“How does an annuity work?”
“How do annuities differ from other investments?”
“Is an annuity really right for me?”
These are some common questions people have when it comes to annuities.
Why is there so much confusion surrounding this financial product? It's because there are several different types of annuities, many financial advisors (or insurance agents) don't tell the whole truth about annuities or they explain them poorly, and there are sometimes add-ons (called “riders”) that complicate annuities.
There are really two ways to react when you hear about annuities: throw your hands up and give up on figuring them out or consider them as an investment option that might be right for you. I encourage the latter.
But remember, that doesn't mean that annuities are right for you. They're right for some people, but not all.
Let's take a dive into the world of annuities. We'll start by seeking to answer the question: “How does an annuity work?”
How Does an Annuity Work?
An annuity is a fixed amount of money that is paid to someone every year. Boom, we can all go home. Ha, not quite.
Annuities typically seek to lower the risk an investor takes on by making one thing certain: regular income. While that benefit might give you peace of mind, it's not necessarily the best benefit if the benefit you're receiving ends up being less than what you could get from other, albeit riskier, investments.
So really, there are two factors to understand about annuities. First, they have the potential to lower your risk when chosen over, say, stocks in the market. Second, they have the potential to lower how much money you make when chosen over, say, stocks in the stock market!
To understand how a particular annuity works, make sure to read the annuity contract.
This is really important. I've seen people scammed into buying ridiculous annuities that have outrageous fees.
Types of Annuities
To better understand how annuities work, let's look at some types of annuities and their main features.
These are very similar to bank CDs. And, like CDs, fixed annuities are similar to a savings account. You put in an amount of money, and that money creates some interest. This interest is then added to the account which in turn helps the account grow.
Pretty straightforward, right?
They are insured by insurance company, not the FDIC. So, like CDs, fixed annuities are insured, but remember that insurance companies are certainly not as stable as the FDIC. It's possible that an insurance company that sold fixed annuities to you could go under, and if that happens, you might lose your money. The chances of this happening are probably very low, but it's worth mentioning.
Ratings are very important for this reason. There are several rating agencies that test the financial strength of companies that issue annuities. A simple search online will reveal the ratings of these companies so you can choose companies that are the least likely to go under. I recommend you do so.
Also, big differences between fixed annuities and CDs include:
- If you surrender prematurely you may have to pay a surrender charge on principal vs. just losing your interest in a CD.
- If you surrender prematurely you may also be subject to an early withdrawal penalty as annuities are subject to retirement account rules since the interest is tax-deferred.
Annuities are supposed to lower the amount of risk you take on in your investing strategy. And, while they may do that in certain regards, fixed annuities do carry some risks.
Let's talk about the first downside a bit. Having to pay a surrender charge on principal could certainly be seen as a risk. Even if you don't intend on surrendering, life's circumstances may prompt you to do so resulting in a loss. When you are considering purchasing a fixed annuity, it's important to factor this risk into the equation.
The second risk comes from having to pay an early withdrawal penalty associated with having to surrender the annuity associated with a retirement account. Here again, if life's circumstances force you to withdraw money, you're out of luck. That's why this is another risk you must factor into the equation before you buy a fixed annuity.
While those are some negatives about fixed annuities, there's one positive that's especially worth mentioning: the rates are usually higher with fixed annuities than with CDs.
I remember I once had a client who wanted a guaranteed return but CDs weren't paying anything. I found him a 5-year fixed annuity paying 3%. That's much better than the measly returns CDs were paying.
But, remember, fixed annuities aren't right for everyone. When I was young, my mom wanted to set me up with an investment. What did she choose? You guessed it: a fixed annuity.
At the time I really didn't know there were much better investment options out there for me. You know, ones where I could take more risk because I had practically my whole life ahead of me.
But I appreciated what my mom did for me. I found out later that my mom's financial advisor was purely an insurance agent (insurance agents like this don't always think about what's best for their clients).
Make sure you know what you're signing up for before you sign on the dotted line. Look for a professional you can trust who will take the entirety of your financial situation into consideration.
When you put money into a fixed-indexed annuity (also known as a “hybrid annuity“), you're guaranteed that you can't lose the money. That's a benefit that's not seen in the stock market.
