Annuities get a lot of press, both good and bad. What it really comes down to is that while annuities aren't recommended investments for everybody, they can be exactly what's needed for certain investors.
They tend to have high fees, and they make it very difficult to withdraw funds from the plan once it is established. But at the same time, annuities have certain undeniable benefits.
For example, purchasing an annuity is a lot like setting up your own pension plan. Since most workers these days don't have a traditional defined benefit pension, an annuity can be the perfect replacement plan.
Another major benefit is that they enable you to increase the amount of money that you are saving for your retirement. That's because virtually every tax-sheltered retirement plan available limits the amount of money you can contribute.
For example, most workers are limited to an $18,000 annual contribution to a 401(k) plan, or $5,500 to an IRA. But if these contribution amounts aren't sufficient, you can use annuities to make a difference. That's because there is no dollar limit on the amount of money that you can contribute to an annuity.
Annuities may be the perfect investment vehicle for a person who is approaching retirement but doesn't have enough retirement savings.
But annuities come in different shapes and sizes, so you'll have to get annuity quotes to make sure that you are investing in the right plan.
There are five major annuity types.
A fixed annuity is exactly what the name implies. It's an investment plan in which the insurance company agrees to make fixed income payments to you the under the terms of the annuity contract. With a fixed annuity, you can earn a stable rate of return on your investment. In a way, it's a perfect investment solution for a retiree, since it effectively creates a traditional pension equivalent for the growing number of retirees who don't have one.
Fixed annuities are similar to certificates of deposit, and other fixed income, stable value investment vehicles. Your investment pays a fixed rate of return throughout the term of the annuity – which can literally be the rest of your life.
Fixed annuities, and really all annuities, are really customized investments. For that reason you will have to get annuity quotes from various insurance companies in order to determine which will be best for you.
You can invest in a fixed annuity that will provide you with immediate income. But you can also include it in a deferred income annuity (see below), which will allow it to accumulate investment income, to provide you with an even higher income in the future.
Like CDs, fixed annuities also come with early withdrawal penalties. Those penalties can be much stiffer than the kind that you will pay on a CD. When it comes to annuities, early withdrawal penalties are referred to as “surrender charges”. They can amount to several percentage points of the value of your annuity, and typically work on a sliding scale. For example, you might be subject to a 5% surrender charge if you withdraw funds from the annuity in the first year. That may drop to 4% in the second year, and down to as low as 1% in the fifth year, before disappearing completely.
If you set up a fixed annuity as a deferred income annuity, where it accumulates investment income, you may also be subject to the IRS 10% early withdrawal penalty on the income portion. This is because the interest accumulation on the annuity is tax-deferred, similar to a retirement plan – which is actually one of the major advantages annuities provide.
Some of the more notable benefits of a fixed annuity include:
- Guaranteed interest rate returns
- Low minimum investment requirements
- Interest rates on fixed annuities are typically a lot higher than they are on CDs
- Income for life
- Interest income is tax-deferred on deferred fixed income annuities
Variable annuities “can” offer an investor a chance to earn higher rates of return than what are available on fixed income investments, including fixed annuities. They provide investment participation in both stocks and bonds – which also brings the possibility of loss of principal due to declines in the financial markets.
The money within a variable annuity is invested in sub-accounts, which are basically insurance industry mutual funds since they aren't listed on public exchanges. The sub-accounts are invested in stocks and bonds, including various specific industry sectors.
Variable annuities are typically deferred, so that you can increase your investment in the plan to produce a higher income when you finally begin withdrawing income payments. Again, like retirement plans, the investments grow on a tax-deferred basis. You can set up a future date when you will begin receiving income, which could be your retirement or some other date.
That's the “good news” on variable annuities. I personally don't recommend them – there's just too much about them that isn't investor-friendly.
The returns on variable annuities are neither fixed nor guaranteed, and they also come with limitations as to when you can withdraw money from them. You'll have to get annuity quotes on specific plans in order to determine the allowed frequency, you will typically be limited to one withdrawal per year. But that one withdrawal will only be allowed so long as it doesn't occur within the surrender period, which is usually 10 years.
More from GFC, Below
But fees are the reason I don't like variable annuities. They charge a national average 3.61% per year, but fees over 5% aren't unusual. Even if you expect an investment return of 7% on the annuity, fees of 3.61% will more than chop that return in half (are you getting the sense something's seriously wrong yet?).
