Basic Concepts of Annuities
Annuities are insurance industry products. You may think of them as investments with guarantees. The type and amount of guaranty will vary from annuity to annuity. Some companies offer more than one type of annuity product.
Annuities are for retirement income and therefore money withdrawn before the age of 59 1/2 can be subject to a 10% penalty tax on top of your regular income tax.
Annuitized vs. Non-Annuitized
This is the most important thing to know about annuities. Pay very close attention.
With Annuitized Annuities you actually give an insurance company your money in exchange for fixed monthly payments
When you buy an Annuitized Annuity you give the insurance company a lump some of money and they in turn will give it back to you in the form of fixed monthly payments.
Depending on how the annuity is set up they may stop making payments after a certain number of months or they will guarantee to pay you a smaller monthly amount for as long as you live. You can make arrangements to receive an even smaller amount each month if you want your surviving spouse to continue to receive payments after you die. The insurance company calculates the size of the monthly payment by assuming the money you gave them will grow at a rate of 1-3%.
Annuitization means that the money you give the insurance company belongs to them. If you die before they have paid it all back, they get to keep what is left. Your heirs will not get any of it. I.e. A man doesn’t want to be a burden to his children so he gives an insurance company a $100,000 to buy an Annuitized Annuity. In return the company agrees to pay him $1,500 a month for as long as he lives. The next day he has a heart attack and dies. The insurance company gets to keep the money and his children get none of it.
Both you and the insurance company are gambling. If you live a lot longer than expected, you’ll come out ahead. If you don’t, the insurance company comes out ahead.
Now that you understand what Annuitization means let’s look at Non-Annuitized Annuities.
With this type of Annuity the money is always yours and when you die what remains in the account will go to your heirs. Because the money belongs to you and not the insurance company, it is considered an investment.
Non-Annuitized Annuities come in two forms, Fixed and Variable. One has a fixed rate of return, the other a variable rate. In both cases the insurance company will offer you the opportunity to annuitize your Non-Annuitized Annuity. Generally that is not a good idea.
A Fixed annuity is similar to a CD with a fixed interest rate that you can make withdrawals from. It will stop making payments when the money runs out. Because it is your money you may arrange to take out as much or as little as you want each month. They will offer you about a 4 to 6% fixed interest rate. The advantage is that the interest rate is guaranteed even if the market goes down.
Like the name indicates, the Rate of Return will vary over time. The insurance company has their own group of mutual funds for you to invest in. The Rate of Return on these investments will vary according to how well the these funds perform in the stock market. Since it is your money you can withdraw it or just leave it to grow, but there are penalties for early withdrawal.
How Variable Annuities differ from just buying mutual funds
When you buy mutual funds you get no performance guarantees. Some years their value can go down or up according to what is happening in the stock market. Variable Annuities will give you certain performance guarantees. This can be very important for people who are nearing retirement.
Variable Annuity Guarantees
When you set up a Variable Annuity they agree to guaranty certain things. In return you have to make certain commitments and pay additional fees. The fees charged by annuities are higher than those charged by mutual funds.
Annuity Guarantees and your Commitments and Costs
Basic Guarantee – You will never have less in your account than what you invested (less withdrawals) and in most cases it will lock-in on the greater of what it is worth on each anniversary of the investment date. So if you set up a variable annuity on Feb 1st, from that point on every Feb 1st, your annuity will compare what it is worth now with what it was worth on the previous Feb 1st and will lock-in the greater of the two values. Once locked in, the new amount is guaranteed yours for life even if the stock market goes down. This guarantee often makes the higher fees worthwhile.
Commitment – You will not take out any more than 10% of your investment a year until it matures. If you do you loose your guarantees. Commonly they mature in 10 years.
Costs – To get all the guarantees it will usually cost between 1% and 2% more than owning a similar mutual fund outside of the annuity.
Other Guarantees – Each company and Annuity has a group of additional guarantees that you can purchase. They vary so much that you will need an Annuity salesperson to explain each one to you.
I recommend that you deal with an investment broker who represents a number of different types of Annuities when tying to decide if it is a good investment instrument for you and which one best meets your needs.
David Bender (previously securities licensed)