Annuity Basics
The dictionary definition of the word annuity is – “A specified income payable at stated intervals for a fixed or a contingent period, often for the recipient’s life, in consideration of a stipulated premium paid either in prior installment payments or in a single payment.” Great, one long sentence with about twenty different options in it. It is true that there are many different annuity products on the market today available from many different insurance companies. All these different products have different fancy sounding names, and slightly different bell’s and whistles (called riders, they will be discussed in a different article), but in reality there are only three main differences between most of the annuities available. By the end of this article we want you to be comfortable with not only knowing what an annuity is, but also the fundamental differences between different types of annuities.
What’s an annuity?
In the world of investments an annuity typically is a long term investment specifically designed to meet the needs of retiree’s. An annuity is a contract between you and an insurance company where you fund the annuity contract, and in return the insurer guarantee’s to return you either fixed, or variable payments over a period of time ( 5 yrs, 10 yrs, the rest of your life etc). While annuities can only be issued by insurance companies, they are not typical insurance policies like everyone is used to. However an annuity can serve the purpose of acting as in insurance policy for at least some of your retirement assets.
An annuity is typically used as part of a retirement plan for several reasons. First, you can fund an annuity with either one lump sum, or a little at a time. All your contributions into an annuity are allowed to grow tax-deferred until the annuitant (contract owner) begins to take withdrawals. (Please note that annuities offer no additional tax advantages when combined with an IRA. There are many other reasons for using an annuity, since an IRA already offers tax-deferred growth without the use of an annuity).As stated in the above definition all contributions and growth can be converted into a specified income payable at stated periods. This means your investment can turn into a stream of income for up to the rest of your life.
Basic Annuity Differences
All the different annuities on the market today can make selecting the right annuity for you a confusing process. Without getting to specific as to differences between annuity A, annuity B, and annuity C, there is essentially only three basic choices you will have to make:
1. Payout Methods: – Immediate or Deferred:
The first question you’ll need to ask yourself is when you will need to draw income from your annuity? An investor who requires income right away, as the name implies an immediate annuity might be right for them. With a deferred annuity, the investor receives payments at some later date. This allows more time for the principal amount invested to potentially grow. Annuitization is the process of converting an annuity investment into a series of periodic payments. Annuities may be annuitized regularly, over a long or short time period, or in some cases in one single payment. Once annuitized, the account holder loses access to the principal amount invested.
2. Type of Investment:- Fixed or Variable.
The next question you will need to ask yourself is, How much risk am I willing to take with my investment? As we all know money that is put under your mattress does not earn any interest. In order for there to be some kind of return the funds must be put to work. A fixed annuity offers investors a guaranteed rate usually over a period of one to ten years. In order to receive this guaranteed rate of return the investor has no say as to how his money is invested, it is up to the insurance company. By the same token if the insurance company does not earn as much of a return on your money as they had initially hoped, they still have to pay your promised payment’s in full, and return your principal at maturity. This is why it is said that with fixed annuities the investment risk lies with the insurance company, and not with you the investor. The guarantees of an annuity contract, including fixed returns, payouts, and death benefit guarantees are contingent on the claims-paying ability of the issuing insurance company. (Fixed Annuity Article)
With a variable annuity the investor (along with your financial planner) decides how his or her money is invested. Variable annuities enable you to invest in a selection of sub accounts. These sub accounts can range from very conservative to very aggressive, it’s all up to the individual. The performance of the underlying investments will eventually determine the monthly benefit the investor is entitled to. Because how the money gets invested is up to the individual the investment risk is said to lye with the individual. The insurance company is still obligated to pay you something, but that payment is not set in stone like with a fixed annuity. One reason people utilize variable annuities instead of fixed is because of the possibility of better returns. Upon redemption, the value of a variable annuity may be more or less then the original cost. Variable annuities are investments and are subject to market risk, investment risk, and possible loss of principal. Variable annuities may have higher internal fees associated with this product. (Variable Annuity Article)
3. Liquidity options.
As previously stated annuities typically are long term investments geared towards retiree’s. Regardless of type most all annuities have some sort of surrender charge associated with it. A surrender charge is a penalty for making an early withdrawal above the free withdrawal amount. Each annuity will have a different “surrender period” associated with it. With a fixed it could be anywhere from one year to ten years. With a variable annuity typical surrender periods are four years, seven years, or nine years. For an individual who may need spur of the moment funds obviously a shorter term surrender option is more suitable. Keep in mind that especially for variable annuities a slightly higher fee will apply for an annuity
with a shorter term surrender period. With either systematic withdrawals or free withdrawals you will be subject to regular income taxes, as well as the 10% tax penalty on early withdrawals prior to age 59 ½. You may also incur surrender charges on amounts withdrawn in the early years of the contract. (72t)
These are the three main variables people are faced with when choosing an annuity. To learn more about the different types of annuities, or some strategies as to how an annuity can be part of a retirement plan don’t hesitate to contact the team at Flagstone retirement toll free at 1-866-892-2081 or fill out the form on the top right of this page.