But of course, there's a downside. Many fixed-indexed annuities have caps that hinder you from riding a portion of the upside of the stock market. Even if investment index rises in the double digits, you might be capped at a single digit, for example. This isn't true of all fixed-indexed annuities, though. Make sure you completely understand what you’re buying.
Fixed-indexed annuities also offer living benefits which can pay out an income stream for your life or a spousal benefit. The biggest confusion I see with these types of annuities – and also variable annuities – in regards to these benefits is how they are sold by shady advisors.
Do these annuities offer a 6% return (I'm using 6% just as an example)? Well, kind of. And that’s where it gets tricky.
When most investors think of a fixed return they think of bonds or CDs. This is nothing like that.
The 6% return in this example is credited to the income benefit that the contract owner can take at a later time.
It’s not interest earned on your principal. Said another way, this is not added to your cash-out, walk-away value. Instead, this is added to your future income benefit that you can take at a later time.
It’s very similar to delaying Social Security benefits and each year your benefit increases. Same deal here. So as long as you don’t touch your money, the annuity company will give you an increase in the amount you can take out each year.
It can be fairly simple to understand how fixed-indexed annuities work as long as you’re working with an advisor that has your back and isn’t only interested in earning a commission.
What are immediate annuities? Immediate annuities allow investors to receive payments immediately from the time the annuity is started.
These kinds of annuities are great for people who need money immediately upon investing (like near-retirees or retirees). Additionally, the payments that are received can be fixed or variable.
The biggest drawback to immediate annuities is that you may have to fork over a lump payment to the annuity company – and after you get past the 30-day “free look” period, there’s no turning back.
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Compare that to fixed-indexed annuities and variable annuities where you still have access to the principal – although you might be subject to a surrender charge if you withdraw before the contract period is up.
I'm going to tell you right now: I don't like variable annuities. Variable annuities are quite complicated, and while they may contain a lot of “features” or “benefits” that sound inviting, you have to be careful.
Variable annuities contain mutual funds (called “sub-accounts”) that are typically selected from a pool of 80 to 300 funds. While that might seem like a lot, keep in mind that were you to shop the market on your own, you would find thousands and thousands of options to choose from.
Variable annuities, unlike fixed or fixed-indexed annuities do not guarantee your principal. Remember: You’re basically investing into mutual funds. If the mutual funds take a hit due to a bad market, you could be out of luck.
When you hear about “guaranteed death benefits” (a benefit for beneficiaries should the annuitant die before payments begin) and “income guarantees” or “guaranteed withdrawal benefits,” remember to read the fine print to see how they work.
Specifically look for the costs you don't initially see. Costs typically start with a mortality expense (called M&E). On top of that you’ll have the costs of the riders (the guaranteed death benefit or income guarantees mentioned above). Just when you think it couldn’t cost anymore you almost forgot cost of the sub-accounts (mutual funds), too.
All in investors could be paying close to 4% of total fees inside their variable annuities.
If you own a variable annuity, and want to know you much you’re really paying, request your free Annuity Stress Test at AnnuityTested.com.
Deferred Income Annuities
Deferred income annuities are very much what they sound like: you would receive payments at some later date. This later date is typically a year or later from the time you start the deferred income annuity.
Here again, like immediate annuities there can be either fixed or variable payments made – it depends on the specific deferred annuity.
For those payments, you're going to find that deferred income annuities offer guaranteed lifetime income but at a later date than some annuities.
The question at hand is, “Why should someone sign up for a deferred income annuity?” The benefit from a deferred income annuity upon the year that you're actually paid is likely to be higher than that of an immediate annuity. Why? There are two reasons . . . .
First, the insurance company knows that the longer you live, the less time you have on the planet. This reduces the amount of time they may have to make payments to you. And, with a deferred income annuity, because you will be taking payments at a later date (say, 15 or 20 years down the road), this fact would be true in your situation. Additionally, they don't have to pay you for a number of years. Therefore, insurance companies are able to offer better payouts because the timeframe in which they will pay is reduced.
Second, deferred income annuities reduce the amount of risk you might incur from the markets. This might be advantageous as part of a retirement plan, as you could purchase a deferred income annuity 10 or 15 years (for example) before retirement and rest assured that you will have some money at retirement. If reducing your risk is important to you, the deferred income annuity can certainly make sense as an option to consider. Here again, the deferred income annuity may pay more than an immediate annuity.