What makes the fee situation even worse is that it's mostly hidden. It isn't a single fee, but a battery of smaller fees buried deep in the annuity. It can include “mortality and expense risk charge” – at an average of 1.25% – administrative fees, underlying fund expenses (sub-account fees), additional rider fees and surrender charges.
That's too many fees in one investment vehicle.
But if high fees don't scare you off, some of the benefits of variable annuities include – if you can live with the many disadvantages – include:
- Income tax deferral
- Investments within the plan can be changed
- Lifetime income
- Ability to earn a higher returns than fixed income investments pay
Fixed Indexed Annuities
This may be the most desirable type of annuity for the largest number of people. It's a type of fixed annuity, except that it uses different methods for creating income within the plan. While fixed annuities concentrate heavily on protection of principal and stable returns, fixed indexed annuities attempt both objectives, but also provide participation in rising financial markets.
Like fixed annuities, fixed indexed annuities also provide an annual guaranteed minimum rate of return. But you can also get the returns provided by investment in a specific stock index. The insurance company will then give you the benefit of the higher return between the two. This gives fixed indexed annuities stock market participation on the way up, but protection against market declines.
There is a limitation on market gains that insurance companies use to offset market declines. They impose caps on the amount that you can earn through stock investments. For example, if the annuity caps your annual stock return at 10%, but the market rises by 15%, your earnings will be limited to 10%. In addition, you typically will not receive dividends paid by the stocks held within the index fund.
Once again, the specific details of these terms will depend upon your annuity quotes, so you'll need to ask questions, and take plenty of notes.
Some of the specific advantages of fixed indexed annuities include:
- No upfront commissions
- Protection of principal
- Low minimum investment requirements
- Tax deferral
- Higher returns than you can get on fixed investments
An immediate annuity is a type of annuity that is setup to provide you with an immediate income. You invest money in the annuity plan, and it begins making income payments to you as early as the following month.
Immediate annuities are sometimes referred to as single premium immediate annuities, because you make the upfront investment (the “premium”, in insurance terminology), and then begin receiving benefits (income payments). For this reason, they are generally set up at retirement.
The payout terms vary based on the immediate annuity contract. You can have them paid out for a specific period of time, such as 20 years, or set them up so that you will receive payments for the rest of your life. This is all information that you can get upfront when you obtain annuity quotes.
Some of the more interesting benefits of an immediate annuity include:
- A safe, secure investment
- A completely passive investment
- Higher returns than CDs
- Immediate income
- Income for life
Deferred Income Annuities
Sometimes referred to as a longevity annuity, a deferred income annuity is a plan that you start and fund, and then allow it to grow through the accumulated investment income. In this way, they work similar to retirement plans, except that you generally make the investment in a lump sum, rather than through annual contributions.
The term of the deferral is completely up to you. You can invest money in the plan, and begin receiving income payments as little as a year later. Or, you can invest in the plan, and begin taking income payments when you retire in 20 or 30 years. Once you begin receiving your income payments, they can be set up as a guarantee lifetime income.
The specific investment terms can be provided through annuity quotes. But they generally come with a fixed rate of interest, that may be guaranteed by the insurance company for as long as 10 years. At the end of that term, there will be a reset – which could occur as often as annually – that will establish a new rate of interest, based on then-prevailing market factors.
The insurance company will also often offer a minimum rate guarantee for the life of the annuity, so that you will always receive at least that rate of return. And naturally, the longer the deferral term of the annuity, the higher the value of the plan, and the higher your income payments will be.
Deferred income annuities offer the following benefits:
- Protection of principal
- You don't need to be concerned with the performance of the stock market
- You can move part of your 401(k) into a deferred income annuity
- No required minimum distributions (RMDs) required at age 70 1/2
Those are the five major categories of annuities. But each annuity type also comes with a large number of potential “riders” that can offer you enhanced benefits. Those benefits include provisions for guaranteed withdrawals, long-term care, death benefits, and cost-of-living adjustments.
These are all potential add-ons that you can learn about through annuity quotes. Annuities tend to be more complicated than most other investment types, so it will help to work with an insurance professional to guide you through the process. Once again, annuities won’t work for everyone, but it can be the right solution in your particular situation.