With the retirement playing field littered with crushed investments and dreams, the safety of guaranteed income streams looks more attractive each day. Annuities can provide such guarantees, so let's take a look at them and consider whether they make sense for you.
1) Simply stated, an annuity is a financial product sold by insurance companies that allows you to put aside money, have it increase each year without paying taxes, and then trigger a stream of future payments on a timetable you may control. Those payments are taxed as ordinary income. Unlike IRAs, there is no income limitation on how much you can place in an annuity.
2) The marketing phrase that insurers like to use about annuities is that they produce an income stream you can't outlive. And that can be true. By being in a pool of other annuity customers, insurers can offer attractive returns to annuity holders that they could not get on their own. People in the pool who pass away at younger ages are, in effect, subsidizing more attractive income streams for longer-lived annuity holders. And while your insurer does not know when you are going to die, it has a pretty good idea about the mortality profile of that larger pool of customers.
3) Insurers make money on annuity fees and management services. As they invest your annuity payments, or premiums, they get to keep anything above the payments they have guaranteed to you. And, of course, they get to keep any remaining funds in your annuity contract once you've passed away and after they've settled any remaining payment obligations to your heirs.
4) Beyond these basics, there is very little about annuities that is simple. The kinds of annuities and rules under which they operate can be very complicated. So, it might help to recognize that most people's basic source of retirement income—Social Security—is an annuity of sorts. If it were discussed as one, it would be known as a flexible premium deferred annuity. Bet you didn't know you owned such a sophisticated product, did you? In a private annuity, it's the insurance company, not the federal government, that's guaranteeing the annuity payments. So it's very important to consider the financial strength of the insurer. Some financial planners go further and want to make sure their clients' annuities funds are held in a separate account at their insurance company and not carried on its balance sheet.
5) In their basic form, the world is divided into immediate and deferred annuities. We've already discussed the deferred variety. In immediate annuities, your payment stream begins when you place your funds into the annuity.
You can fund an annuity with a single payment, or premium, or, as with Social Security, a series of premium payments.
6) Annuities also come in fixed and variable forms. A fixed annuity provides you a fixed series of payments under conditions that are determined when you buy the annuity. In this respect, fixed annuities are like defined-benefit pensions. The insurer is promising to provide you with the payments specified in your annuity. You don't particularly care how the insurance company comes up with those payments and you have no involvement with how your annuity funds are invested by the insurer.
7) With a variable annuity, you do have a lot of control. Variable annuities were designed to let investors participate in the stock market and still enjoy the tax-deferred, insurance, and lifetime income benefits of an annuity. You may have seen these products described as mutual funds with an insurance wrapper.
8) Your annuity premiums are invested in a variety of subaccounts—usually mutual funds; but there are some conservative options as well. It's a lot like a 401(k) plan in the extent to which you control where your premiums are placed, and thus the overall returns on your annuity. This means the insurance company's guarantees to you are a lot different in a variable annuity. Generally, you have the opportunity to gain returns higher than in a fixed annuity; but, as this year's market proves, there is downside risk as well.
9) Because annuities do have life insurance protection and also, in many cases, will guarantee you that you never receive less than the amount of premiums you've paid into the annuity, they are marketed as safer investment options than just placing your funds in a mutual fund account, even one that has tax-deferred features such as an IRA or 401(k). Safe is as safe does, however, so be very careful that you fully understand any annuity product before purchasing it.
10) Because annuities enjoy tax-deferred treatment on investment gains, some advisers do not feel they are appropriate inside a retirement account that already has these tax-deferral benefits.
11) Beyond fixed and variable, there also is a type of annuity known as an equity index annuity, which claims to blend the secured returns of a fixed annuity with the potential stock-market upside of a variable annuity.
12) Financial planners caution that the insurance company management fees and charges need to be carefully reviewed and fully understood. They can be steep, especially in terms of charging high early withdrawal fees for people who want to take their funds out of the annuity. Often, such fees are charged for several years after the annuity is purchased, so buyers should be very comfortable that they plan to be in the annuity for the long haul.
13) Buyers of annuities also need to know the details behind any performance guarantees that insurers make. If there is a minimum return guarantee, for example, what is its time duration?
14) There is great flexibility in how annuity payments are handled. Because the insurance company retains the annuity premiums, for example, some people are concerned about turning over a large amount of money and then dying before they've received much income in return. In that case, annuities can be structured to trigger payments for a fixed number of years to you or your heirs, or, for example, to make payments until you and your spouse have passed away.
15) In short, you can tailor an annuity to meet specific timing and family needs, and you will see corresponding changes in your anticipated payments based on what you decide. Just walk through the steps carefully with an adviser—this is not recommended as a do-it-yourself task. Make sure you understand exactly what's entailed in the annuity you choose, particularly all of the insurance charges, fees, and conditions that may govern subsequent decisions you might need to make.