Annuities: They May Be a Better Option than You Think
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Mention the word “annuity” to an investor, and you’re likely to receive mixed reactions. The concept is often misunderstood, leaving the everyday investor who is planning for retirement concerned that his or her money will end up tied up and inaccessible — and subject to market losses. But this isn’t an accurate characterization.
The following is a summary of the basics. The range of annuity products is broad, running the gamut from very simple to deeply complex. Like all the investment options we have, they have their pros and cons — or as I like to say, every rose has its thorns. Here are the basics:
What are annuities?
Annuities are contracts issued by insurance companies that can be used by investors to accumulate wealth and/or create a stream of guaranteed income for a period of time (for example, 10 or 15 years, or even a lifetime). You can fund an annuity with all types of money and accounts, such as an IRA, Roth or money transferred from a savings account.
What types of annuities are available?
There are several types of annuities out there for investors. Choosing the right one comes down to your retirement goals and income needs. When do you plan to retire? What do you anticipate your minimum income requirements will be in retirement? How averse are you to market risk? Here’s a breakdown of your options.
First off, annuities can be broken down into two categories, based on when payments start:
- Immediate: Payments begin as soon as the investment is made.
- Deferred: The investor commits money to the annuity for a certain period of time, such as five, seven or 10 years, after which he or she can either take it out as a lump sum, move it somewhere else or start payments. As part of this, there is a “surrender period” during which early withdrawals may be subject to penalty fees.
Beyond that, annuities come in three different types, based on how they are paid.
- Fixed: Similar to CDs, these are the simplest type of annuity to understand. Under the terms of a fixed annuity, you commit a sum of money, and the annuity provider guarantees a yield. As an example, a 65-year-old woman is in need of dependable income to supplement her Social Security. She can take $200,000 and give it to an insurance company, which in return supplies a monthly income of $1,100 for the rest of her life.
- Indexed: These become more complicated. You commit your money to a similar time period, but you may earn a yield within a range, usually dependent upon a market index. There are many nuances that need to be understood, as the terms of an indexed annuity (that is, how much yield you might see) can vary from carrier to carrier. For example, there may be a cap on the index’s returns, or there may be certain returns that are not included in the annuity (e.g., dividends). Moreover, there are a variety of riders (such as guaranteed income options or death benefits) you may opt for as part of the annuity, which introduces further complexity. There are many moving parts to an indexed annuity, so it is important that you study up and work with an adviser to determine if it is right for you.
- Variable: To fully explain these would demand much more space. Suffice it to say, these are where significant complexity enters the equation. Returns are based on the performance of the funds you choose to invest in, vs. an index. You may also consider purchasing riders. Variable annuities can be compelling, but only if you are willing to put in the time to properly educate yourself on how they work.
The potential downsides
So, what are the thorns on the annuity rose? Complexity is certainly one of them, but others include a possible lack of liquidity and fees.
Liquidity: Annuity contracts can restrict your access to your money. With immediate annuities, you cannot withdraw your funds once they are handed over to your insurer; you can only take the income payments. With deferred annuities, you may withdraw funds — up to a certain amount of the principal, depending on the contract — during the surrender period; however, as noted above, you may be subject to fees if your withdrawals exceed the amount permitted by your contract.
Fees: Fixed and immediate annuities seldom have any fees, but occasionally they may have a “market value adjustment” that can add to early withdrawal penalties. Variable and indexed annuities may have significant fees — and in the case of indexed, those fees may be deducted from your payouts — and they have to be weighed against the benefit you are deriving.
In summary, annuities may or may not have a place in your long-term plan. Approach them with an open mind. Some investors may immediately dismiss them because of what they have read or heard, but annuities can be attractive to investors who want to protect some of their portfolio from another serious market downturn. They can also be attractive for people in need of dependable cash flow.
All investment options have benefits and drawbacks. It is incumbent upon all of us, however, to educate ourselves and take control of our financial decisions.
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