Many people in the financial world have a lot to say about annuities – but what are they really saying? It can sound like straight gibberish. Like anything, annuities can be simple, or they can be complex. The goal of capital management is to enjoy your retirement by doing things you love with people you love, not spending more time digging through a web of fees and taxes.
What is an Annuity and Why Do People Buy Them?
An annuity is a contracthttps://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities between you and an insurance company that requires the insurer to make payments to you either now or in the future. Before you start receiving any income, though, you must first agree to and fund a contract.https://www.forbes.com/advisor/investing/what-is-index-annuity/ Some people look to annuities to “insure” their retirement and to receive periodic payments once they no longer receive a salary. There are four different types, but in general, the contract is either a lump-sum payment or a series of payments over time.
Let’s unpack the four types of annuities:
1. Immediate Annuity
With an immediate annuity,https://www.investor.gov/introduction-investing/investing-basics/glossary/immediate-annuity you put a sum of money into an investment, and the insurance company either immediately, or in a few years, will start sending you a monthly paycheck for the rest of your life.https://www.thebalance.com/annuitize-what-it-means-to-annuitize-315087 You have the option to spread the annuity payment over two lives if you’re married, but the payout tends to be less.
Immediate annuities are often compared to traditional pensions, in fact, they’re sometimes referred to as a “personal pension”https://www.immediateannuities.com/immediate-annuities/create-a-personal-pension-with-an-immediate-annuity.html, in that they both necessitate paying money into a system in exchange for a guarantee that you’ll receive a monthly check either for the rest of your life or for a specified period (or both).
One of the major differences, however, is that with a pension, when you pass away and have money left, the insurance company keeps that.https://www.annuity.org/annuities/beneficiaries/#:~:text=For%20some%20immediate%20annuities%2C%20such,would%20receive%20any%20remaining%20payments. With an immediate annuity, when you die with money left in the annuity, it can be paid out to a beneficiary as long as you have specified a death benefit.https://www.blueprintincome.com/resources/retirement-income/what-happens-to-an-immediate-annuity-when-you-die/#:~:text=If%20you%20have%20an%20immediate,had%20received%20prior%20to%20death. It may sound morbid, but it’s critical.
2. Fixed Annuity
Fixed annuitieshttps://www.investor.gov/introduction-investing/investing-basics/glossary/fixed-annuity are a contract with an insurance company wherein the insurance company guarantees the account will earn a certain rate of interest.
While this may sound great, be aware there can also be caps on growth. A cap ratehttps://www.immediateannuities.com/fixed-index-annuities/ is the highest percentage gain an insurance company will credit to your annuity in any period. For example, if your annuity has an annual cap rate of 7% and the underlying benchmark index grows by 10% that year; your annuity will be credited with a maximum of 7%.
The rates on fixed annuities are derived from the yield that the life insurance company generates from its investment portfolio, which is invested primarily in high quality corporate and government bonds.https://www.investopedia.com/terms/g/government-bond.asp
The insurance company is then responsible for paying whatever rate is promised in the annuity contract. This is not the same as a variable annuity,https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities which, as you’ll see later, is where the annuity owner chooses the underlying investments and therefore assumes much of the investment risk.
When you invest a sum of money into a fixed annuity, the insurance company will pay you a set or a flat rate of interest. There is a time commitment, for example, of 3, 5, 7, or 10 years, and over that length of time, the insurance company will issue you a set rate of return it will pay you every year.
These investments do offer some liquidity. You can take money out, typically the interest. You can let it accumulate and then take it out or take the interest as a monthly paycheck. But again, in the end, you can take that money out and move it somewhere else.
Fixed annuities are often compared to CDs, or Certificates of Deposit,https://www.investor.gov/introduction-investing/investing-basics/investment-products/certificates-deposit-cds in structure, but are different in a couple of significant ways. First, fixed annuities typically offer a higher rate of return than CDs,https://www.allthingsannuity.com/fixed_annuity_performance.html#:~:text=Fixed%20annuities%20sometimes%20offer%20higher,returns%20than%20short%2Dterm%20bonds. and second, because fixed annuities are an insurance product,https://www.lawinsider.com/dictionary/insurance-products#:~:text=Insurance%20Products%20means%20any%20insurance,contingencies%20or%20perils%20or%20to they are not FDIC-insuredhttps://www.investopedia.com/terms/f/fdic-insured-account.asp (only bank investments offer FDIC insurance), and thus, carry a higher risk because they are based on the claims-paying ability of the insurance company.
