Annuity information

WHAT IS AN ANNUITY?

An annuity is an insurance product that pays out income, and can be used as part of a retirement strategy. Annuities are a popular choice for investors who want to receive a steady income stream in retirement.

Here's how an annuity works: you make an investment in the annuity, and it then makes payments to you on a future date or series of dates. The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment.

The size of your payments are determined by a variety of factors, including the length of your payment period.

You can opt to receive payments for the rest of your life, or for a set number of years. How much you receive depends on whether you opt for a guaranteed payout (fixed annuity) or a payout stream determined by the performance of your annuity's underlying investments (variable annuity).

While annuities can be useful retirement planning tools, they can also be a lousy investment choice for certain people because of their notoriously high expenses. Financial planners and insurance salesmen will frequently try to steer seniors or other people in various stages toward retirement into annuities. Anyone who considers an annuity should research it thoroughly first, before deciding whether it's an appropriate investment for someone in their situation.

What are the different types of annuities?

There are two basic types of annuities: deferred and immediate.

With a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, typically in retirement.

If you opt for 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.

The deferred annuity accumulates money while the immediate annuity pays out. Deferred annuities can also be converted into immediate annuities when the owner wants to start collecting payments.

Within these two categories, annuities can also be either fixed or variable depending on whether the payout is a fixed sum, tied to the performance of the overall market or group of investments, or a combination of the two.

 

Are there tax benefits to annuities?

Yes. Money that you invest in an annuity grows tax-deferred. When you eventually make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate.

 

What are the advantages of annuities?

The biggest advantages annuities offer is that they allow you to sock away a larger amount of cash and defer paying taxes.

Unlike other tax-deferred retirement accounts such as 401(k)s And IRAs, there is no annual contribution limit for an annuity. That allows you to put away more money for retirement, and is particularly useful for those that are closest to retirement age and need to catch up.

All the money you invest compounds year after year without any tax bill from Uncle Sam. That ability to keep every dollar invested working for you can be a big advantage over taxable investments.

When you cash out, you can choose to take a lump-sum payment from your annuity, but many retirees prefer to set up guaranteed payments for a specific length of time or the rest of your life, providing a steady stream of income.

The annuity serves as a complement to other retirement income sources, such as Social Security and pension plans.

What are the disadvantages?

Many annuities sound like great moneymakers, but there are often hidden fees that can cut into any profits the annuity pays out, so buyer beware.

Surrender charges: You're also likely to face a prohibitive surrender charge for pulling money out of an annuity within the first several years after you buy it. The surrender charge typically runs about 7% of your account value if you leave after one year, and the fee generally declines by one percentage point a year until it gets to zero after year seven or eight. Note that some annuities come with even heftier surrender charges - up to 20% in the first year.

High annual fees: If you invest in a variable annuity you'll also encounter high annual expenses. You will have an annual insurance charge that can run 1.25% or more; annual investment management fees, which range anywhere from 0.5% to more than 2%; and fees for various insurance riders, which can add another 0.6% or more.

Add them up, and you could be paying 2% to 3% a year, if not more. That could take a huge bite out of your retirement nest egg, and in some cases even cancel out some of the benefits of an annuity. Compare that to a regular mutual fund that charges an average of 1.5% a year, or index funds that charge less than 0.50% a year.

Also, as with a 401(k) or IRA, in an annuity it's generally not a good idea to take out any money until you reach age 59 ½ because withdrawals made prior to that are hit with a 10% early withdrawal penalty.

What investment options do annuities have?

It depends on which type of annuity you have. If you choose a fixed-rate annuity, you are not responsible for choosing the investments - the insurance company handles that job and agrees to pay you a pre-determined fixed return.

When you opt for a variable annuity, you decide how to invest your money in the sub-accounts (essentially mutual funds) offered within the annuity. The value of your account depends on the performance of the funds you choose. While a variable annuity has the benefit of tax-deferred growth, its annual expenses are likely to be much higher than the expenses on regular mutual funds - so ordinary funds may be a better option.

What payout options do I have?

When you invest in your annuity you also choose how you want your eventual payouts to be calculated. Your options include:

Income for guaranteed period (also called period certain annuity). You are guaranteed a specific payment amount for a set period of time (say, five years or 30 years). If you die before the end of the period your beneficiary will receive the remainder of the payments for the guaranteed period.

Lifetime payments. A guaranteed income payout during your lifetime only; there is no survivor benefit. The payouts can be fixed or variable. The amount of the payout is determined by how much you invest and your life expectancy. At the time of death all payments stop - your heirs don't get anything.

Income for life with a guaranteed period certain benefit (also called life with period certain). A combination of a life annuity and a period certain annuity. You receive a guaranteed payout for life that includes a period certain phase. If you die during the period certain phase of the account, your beneficiary will continue to receive the payment for the remainder of the period. For example, life with a 10 year period certain is a common arrangement. If you die five years after you begin collecting, the payments continue to your survivor for five more years.

Joint and survivor annuity. Your beneficiary will continue to receive payouts for the rest of his or her life after you die. A popular option for married couples.

 

What if I decide to withdraw the money?

Withdrawing money from an annuity can be a costly move, so make sure you review your plan's rules and federal law before you do.

If you make withdrawals before you reach age 59 ½ , you will be required to pay Uncle Sam a 10% early withdrawal penalty as well as regular income tax on your investment earnings. (The amount you contributed to the annuity will not be not taxed.)

If your withdrawals come within the first five to seven years that you own the annuity, you probably will owe the insurance company a surrender charge. The surrender charge is typically 7% or so of your withdrawal amount if you leave after just one year, and the fee then typically declines by one percentage point a year until it gets to zero after year seven or eight.

Beware: Some annuities have initial surrender charges that can be as high as 20%. But check your plan's rules, because some annuities allow you to withdraw up to 10% of your investment without having to pay the surrender charge.

What happens to my annuity after I die?

It depends on the type of annuity and how your payouts are calculated. There are several different methods.

You do have the option of naming a beneficiary on your annuity, and with certain types of payout options that beneficially could receive the money in your annuity when you die. Other options just pay out during your lifetime, and the payments stop when you die.

 

How do I know the company will honor my future payments?

When you purchase a deferred annuity you are giving an insurance company money today, and you may not receive your payments for a number of years (the earliest you can make withdrawals from an annuity without incurring a 10% penalty is age 59 ½). So it is critical to purchase annuities only from insurance companies that you're confident will be in business when you retire.

Check the insurer's credit rating, a grade given by credit bureaus such as A.M. Best, Standard & Poor's and Moody's that expresses the company's financial health. Each rating firm has its own grading scale. As a general rule, limit your options to insurers that receive either an A+ from A.M. Best or AA- or better from Moody's and S&P. You can find the ratings online, or get them from your insurance agent.

There are state guaranty funds that protect annuity owners if an insurance company fails, but the coverage is limited and varies from state to state.

What if I bought an annuity I no longer want?

You can ask to surrender the annuity. If you have owned the annuity for less than seven years or so, you may have to pay a surrender charge. That fee can start at around 7% if you pull out in the first year you own the annuity, and then it typically declines by one percentage point a year until it disappears after seven or eight years. You also will have to pay income tax on all the investment earnings in your annuity, and if you are younger than 59 ½ you typically will be hit with a 10% early withdrawal penalty courtesy of the IRS.

Alternatively, you can opt to transfer your money to another annuity in what is known as a 1035 exchange. The surrender charge, if any, still applies, but you won't incur any tax or penalty.