Annuities are investment contracts made between insurance companies and investors. As opposed to life insurance, where payment is made for an unexpected death, annuities can ensure that an individual will not outlive their money. Most annuities can be tailor made to fit the individual’s needs.
Types
There are many types of annuities, but the Bond Market Foundation condenses this list to two varieties. Annuities are either variable or fixed rate. Either of these, in turn, can be single or flexible premium and immediate or deferred.
Variable rate and fixed rate annuities refer to how the annuity is invested. Variable rate annuities are usually invested in mutual funds or stocks. The advantage is that as the stocks or mutual funds increase in value, the annuity amount also increases accordingly. This can increase the original value of the amount placed into the annuity, increasing payment benefits. However, if the stock market falls, the original amount placed in may become less, resulting in lower than anticipated payments. This vehicle is good for people who don’t need their money for ten to fifteen years, to bypass stock market fluctuations. Fixed rate annuities, on the other hand, are invested in bonds or other fixed rate investments. The advantage with these is that the principle amount is safe, however it doesn’t have the growth potential that the variable rate annuities offer. This type of annuity is good for those who need their money soon or don’t like taking risks.
When purchasing annuities, you can pay in one single lump sum or pay with flexible payments. The flexible plan allows one to make smaller payments over time to reach the financial total that they desire, while a single annuity is a lump sum payment that may be used by someone, gaining an inheritance or settlement of some sort.
Immediate annuities are annuities that start making payments to you, on a monthly, quarterly or annual basis, as soon as a lump payment is made. Immediate annuities can be paid out for a defined number of years or for your lifetime, depending on what you choose. The shorter payout period results in higher payments to you, but doesn’t provide lifetime income, while the lifetime guarantee variety makes smaller payments to you, ensuring income for as long as you live. A deferred annuity on the other hand, allows the money you invest, to grow tax free until needed by you, for retirement. The annuity can start making payments as soon as the investor reaches fifty-nine and a half years of age. The income growth during this time is tax free, until the annuity contract is exercised. Immediate annuities, on the other hand, have no tax-free growth advantage.
Pros and Cons
Annuities aren’t for everybody. Generally they are good for people who have maximized their retirement contributions. As opposed to retirement contributions, annuity contributions are not tax deductible. So it behooves the individual to only use any surplus amount left over from retirement investment vehicles, for annuities. Also annuities aren’t liquid like other investments. Annuities are good for people who don’t need the money being placed into these investment vehicles until retirement. If money were needed, the insurance company may impose fines and penalties for withdrawals . Finally annuities make sense for individuals, near retirement age, who get a lump sum of money near retirement and want a lifetime guarantee of income.
Remember that insurance companies are in this to make money. Every insurance company will charge annual fees, management fees and a sales commission to the person who sold you the policy. Also, make sure that the insurance company used is financially well off and solvent. If it runs into financial trouble, it may not be able to guarantee payments to you when the annuity contract is exercised. Regardless of this, annuities are a secondary way to increase and guarantee lifetime income, after retirement plans, and deserves consideration for any portfolio.
References
US Securities and Exchange Commision