That said, both CDs and fixed annuities are considered low-risk,https://www.newyorklife.com/articles/cd-vs-fixed-deferred-annuity and it is possible, for those who are qualified, to get a five-year fixed annuity that guarantees 3.5% today.https://www.blueprintincome.com/fixed-annuities
At the end of your fixed term, or when the annuity reaches maturity, the insurance company will allow you to make a lump-sum withdrawal, or cash out; leave your money invested and withdraw on a fixed schedule; renew your contract (for the same or different term); annuitize (or, convert) by creating a permanent stream of guaranteed income, or rollover via a 1035 exchange into a new fixed annuity or another annuity.
Remember, there can be tax implications on fixed annuities,https://money.cnn.com/2018/05/11/pf/taxes/annuities-taxes/index.html#:~:text=Payments%20from%20qualified%20annuities%20are,or%20other%20tax%2Ddeferred%20account. so seek tax advice, depending on the money being used to go into them.
3. Variable Annuity
A variable annuity is, like the other types of annuities, a contract between you and an insurance company. It serves as an investment account that may grow on a tax-deferred basis and includes certain insurance features, such as the ability to turn your account into a stream of periodic payments.
Many people with non-IRA money seek variable annuities because the growth in the variable annuity (if it’s not retirement money) is tax-deferred until you withdraw it or at a later time.
The amount of each periodic income payment will depend, in part, on the time period you select for receiving payments. Be aware that, in general, variable annuities are designed to be long-term investments, so they do not want you to withdraw money from your account once you have started receiving income payment. You can take money out each year, usually up to 10 percent of what the account is worth.https://www.sec.gov/investor/pubs/sec-guide-to-variable-annuities.pdf When the account matures at the set time-period and doesn’t re-renew, it becomes a liquid investment that you can take money out of, in any amount.
With variable annuities, also come fees.https://www.forbes.com/sites/davidrae/2019/07/01/variable-annuity-fees/?sh=6882d1727de2 Quite a few of them. Administrative fees (typically around 0.15% a year), fees and expenses imposed by mutual funds, and even additional fees and charges for special features like stepped-up death benefits, a guaranteed minimum income benefit, or long-term care insurance. It’s not uncommon to be looking at fees from 2.5 to 4 percent or more a year.https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities#Annuity_Fees
At Beacon, we believe you should understand all the fees and expenses before you invest. Fees and expenses will reduce the value of your account and the return on your investment.
4. Indexed Annuity
An indexed annuity,https://www.investor.gov/introduction-investing/investing-basics/glossary/indexed-annuities or fixed-index annuity, is an annuity where income payments are tied to a stock index, such as the S&P 500, Russell 3000, or the Dow Jones Industrial Average.
These have become popular in the last 15 yearshttps://www.thinkadvisor.com/2019/11/26/are-fixed-indexed-annuities-trending-again-for-2020/ because they provide protection against loss of principal. With an indexed annuity, your money does not go into the stock market but is based on how an index performs from year to year.https://www.finra.org/investors/alerts/equity-indexed-annuities-complex-choice
If the index goes up, you earn with those gains up to a cap or a participation rate. At the end of that year, the insurance company will lock in that interest.https://www.annuityexpertadvice.com/annuity-101/what-is-a-fixed-index-annuity/#:~:text=Locking%20In%20Your%20Gains.,to%20that%20point%20in%20time. For example, if you make 5% the first year, that 5% is added in. Next year, if the stock market index goes down in value, you don’t make any interest, but you don’t lose any money based on the market going down; you stay right where you are. If the market goes back up, you go up with it, less the cap or participation rate. You can see it works kind of like a stair-step approach.
You can typically take somewhere between 5 and 10 percent of your money out every year with an indexed annuity, though some insurance companies offer more liquidity.
Indexed annuities typically have very little or no feeshttps://www.annuity.org/annuities/fees-and-commissions/ but know that investors still incur a cost to own these products, by giving up higher returnshttps://www.fidelity.com/viewpoints/retirement/considering-indexed-annuities in exchange for guarantees. They also have riders you can attach to them. A typical rider fee for a fixed indexed annuity is around 1 percent,https://myannuityguy.com/income-riders/#:~:text=Riders%20are%20optional%20and%20generally,fees%20as%20high%20as%201.5%25. but a lot of these indexed annuities have zero fees. The fee is for time and commitment. You’ve got either a 5, 7, or 10-year term, just like the others, but with lower or no fees.
Penalties on Withdrawing Before Age 59 ½
With finances, the ride gets smoother after age 59 ½. With annuities, if you’re under 59 ½, and this is not retirement money, you can be penalized on withdrawals.
Why You Should Meet With a Financial Advisor
Because annuities are insurance products that require understanding, it’s a good idea to work with an experienced financial advisor to determine which type of contract best suits your particular needs. At Beacon Capital Management, we’re here to guide you in deciding if an annuity is appropriate for your situation.
Today’s annuities offer a wide spectrum of features and benefits to help customize your income stream, and if you want some assurances in retirement, you need a plan. Call us today, and let’s get started building a strategy that puts you first.
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