This second benefit might not just lower your risk compared to traditional investing, it might give you a tremendous amount of peace of mind. Those beginning their investment plan a decade before retirement may find themselves worried about a stock market crash – and reasonably so. Remember the stock market drop after 9/11? How about after the housing crisis? Many retirees found themselves with severe losses in their portfolios after these events. Purchasing a deferred income annuity alleviates much of this concern.
To sum up, deferred income annuities might be relevant to those who are nearing retirement or who are starting retirement and would like to have some “longevity insurance.”
These policies are pretty popular, and they're worth your consideration. Talk with a comprehensive financial planner to explore this option.
Also please keep in mind that there are other types of annuities, but these are some of the most common types. Also remember, that while these are some of the highlights of these types of annuities, some of the benefits and features may exist in other types of annuities as well.
A Simple Annuity Example
To better understand annuities, picture this. Say you have a wealthy uncle who is great at investing in the stock and bond market. He is financially secure and you're unsure about investing in the stock market because you don't want to lose money.
So, you make a deal with your uncle. You'll send him payments over time (or perhaps a lump sum), he'll go ahead and use his experience and his high tolerance for risk to invest the money, and he'll send you payments every year that may include a portion of what he has made in the markets.
Now, your uncle wants to teach you responsibility and doesn't want to provide this service free of charge (or maybe he's a bit hungry for some more dough), so he's going to charge you some fees. The fees differ depending on how you set up the deal.
You're happy because (1) you want your principal protected, (2) you want guaranteed returns, and (3) you like the idea of predictable income. Your uncle is happy because he's able to use his financial security to make some more money through the deal.
That, in a nutshell, is how an annuity works.
While this is a simple example, remember that annuity contracts aren't so simple. Again, read them!
How Do Annuities Differ from Other Investments?
I've already answered this question somewhat earlier in the article, but let's dive into a little more detail.
Many investors think of the stock and bond markets when considering where to put their money. So, that's what we'll focus on here.
When you buy shares of a stock, you're buying ownership in a company. The price per share will fluctuate and it is up to the investor to buy low and sell high (to make a profit). However, this isn't always easy – especially if the investor is buying over short periods of time.
A stock index is a measure of how well a group of stocks are doing as a whole. Perhaps you've heard of an “index fund.” Index funds track an index to provide similar returns as you would see from the index.
Bond index funds operate in a similar fashion. However, at the core, bonds are basically debts that are owed to you, the investor.
Now, what does all this have to do with annuities? Well, fixed-indexed annuities track an index (most commonly the S&P 500) but remember, they have constraints on them many times. While you won't lose the money you put into a fixed-indexed annuity, your potential for index fund-like gains might be limited by caps.
What this means is that you are lowering your risk by going with a fixed-indexed annuity. I like fixed indexed annuities, but they still aren't for everyone.
Another way annuities differ from other investments has to do with liquidity. With mutual funds, ETFs, or managed portfolios, if you need the money, it’s relatively easy to get to. Annuities are a different story.
Variable, fixed, and fixed-indexed annuities typically have a contract period that will range from 3 to 12 years – this is why you read the contract before you sign! While most allow an annual free withdrawal (10% per year of the principal plus interest earned is common) any amount above that is subject to a surrender charge. I’ve seen surrender charges has high as 9% before so this could be a huge blow if you were in need of some quick cash.
That’s why I tell anyone who interested in the security of annuities to never put all of their money into annuities.
Is an Annuity Right for You?
Typically, I ask investors these questions to see if an annuity makes sense for them:
- “How important is protection of your principal?”
- “How important is having a predictable income stream in retirement?”
I encourage you to read 15 Reasons Why You Shouldn't Buy an Annuity – (And 5 Real Life Scenarios When You Should).
If you have an annuity and aren't sure if you should continue with it (or how much you're paying in fees), be sure to get your [currently free at the time of this writing] Annuity StressTest. Find out everything you don't know about your annuity.
It’s imperative to reverse engineer your retirement income needs to see how an annuity could help with that amount. That’s why we encourage anyone interested in purchasing an annuity to go through our unique financial planning process, The Financial Success Blueprint™.
At the end of it you’ll have a good understanding if an annuity should have its place in your investment portfolio or if another strategy makes much more sense.
Don't let annuities freak you out. For the best explanation of how an annuity works, you must look at the documentation to find out and seek a competent financial professional for more information.