What is an Annuity?
Why Buy an Annuity?
How an Annuity Works
Types of Annuities
Reasons to Buy an Annuity
Disadvantages of an Annuity
Annuity Payout Options
What Happens when the Annuityholder dies?
Who Should Buy an Annuity
What is an Annuity?
An annuity is a contract between an individual and an annuity provider (typically an insurance company). The individual makes purchase payments either in a lump sum (also known as a single premium) or periodic payments (also known as flexible premiums). The payments generally are referred to as deposits. The insurance company invests the deposits. The insurer eventually pays money to the individual. These money can be paid in either a lump sum or a series of payments.
In the classic annuity, known as an immediate annuity, the annuity provider pays a guaranteed amount every month to the individual as long as the annuity holder lives, regardless of the length of time. If the annuity holder lives many years, the payout will far exceed the amount invested upfront. However, an annuity holder who dies prematurely likely will receive less than the amount invested in the annuity.
Let me provide a real life example of an immediate annuity that turns words into numbers:
Angela, a 65 year old widow who is concerned about outliving her savings, buys an annuity from Pacific Life Insurance for $100,000. In exchange, Pacific Life agrees to pay Angela the amount of $440.43 per month for the rest of her life starting immediately. This is probably the simplest annuity structure. It involves a single lump sum payment, it pays out a fixed amount, and it starts immediately (there are more complex types of Annuity that I will discuss later).
Angela lives until she is 97 years of age and ends up receiving a total of $169,125.12 over the rest of her life in exchange for one lump sum annuity investment of $100,000.
Why Buy an Annuity?
This guaranteed payout feature is the most important reason why retirees invest in annuities. One of the greatest fears of retirees is that their savings will run out before they die, leaving them with Social Security as their only source of guaranteed income. By investing their savings in an annuity, the annuity provider is guaranteeing that individual an additional monthly annuity check on top of Social Security. The retiree who invests in an annuity is essentially buying financial peace of mind to enjoy retirement without financial stress. People typically buy annuities to help fund their retirement because it is a long term financial strategy that can be used to guarantee income later in life.
How an Annuity Works
When an individual purchases an annuity from an insurance company (the annuity provider), that person, who is called the annuitant, is transferring the risk of owning an investment to the insurance company. Similar to other types of insurance, the buyer needs to pay the annuity company to bear this risk and exchange it for the certainty of a guaranteed stream of annuity income into the future. The annuity is usually paid for through a lump sum, but can be covered with a series of payments over time, depending on the type of annuity. The period of time in which the annuitant is making payments and buying the annuity is called the accumulation phase.
The insurance company invests the money that the annuitant and other annuitants pay throughout the accumulation phase, most often in stocks, bonds, and real estate. The annuity company uses the earnings from these investments to make regular payouts to the annuity owners. The payments received by the annuitant from the annuity are usually structured as periodic over time, and only rarely as a lump sum. Unlike other types of insurance, you do not need to pay for an annuity indefinitely. Instead, you stop paying the annuity at the end of the accumulation phase and start receiving money in return. Once you start collecting payments from your annuity, you have entered the annuity payout, or distribution, phase.
Types of Annuities
There are more types of annuities than the immediate annuity in the example above. In addition, the immediate annuity and the other types of annuities have a lot of flexibility. The choice of annuity and the terms of the annuity can be structured to meet the annuitant’s needs and preferences.
First, the annuitant can decide when to start receiving payments. An immediate annuity is one that begins paying out as soon as it has been bought. Alternatively, a deferred income annuity starts making its payments at a predetermined date in the future. These also can be called longevity annuities and qualified longevity annuity contracts (QLACs). Deferred annuities offer the annuitant the opportunity to generate the same amount of income payments with a smaller deposit than an immediate annuity, because the insurer will invest the deposits and earn returns from the investments before the payout phase begins. Plus, the payout period will be shorter than with an immediate annuity.
The annuitant also can choose the terms of the income payments. This is discussed in more detail later.
During the accumulation phase, there are three basic types of annuities to choose from. These generally are called the fixed, variable, or indexed annuity.
A fixed annuity (or fixed deferred annuity) guarantees the safety of the principal and guarantees a minimum rate of interest on the investment during the accumulation phase. The interest paid on the account is redetermined each year based on market interest rates. Fixed Annuities are predictable and safe, so the annuitant does not run the risk of losing any money. However, fixed annuities may provide a relatively modest annual return, especially in times of low interest rates. The interest rate earned generally is higher than on certificates of deposit.
Variable annuities carry greater risk than fixed annuities, but they also have the potential to provide larger payouts. In a variable annuity, the deposits usually are invested in mutual fund-like investment options that might be selected by the annuity owner or by the issuing insurance company. The value of the annuity account changes over time based on the performance of the investments. The investments could rise or fall in value. So the choice of investments may cause the annuitant either to lose money or to earn more than would be possible with a fixed annuity.
An indexed annuity will pay an annuitant a guaranteed minimum interest rate and usually guarantees the principal’s safety. Plus, an indexed annuity also provides the potential to earn a higher interest rate based on the performance of an investment index, such as the S&P 500, or a basket of market indexes. Indexed annuities fall between fixed and variable annuities in terms of potential risk and reward.
Benefits of Investing in an Annuity
The most prominent benefit of owning an annuity is that the annuity holder is guaranteed a steady stream of lifelong income during the payout phase. They are also quite flexible because the contract with the Annuity Provider can be customized to fit an individual’s specific needs. For example, an annuitant can pay into it periodically or with a lump sum, and can receive return payments monthly, quarterly, annually or in a lump sum. The annuitant also can decide exactly when to receive payments, and can manage how much risk to assume. Again, most importantly, annuities provide reliable long-term income that, if desired, can grow over time. The guarantee of income from an annuity also allows the annuitant to adopt a more aggressive investing strategy with any other assets he owns, because the combination of an annuity and social security means the annuitant is assured a certain level of guaranteed retirement income no matter what.
