Maybe your uncle warned you against annuities, or maybe Grandma loves them. Like most investment products, annuities have their place – but are not one-size-fits-all. They come in four very distinct flavors with important differences, so here’s an overview.
Two-thousand years ago, an “immediate annuity” was strictly for income, not investment growth, and this is still available. Hand a chunk of money to an insurance company and receive a guaranteed income stream for a certain period of time, or for your lifetime. If you live an average lifespan or longer, you may receive more total income than your original investment might have reasonably been expected to generate elsewhere. If you die the next day, you lose the bet – your initial investment is gone, and you didn’t get much income.
This gamble is attractive for some because it eliminates the risk of running out of income in retirement, thus insuring against a long lifespan. But nobody likes giving up part of their savings without knowing whether the gamble will pay off.
Enter the variable annuity, introduced in 1952. It includes an underlying stock/bond investment account in addition to an optional guaranteed “income rider.” With this, you don’t sacrifice your account balance up front. Instead, you activate the income rider either immediately or later; the money is automatically distributed to you from your account balance regularly and, if there’s money remaining at death, it goes to your heirs. If you live long enough to completely drain the account, the company keeps sending you the guaranteed income.
The investments inside variable annuities have fees, as do optional riders and the contract itself. So, variable annuities can be very expensive. This directly affects growth potential. However, such an annuity may still be appropriate if the features fit your needs, especially if you’re an aggressive investor, willing to weather market swings for more growth potential.
A variable annuity normally has a “surrender period” for four to seven years or more, during which annual withdrawals are limited and excess withdrawals are penalized. You’re giving up some liquidity in exchange for the features of the annuity, so make sure the trade-off is appropriate.
The equity indexed annuity may be a better fit if you’re a conservative investor. You’re not invested directly in the stock market; instead, yearly interest payments are based on the performance of a stock market index (yardstick) such as the Standard & Poor’s 500. If the index is up for the year, you get part of the gains as a percentage of the index, or up to a limit, or by some other formula. If the index is down for the year, you don’t gain, and you don’t lose. This can be attractive to investors seeking conservative growth potential for part of their savings, without the stock and bond roller coaster.
Indexed annuity fees tend to be very low or nonexistent. An optional income rider distributes income from your account balance, and if there’s money remaining when you die, it goes to your beneficiaries. Again, a lifetime income rider means the company contractually guarantees to keep distributing that income no matter how long you live.
Finally, the fixed annuity pays a fixed interest rate, with no income rider option. There are typically no fees. Performance is usually somewhat better than bank certificates of deposit, but generally less growth-oriented than indexed annuities or variable annuities. This is a conservative option with conservative growth potential. Most have a surrender period of five to 10 years, during which you may be able to make limited withdrawals. Excess withdrawals result in a penalty. Generally, the longer the surrender period, the better the interest rate.
Variable, indexed and fixed annuities are all tax deferred, so work with a tax professional to see if this may be of benefit to you.
If you decide to look further into annuities, here are important considerations:
Keep plenty of funds available for basic spending needs and emergencies before investing in any product with limited liquidity, including most annuities. Work with qualified financial professionals to determine whether a particular product is suitable for you, and get a second opinion if in doubt. Use highly rated annuity companies, as a guarantee is only as good as its issuer. And be very wary of up-front bonuses or other features which may be attractive at first glance but may be offset by less favorable long-term growth potential. Ask to see a nonbonus version, too.
Most importantly, there are always alternatives – so understand all the moving parts of whatever you’re buying. Or just don’t buy it.
Certified financial planner Kenny Gott is president at Piatchek & Associates and author of the book “Bottom Line Financial Planning.” He can be reached at email@example.com.
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