higher rate of participation than annuities that use other methods.

The typical term of annuities is 6 to 7 years and since the earned interest won’t be calculated until the end of the contract term, you might not be able to receive that index-linked interest until the term is complete.