So, you are considering purchasing an annuity to help protect your retirement savings or to solve a concern that may not be easily addressed with other investment vehicles. Here are a few things to consider when making a decision about buying an annuity.
1. Surrender Charge Period
Expressed in terms of years, the surrender charge defines how long your money must remain in the annuity before you have unrestricted access to it. With most annuities, a portion of your money is available penalty-free during the surrender period, but only after this period has passed do you have complete access.
Surrender periods can range from 5 to 16 years. A longer period equals better terms, so you need to consider the features before committing to a product. For many, the surrender charge period is irrelevant – they intend to take lifetime income withdrawals, make only penalty-free withdrawals, or leave a financial legacy.
2. Crediting Methods
Various crediting methods exist, so you can find one that fits your needs.
Monthly average crediting tends to smooth out returns during years of volatility, ensuring a negative final month does not have a disproportionate effect and wipe out an entire year’s worth of gains. This is because each month’s return is averaged over the course of the year.
Point-to-point methods are very straight forward, making them the most common form of interest crediting. In most “uncapped” or participation rate strategies, point-to-point is the only option.
In an uncapped crediting method, the gains are not limited by a defined maximum interest rate. The annuity company may deduct a “spread” or charge a fee that will reduce the interest credited, but a cap does not limit the gains. For example, if the index were to rise by 15% during the period and the company charged a 1% fee or spread, your account would be credited with a 14% gain.
Participation rate crediting works in a similar manner, but instead of deducting a fee or spread, the account “participates” in a percentage of the gain. In the same example as above, if the index were to rise 15%, but there was an 80% participation rate instead of a spread, the amount of interest credited to the account would be 12% (15% x 80%).
The final example of an uncapped crediting method is a blended or balanced allocation. In this case, a portion of the interest is based on a fixed return, and a portion is based on the index return. The method uses the same 15% index gain, but with 60% in the index and 40% in a 1.5% fixed account. As a result, the amount of interest credited to the annuity would be 9.6% (15% x .60% plus 1.5% x 40%).
We do not recommend monthly sum crediting. This method is subject to caps, but only to the gains, so your upside is limited each month, but your downside is not. In volatile years, the index may be positive (even substantially so), but the monthly sum method results in zero gains for the annuity. We suggest avoiding this method, which should be easy as it is quickly becoming obsolete.
3. Index Options
Typically, index annuities have offered the S&P 500 as the most commonly available index, but in recent years, companies have offered several new options. Some are common, such as the Dow Jones Industrial Average, the Euro Stoxx Index, and the NASDAQ Composite. Also, there are many you have probably never heard of such as commodities, treasury and corporate bonds, and emerging markets. Additionally, indices exist that utilize volatility controls to attempt to smooth out returns, and are becoming options within an annuity.
4. Death Benefit
Nearly all annuities provide some type of death benefit to the annuity owner’s beneficiary, but for people whose primary goal is to leave a legacy, it may make sense to select an annuity with an enhanced death benefit. This can come in different forms, such as a guaranteed interest rate, interest “stacking,” or paying out the income account value as a death benefit.
5. Income Rider
One of the most valuable features of annuities, the income rider provides for a guaranteed lifetime income stream that begins at the owner’s discretion. In some cases, there is a minimum period that you must wait to begin income. It is a way to create a personal pension when the employer does not offer one.
The growth and payout rates and terms vary by annuity, but all can provide the sustainable income crucial to a successful retirement. Another factor to be aware of are the fees related to these riders. There are some companies that offer an income rider at no cost, but most charge from .75% – 1.3% per year based on the account value.
6. Other Features
There are many additional features offered by annuity companies should be considered.
Confinement/Terminal Illness Benefit – This allows the annuity owner to withdraw the full account value without charge in case of nursing home confinement or terminal illness.
Withdrawal privileges including Required Minimum Distributions – These vary widely, but if flexibility in accessing your money is important, look for the ability to withdraw 10% annually, with the benefit of withdrawing 20% when no withdrawals were taken in the prior year.
Liquidity – Many people avoid annuities due to the time commitment required. However, some annuities offer full liquidity or return of premium in as little as 3 years. This allows you to move forward with an annuity and get out in a short period of time if it is not performing as expected.
Annuities can be complex, but when used within the framework of a comprehensive financial plan, it can be an invaluable tool. Be sure to find an advisor who works with many different annuity carriers and understands the complexities that these contain and you will be well served.
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