Annuities can be an appropriate retirement savings vehicles for those individuals with specific needs and investment objectives. There are a dizzying array of annuities marketed by financial advisors.
Regrettably, over the years, unscrupulous financial planners, motivated by the high commissions paid, have sold annuity products to individuals for whom the product was clearly unsuitable in light of their overall circumstances and specific financial needs upon their retirement.
Before purchasing an annuity, investors should educate themselves about the basic types of annuity products that are available, how each type pays out income and whether the stream of income is guaranteed or will change upon retirement or during the life of the annuity.
What is an annuity?
An annuity is a contract with an insurance company, that in consideration for a lump sum or a series of payments, agrees to pay you (the annuitant), a certain sum for a specified period of time. The best way to understand annuity contracts is that they all basically fall under one of two categories: immediate and deferred. All other annuities available to investors are variations of these two income-generating contractual instruments.
Since the insurance company is obligated, in most cases, to continue paying out income to an annuitant even if the assets in the investment account have been depleted, this retirement vehicle is a suitable choice for those who are concerned about outliving their available retirement income.
An immediate annuity contract, gives you the option to receive either a predetermined, fixed amount for the specified life of the annuity, or an amount that varies, based upon the performance of the investments in the annuity account. With an immediate annuity, the investor makes a one-time lump-sum payment (single premium) and the insurance company begins disbursing regular payments on a monthly basis right away, or usually, within one year after the contract was executed.
Insurance companies allow those who purchase immediate annuities, the option of electing to receive a guaranteed amount for the life of the annuity contract, based on a fixed rate of return, or a variable amount, that is tied to the performance of the investments in the annuitant’s account.
With deferred annuities, you have the option of making a single, lump sum premium, or monthly payments, prior to your retirement or when the annuity matures, usually on the death of the policyholder or on a pre-established date. The payments you receive, are at a guaranteed rate of return for a specified period of time. Typically, these types of annuities guarantee payment over the life of the annuitant and if the contract allows, the life of the surviving spouse.
Some deferred annuities only guarantee a fixed rate of return for a specified period of time, usually one to ten years, at which point your rate of return may be adjusted pursuant to the terms of the annuity contract. This rate of return may be lower or higher than your initial contract rate.
One of the advantages of a deferred annuity is that your contributions to the account grow tax-deferred prior to your retirement.
Under the terms of a variable annuity, you have the option to invest your premiums in certain specified investments provided by the insurance company. Typically, these are mutual funds, but can vary insurer. The benefit of a variable annuity, is that you can participate in the growth of the stock market and have the ability to earn a higher rate of return on your pre-retirement payments than that you might receive with a fixed rate contract. This could be a distinct advantage if the contract rate is low or interest rates have stayed low for a long period of time. Of course, the amount available for paying out retirement income to you in the future, is subject to market risk.
Insurance companies offer variable features for both immediate and deferred annuities.
Some annuity providers, offer a blended product, where you are guaranteed a fixed monthly sum or rate of return and you can seek a higher return by investing a portion of your premiums in the stock market. Some insurance companies will provide you with a choice of index funds, that are tied to the performance of the S&P 500 or the smaller cap Russell 2000 index.
Investors should be aware, that under the terms of a blended product, since you are getting the best of both worlds — the ability to participate in stock market gains, as well as the benefit of receiving a minimum guaranteed payment, the fixed payment will always be less than that payable under a fixed annuity.
Is an annuity a suitable investment for you?
There are a number of factors that you should carefully consider before purchasing an annuity. Investors should not rely on the advice of a financial advisor alone; independent due diligence is necessary, in order to insure the annuity you are considering, is suitable for your investment objectives and retirement needs.
There are a plethora of annuity contracts offered by insurance companies that are variations on the two basic types of annuities noted above. Investors should scrutinize the terms and conditions of each product.
For those annuity contracts that pay a specified rate, make certain to ascertain whether the “fixed return” or stream of payments is for a limited duration, or is guaranteed for the entire life of the annuity. For variable products, make certain that the term of the payout is specified, once the annuity matures.
There are additional issues to consider. For immediate annuities, is the guaranteed payment or interest rate for the life of the account, immediately after execution of the contract, or will the rate change at some point in the future, pursuant to the terms of the contract?
For variable annuities, check the performance of the mutual funds the insurance companies offer for your investment account. If the long-term performance has lagged the market as a whole, it might be best to consider another insurance company with funds that have matched or exceeded the long-term return of an overall index.
Prospective annuity purchasers should be aware of the fees assessed for each type of product. Variable annuities have expense charges to cover the insurance companies’ risk of paying out income beyond the actuarial life expectancy of each annuitant. These fees can be substantial, ranging from 2% to 3.5%. For many annuities, these charges are paid up front. This type of a front-loaded product, prevalent during the 1980’s, will impact the overall return on your account. If the stock market performs poorly, or interest rates remain at historically low levels, the dollar amount of your payout could decrease markedly.
Investors should also note, that some annuity contracts have surrender charges, if you withdraw money prior to retirement age. These fees vary by insurer, but they can be substantial.
Comparison shop online
Marketing of annuities has changed markedly over the years. Instead of relying solely on the advice of a financial advisor, individuals can now do their own comparison shopping online. Blueprint income is an online site that provides investors with flexible products. Consumers can find annuities where the contractual minimum can be as low as $100, instead of the typically $5,00 to $10,00o minimums for traditional annuities offered by the big insurance companies.
Finally, investors should understand, that an annuity rarely makes sense as a retirement savings vehicle, because the investments in an IRA also enjoy the benefits of tax-deferred compounding. Those planning for retirement, should purchase an annuity only after they have maxed-out on the statutory contribution limits for their other qualified retirement plans.
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