In addition to providing a steady stream of lifelong income, annuities also have the capacity to fulfill other functions if an annuitant chooses to take advantage of their versatility. For example, an annuity provides the annuitant with the option to create a legacy plan because to preserve funds for future generations. In addition to taking care of future generations, the annuitant can choose to use the annuity to protect and preserve assets for a surviving spouse through death benefits to sustain a spouse’s lifestyle.
Disadvantages of Annuities
While annuities can be attractive, they also have some drawbacks. Annuities can be associated with high fees. These fees may include initial commissions, ongoing investment management fees and early withdrawal fees. The level of the fees depends on the type of annuity. Immediate annuities and fixed annuities have very low fees and expenses. Variable annuities and indexed annuities can have high fees and expenses, though the level depends on the annuity purchased and the features of the annuity.
Additionally, some annuities are complex and can be difficult to understand. It is important for an investor to understand any investment fully, and some people may struggle to grasp what some types of annuities entail.
Finally, it is vital to consider the financial standing of the annuity company before buying one. Annuities are not backed by the federal government, rather the payment guarantee comes from the insurance company. The financial strength of the insurer is a very important aspect to consider before opening an annuity, as the payment guarantee is only as secure as the insurance company that issues it. However, states do have associations that are responsible for covering an insurer’s annuity obligation up to a state-determined coverage limit and provided the association or fund doesn’t run out of money.
Annuity Payout Options
There are three options to choose from when deciding how you would like to receive your annuity payments.
The first annuity distribution structure is called the annuitization method, and it simply provides income payments to the annuitant for the rest of his life or for a specified period of time. When the annuitant decides to use this method, the amount of money that will be received with each payment is determined by the insurance company based on his life expectancy or based on the period of time he wishes to receive payments.
The systematic withdrawal schedule is another payout option. When this is the chosen payment method, the annuitant must specify how frequently to receive payments and the amount of each payment. Funds are withdrawn from the annuity based on those decisions. With the systematic withdrawal schedule, one chooses to withdraw funds from the annuity until it is empty, thus creating the risk that the annuity will run out of money before the annuitant dies.
The final option is for the annuitant to receive a lump sum payment: a large sum that is paid in one single payment on a determined date instead of being broken up into smaller installments. The lump sum payment is most likely to be selected when the annuitant used a variable annuity or indexed annuity during the accumulation phase and wants to use a different annuity or other option during the payout or distribution phase.
What Happens to the Money in the Annuity when the Annuitant Dies?
After the death of an annuity owner, the remaining annuity can be left to be inherited by a beneficiary who must have been selected by the original owner. The contract that is negotiated between the annuitant and the insurer includes death benefit provisions, in which the annuitant can designate a beneficiary. Typically, the beneficiary is a spouse, child, or other loved one. This beneficiary may receive all of the remaining money in the annuity or a guaranteed minimum, and the insurance company may distribute the money to the beneficiary in a lump sum or in a series of payments. If the annuitant does not pick a beneficiary, the death benefit is paid to the annuitant’s estate.
Keep in mind, however, that there often are no payments to a beneficiary when the annuitant chooses to have payments last for life or for the joint life of two people. When the initial payee or payees pass away, the income payments stop. Some life payment annuities have provisions that offer some payout to a beneficiary if the annuitant dies before reaching life expectancy or before a minimum period of years has passed. But with these annuities, the payments to the annuitant during his or her life will be lower than for an annuity without the provision.
How Annuities are Taxed
Annuities are tax-deferred, meaning the money invested in the annuity grows without being taxed until the payout occurs. You don’t pay taxes on the earnings while they remain in the annuity, but taxes must be paid when the money is withdrawn. The rate at which withdrawals are taxed depend on how an annuity is funded.
If an annuity is funded with pretax dollars, everything withdrawn will be taxed at the annuitant’s ordinary income rates, and this is called a qualified annuity. These annuities usually are part of a retirement or pension plan.
If post-tax dollars are used to pay for an annuity, making it a nonqualified annuity, the annuitant will not be taxed on the portion of withdrawal that represents a return of the original principal, which are the deposits or premiums. Since a nonqualified annuity is funded with earned income that already has been taxed, only the portion of a withdrawal that is considered to be earnings is taxable. Nonqualified annuities use a method called the Exclusion Ratio to determine how much of the withdrawal correlates to the principal investment and how much comes from earnings. The purpose of the Exclusion Ratio is to split payouts between taxable and non-taxable in an equitable manner.
Who Should Buy an Annuity?
Generally, only consider an annuity after maxing out retirement investment methods, such as 401(k) plans and IRAs that offer a tax deduction. If these more tax-efficient retirement saving options are maxed out and money has been set aside, the tax deferred growth provided by an annuity may be a good idea.
An immediate annuity or the life payment option of an annuity would not be an advantageous strategy for someone who has health problems that make it unlikely for the individual to reach his life expectancy. A fixed deferred annuity, indexed annuity, or variable annuity might be a good choice for this person during the accumulation phase to provide for a spouse or future generations.
Someone who is healthy and desires the security of steady income that he will not outlive may benefit from an annuity. However, it is best to use annuities as a complement to other retirement income sources, and not choose to make an annuity the sole source of retirement income.
If an annuity isn’t right for an annuitant, he always can get out of the annuity for free during the free look period. That is the period of time that annuitants can receive a full refund for their contract. Free look periods vary by state, and can range from 10 to 30 days. After that, the annuitant generally is locked in to the annuity for a period of years or must pay a penalty to have the deposits returned.
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