The truth about annuities is that there is not so much a good or bad annuity as much as a good or bad fit for your personal situation. There are many different types of annuities and dozens of insurance companies offering them. There are literally hundreds of different annuity product options. It can be very challenging to understand and compare products.
To begin with, an annuity is a contract issued by an insurance company to meet specific financial goals, wants, or needs. It’s a contract between two parties for specified outcomes that are a concern to you. Therefore, when you think of insurance companies, you should recognize that insurance companies should be used in your financial planning to minimize or eliminate some type of risk (that’s the main purpose of insurance companies in general). So, you might ask, what are some of the risks that annuities are used to minimize or eliminate?
One area of risk that annuities may address is stock market risk. Many insurance companies have developed products called fixed indexed annuities. These contracts generate your credited interest rate return that is tied to the performance of a stock market index like the S&P 500 index or the Dow Jones Industrial Average or others. Your participation is tied to some of the gains of the index while not owning the index itself. You have principal protection based on the claims paying ability and financial strength of the issuing insurance company. Usually based on the terms of the contract, gains are also protected. So you have protection on the downside (eliminating risk of stock market losses) and growth potential at the same time.
These popular products will usually have a limit on the portion of growth in the index that you receive. This is done by having a cap (limit on the upside) or other options including a charge sometimes called a spread which gives all the market gains above the spread to you. Some contracts allow you to participate in the index growth based on a percentage of the growth. All of these options offer growth potential without market risk.
If you are interested in deferring taxes on your gains, an annuity may be right for you. There is a type of annuity called a deferred annuity which can provide the opportunity for some tax planning strategies. With a deferred annuity, you don’t have to pay tax until you withdraw money from the annuity. When you receive money from the annuity, the gains come out first and are taxable at that time. However, you only pay tax on the growth in these types of annuities as long as they are funded with after tax dollars. This might be helpful if you are saving for the future and your tax bracket is higher now than your projected future tax rates.
Annuities can be a safe place for some of your money based on the financial strength and claims paying ability of the issuing insurance company. When the recent recession was into full swing, many people moved money from the stock market to annuities. If you were invested in the stock market, you may have recovered those losses by now. Having a balance of safe money to money at risk is a personal decision. However, having some money in safe places is always a good idea.
Another type of annuity product is called a variable annuity. These products are mainly used in situations where someone is looking for higher growth potential and is willing to risk their principal to achieve those returns in a tax deferred annuity. Variable annuities do participate directly in the stock market through sub-accounts that can closely resemble mutual funds or other types of market related funds. You may have a higher potential for growth in these types of products yet also have direct exposure to market risk.
Many times the variable annuity contracts also offer insurance riders that provide benefits to the insured for a fee. You should be aware that these fees are deducted from your contract value in these types of contracts. For example, mortality and expense fees, sub account fees and rider fees are common with this type of annuity. It is not unusual to see fees around 4% of your account balance per year. Sometimes these fees can make it difficult to achieve the higher returns that you might be looking to attain. Unless tax deferral is important or the contract has insurance riders that you need, it may not be the best fit for your funds due to the fees.
If you are concerned about stock market risk yet not happy with the interest rate returns on bank CDs or money markets, fixed annuities are a third type of annuity that works similar to bank CDs in that they will offer a fixed rate of return for a specified period of time that does not vary with the stock market. In general, with fixed annuities, the longer the time period of the contract, the higher the rate of return the company will offer. As with any annuity, variable or fixed, it’s important to consider your liquidity needs because surrender charge penalties may be applied for early withdrawals. So be certain to understand the terms of the contract. Historically, fixed annuity interest rates are generally priced to be higher than CD rates for the same time frame and are also tax deferred during their accumulation phase, where CDs are not. Also, surrender charge penalties for early withdrawal are usually higher than CD penalties.
As mentioned above, many of the annuities have insurance riders available which are designed to provide pension-like benefits. You may be concerned about running out of money in retirement. That’s a valid concern. The insurance industry has developed something called income guarantee riders. When you have an annuity that guarantees an income to you for life, you have added peace of mind. This makes it possible for you to have the assurance of a continued income stream for life. The costs for this vary from company to company and from contract to contract. You should work with a local specialist and always make sure you understand all of the components of any annuity contract including but not limited to surrender charge penalties and free look periods before moving any funds.
Another concern (or risk) you may have is the possibility or maybe even probability of a loss of independence during you retirement years and the costs associated with this risk. Once again, many annuity contracts provide benefits through contractual provisions should you need assistance with usually two or more activities of daily living. Annuities with these features will leverage your deposits in the event of a long term care issue while continuing to grow your money if you have no need for long term care. The result may be more assets accumulating and less premium payments to help with some of your concerns regarding long term care.
As you can see, annuities aren’t good or bad, they are products designed for specific purposes. Having the wrong type of annuity would not be any better than wearing the wrong size shoes. Always remember that annuities are contracts. The insurance company you choose to hold your money may be more important than the features and benefits promised in the contract.
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