An annuity is an insurance product by which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date. Annuities can be used as part of a retirement strategy as many retirees want to receive a steady stream of income.
The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment. Additionally, the amount you receive at each payment depends on what type of annuity you opt for. There are generally two types of annuities: a fixed annuity or a variable annuity.
Fixed annuities are CD-like investments issued by insurance companies; they pay guaranteed rates of interest, most times higher than bank CDs. Fixed annuities can be deferred or immediate. As it pertains to a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, usually in retirement i.e., the deferred annuity accumulates money. With an immediate annuity, you begin to receive payments soon after you make your initial investment. For example, you might consider purchasing an immediate annuity as you approach retirement age.
If you choose a fixed-rate annuity, the insurance company handles choosing the investments and pays you a pre-determined fixed return. Fixed rate annuities are attractive because they provide investors with the comfort of receiving a set payout; this is especially important for retirees who want a known income stream to supplement other retirement income. It is also ideal for investors who are risk averse and do not have the “heart” to deal with the volatility of the stock market. They also offer low investment minimums of $1,000 to $10,000.
From a tax perspective, the interest with fixed annuities is not taxed until it is withdrawn. Be aware, however, the rates on fixed annuities may be fixed only for a limited period, after which they drop. At that time, if you do not like the new rate and want to withdraw your money early, heavy surrender charges could apply. Finally, one must consider the impact that inflation will have on your fixed payment. As the payments are not adjusted for inflation, the purchasing power of the payment will decrease over time as inflation rises.
The other type of annuity is a variable annuity. A variable annuity is a tax-deferred retirement vehicle that pays you a level of income in retirement that is determined by the performance of the investments. Unlike a fixed annuity, the investor has control over how his/her money is invested in the sub-accounts (essentially mutual funds or a limited amount of individual stocks) offered within the annuity. The value, therefore, depends on the underlying performance of the investments. While a variable annuity also has the benefit of tax-deferred growth, annual expenses tend to be much higher than those for regular mutual funds. By being able to choose a variety of the investments, the investor has more upside potential and the ability to outpace inflation.
Of course with the positives, there are also the negatives. The risks of investing in a variable annuity include
- Investment Risk & Taxes – Although long-term gains are deferred until withdrawal, upon withdrawal they are taxed at ordinary income rates rather than capital gains rates
- Fees – Aside from a surrender fee you face for early withdrawal, variable annuities can have steep sales commissions, management fees, etc.
Industry experts recommend variable annuities only if you have maximized your 401(k) and IRA contributions. Variable annuities are also regulated by the SEC while fixed annuities are not.
Equity Indexed Annuities
A third type of annuity which is not considered a “run of the mill” annuity is an equity-indexed annuity. During the accumulation period while you are making either a lump sum payment or a series of payments, the insurance company credits you with a return that is based on changes in an equity index, such as the S&P 500 Composite Stock Price Index. The insurance company typically guarantees a minimum return. In other words, if stocks rise, you benefit from the increase. If stocks fall, you do not lose any money. However, the company that issues the annuity will also so limit the maximum returns that you receive in return for the downside protection they provide. The limit depends on the particular indexing method used. The most common method is called the “participation rate” and works as follows: the insurance company may set the participation at 90% (some companies are as low as 50%), which means the annuity would be credited with 90% of the growth experienced by the index. If the index gained 10%, your gain would be 9% for that year. Essentially, you’re trading 100% of the market risk in order to receive a share of the market gain.
After the accumulation period, the insurance company will make periodic payments to you under the terms of your contract, unless you choose to receive your contract value in a lump sum. Equity-indexed annuities combine features of traditional insurance products such as a guaranteed minimum return and traditional securities. These annuities are anything but simple and there are several methods insurance companies use to index. Make sure you consult someone knowledgeable before you fall victim to what seems like a no-lose investment.
For the most part, annuities are viable investment options but there do appear to be many nuances and one must read the fine print and understand the product before investing. It may be wise to max out contributions to other retirement accounts, ROTH IRAs, IRAs, or 401(k)s before considering an annuity.
Published or updated March 15, 2013.