How Do Annuities Work?
Let’s take a look at annuities: what they are, how they work, and what you should you know to select the option that will best serve your individual life goals.
Retirement planning should be exciting—not anxiety-inducing. You want to maximize your life’s earnings as much as possible, and the right annuity policy offers an additional tool to protect your nest egg and give you full flexibility during the latter years of your life.
So What Exactly is an Annuity?
An annuity is a formal arrangement with your insurance company that helps to cover your financial future. Annuities are designed for priorities such as:
- Principal Protection
- Lifetime Income
- Legacy Planning
- Long-term Care Costs
It’s important to make the distinction that an annuity is not technically an investment, but a contract. You’re using your insurer to do the investing, and they take on the risk.
This setup has been around since Roman days, but took hold in the United States around the Great Depression. The stock market crash awakened people to the fear of losing their retirement, and people now look to annuities as a central part of their retirement plan—a valuable and viable income stream alongside resources like social security and their 401k.
The Social Security system is actually a helpful way to understand annuities. It functions as a parallel model, giving individuals limited annual access to funds that are paid out gradually over time. Unlike other investments, people choose to purchase an annuity to secure a guaranteed and indefinite income. This is a disbursement of funds intended to help you move through the rest of your life. An annuity gives you the advantage of
- a tax exempt savings method
- a supplement to your 401k and IRA
- no contribution limit
- the security to invest elsewhere with more risk
How Does an Annuity Work?
Let’s say you’ve made an appointment to set up your annuity fund. When you walk into the financial institution, here’s what you can expect. You will be designated as the annuitant, and you will choose a particular payment or premium (sound familiar?) that you pay the insurer for assuming the investment risk. You have the option of making this payment either all at once, or over the course of a period called the accumulation phase.
Once the accumulation phase is complete, you will then commence the payout phase. You can choose to receive payments in any of the following ways:
- As fixed payments for a predetermined number of years.
- For the remainder of your lifetime—however long that may be.
- For the remainder of your lifetime, including a “period certain” payout.
The third option allows a particular beneficiary to receive the remainder of the payments. Payments operate similar to social security. They’re apportioned in amounts reflective of your life expectancy and come to you according to the schedule you designate—even when you pay for your annuity in a lump sum.
The payments schedule can be:
- Immediate, bringing in money as soon as 30 days after a lump sum payment.
- Deferred, with an option for tax-deferred premiums.
The payment amounts can be:
- Fixed, with a set rate of return, as with a multi-year guaranteed annuity (MYGA.)
- Variable, set to fluctuate with the market—typically not the the best choice for retirees.
What are the Different Types of Annuities?
An income annuity is the most low-risk annuity option that turns part of your assets into a stream of income payments. These plans are not affected by market movements. You simply put your in your money, and a check shows up every month for the rest of your life. Like social security or a pension plan, you know exactly what you’ll get.
Fixed annuities, like an MYGA, function similar to a CD by offering a guaranteed amount of interest. These will protect a portion of your assets from market losses while also providing guaranteed growth at a fixed rate over the term of the annuity.
If you want an annuity option that allows for market growth while also protecting you from losses, you might consider an indexed annuity, also know as a fixed index annuity. Index-linked annuities don’t invest directly in the market, but they do track with its performance. You’ll consequently enjoy protection but, as a trade-off, the annuity will also place limits on your growth by capping your gains. A better choice might be to keep a more simple annuity in one basket and your stocks and bonds in another.
Lastly, for those who prefer the risk factor, you’ve got your variable annuities, which offer the highest growth potential. These ones are a sheer gamble—a high reward coupled with the distinct possibility of losing money. Unless you have discretionary funds to play with, this setup typically isn’t wise in the late stage of life.
Any Pitfalls or Traps to Avoid?
With annuities, you obviously want to protect your principal payment and avail yourself of all the additional funds you can accumulate with interest. Let’s look at how to avoid losing that steadily accruing money.
Like CDs, a MYGA annuity imposes a “surrender charge” for early withdrawal if you take out money during what’s known as the surrender period. This penalty amount does decrease during the later part of the the surrender period, but you will still want to do all you can to refrain from breaking in early.
It’s similarly important to meet with your financial advisors about tax considerations, since, much like IRAs and 401(k)s, you’ll face tax penalties for early withdrawal. Your payments are taxed as income once you receive them, but the money is tax deferred while it is in the annuity. If you have funded your annuity with pretax money, it’s considered a qualified annuity that is taxed at the typical rate upon withdrawal. If you’ve funded it with after-tax money, it’s considered a non-qualified annuity and you will not be taxed on the accumulated interest.
Stay wary of riders. As a way to further customize the details of your annuity contract, you have the option of including riders that supply additional advantages to future beneficiaries. These riders are known as living riders or death riders depending on when they take effect. However, all riders come bundled with fees that are assessed during the duration of the policy. Always look at how much you’re limiting your income as a result of the riders you’re placing. While riders appear to be a worthwhile way to direct more money to your family and less to the insurance company, they frequently do the opposite.
Remember, annuities are private purchases that are not guaranteed by the federal government. It’s crucially important to research and weigh the strength and credibility of the individual insurer. The Comdex index offers rankings that show you the best and most reliable providers. They will usually be names like:
- A.M. Best
- Fitch and Standard & Poor’s
How to Decrease Risk with an Annuity?
Opportunity cost poses a certain risk to annuities. Suppose you lock in a rate and then witness a rise in the interest rates in the market. Unfortunately, you’ll have lost out on those gains. While people sometimes attempt to time their annuity purchase in conjunction with the rate patterns of the treasury, it’s usually a losing strategy when you consider the payments you’re forgoing.
A better way to offset the risk of opportunity cost is to make a plan for gradual annuitizing. For example, if you have $300,000 to put toward an annuity fund, you might halve that amount, set up the annuity, and feed in the remaining $150,000 down the road. This lets you take advantage of interest rates, while granting yourself the extra time to determine how much you actually need in your annuity, and how you ultimately prefer to allot your funds.
Do You Need an Annuity?
For many people, and annuity represents roughly 25% of their retirement assts. Others are in a secure enough position where an annuity simply doesn’t make sense for them. If you’ve run the numbers, totaled your assets, calculated your living expenses, and concluded that you won’t run out of money over the upcoming decades—then an annuity may not be useful.
But if you’re looking for a steady stream of income to last you the rest of your life, one that can also be inherited to benefit those closest to you, then an annuity is a great option.
Keep in mind that annuities come with a 10 to 30 day free look period. During this window, if you realize the agreement isn’t right for you, all your money can be paid back in full. To fully,
Above all, make sure you’re working with trusted financial advisor who can guide you through the steps of selecting the right plan. Then will help you understand all of the terms and conditions and legalese, while also ensuring you build in the timeframes and customizations the fit your own unique circumstances.
When done right, you’ll give yourself a solid monthly income, and priceless peace of mind.