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The Basics of Annuities

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One of the financial products that has been garnering a lot of interest lately is the annuity. Annuities can be very tempting because those providing them tout a “guaranteed income stream.” It is important to remember, though, that annuities can be very complex financial products, and that getting your money is not always straightforward.

For some people, annuities work well. They can be a way to ensure steady income, and they offer a degree of stability that many — especially retirees in an uncertain time — value. Before you decide on an annuity, it is best to consult with a financial professional, and also understand some of the tax implications that may come with an annuity. Study the ins and outs, and figure out if an annuity is right in your situation. The following is meant as a general overview of annuities:

What is an Annuity?

Annuities are investments that pay you a set amount on a regular basis. You make payments for a certain amount of time, and later you will receive regular payments. You can make annuity payments over the course of years, and then when you retire you can begin making withdrawals. Another option is to pay a lump sum up front, and begin receiving regular income at once. This is known as an immediate annuity.

The money you pay to the company providing the annuity is invested in different accounts, and the company receives income from the earnings. Some annuities are structured so that you receive a set pay out after a certain number of years, or when you reach a certain age. Other annuities will provide you a sort of “bonus” if your contributions seeing certain earnings.

Realize that an annuity is only as good as the company offering it. If the company folds, you could lose your money. This can happen even in the middle of receiving your payments. It can help to research the company, and see what sort of rating it has received in order to put your mind at ease.

Understand, too, that annuities often come with high fees. You will want to shop around to make sure that you are getting the best deal, and you need to be aware that you might not get your money’s worth if you die soon after you begin receiving payments. Check with a tax professional regarding the issues that can arise from annuities.

Types of Annuity

Annuity products vary widely. In addition to the option to have a deferred annuity or an immediate annuity, some of the more popular annuity offerings fall in the following categories:

  1. Fixed
  2. Variable
  3. Hybrid
  4. Indexed

At their most basic, annuities are fixed or variable. A fixed annuity is one that offers a guaranteed pay out. It is either a percentage of assets held, or it is a set dollar amount. In most cases, your principal is safe. Your rate of return is usually guaranteed — and it is usually low. A variable annuity, on the other hand, features the possibility of higher returns. Your pay out will be determined by the rate of return on the account, and your principal may not be guaranteed.

A hybrid annuity takes a different approach. It includes features of fixed and variable annuities. One example is an annuity that allows you withdraw a fixed percentage of your account value, while providing a bonus when you have higher earnings.

There are also indexed annuities. These products are connected to indexes. When a specific index rises, you see an increase in your potential payout. Most indexed annuities guarantee a minimum rate of return, so you are somewhat protected against market crashes.

Do your research, and make sure you know what you are doing, before you commit to an annuity.

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17 Responses to “The Basics of Annuities”

  1. Jeff says:

    I’ve looked into variable annuities and I can’t get a clear response on exactly how it works. The salesmen paint a very pretty picture but if I can’t see the nuts and bolts then I’m not interested. What I will likely do when I retire is buy an immediate annuity to ensure that I will always have enough money to get by.

    • Miranda says:

      I’m not expert, and annuities can be convoluted. But as far as I can figure, the variable works by taking the money you put in and investing it. If the returns are good, you get a higher pay out. If the returns aren’t so good, your pay out is lower. It’s a nice thought to possibly get higher returns, but you have to remember that any time there is the possibility of a higher return, the risk is also higher.

    • NateUVM says:

      Plain old, vanilla variable annuities operate much the same way as the typical 401(k) does. You have a variety of investment options, called sub-accounts, where you can invest your funds. These sub-account options, much the same as a typical 401(k), are very similar to mutual funds, if not identical. In fact, often they are just insurance versions of mutual funds that you can purchase through your broker or within your 401(k). Options vary from the most conservative (money market / fixed interest options) to more agressive equity funds. Again, very much like mutual funds.

      Before you switch to any sort-of payout, you contribute to your account much the same way you would contribute to any other account. You have a balance that you can check and you typically receive periodic statements summarizing past transactions and balance history, etc…, much like any account.

      Performance is driven by the performance of the funds you have chosen, factoring in, of course, the expenses. With annuities, because there is a guaranteed benefit in the case of your passing(which CAN be higher than the market value), the expenses can be high. In any case, it’s not a vague formula that determines how much is available for the payout, when you do decide to annuitize (receive payouts). It’s simply how much your account is worth at that time.

      After that, your payout amount is dependent on your age, how often you are looking for a payment and how long you are looking to receive it for.

      • Darth says:

        “Plain old, vanilla variable annuities operate much the same way as the typical 401(k) does.”

        Congratulatios, Nate. Your credibilio is now less than your balancio.

        And your balancio is tostito.

  2. Hunter says:

    I’m not an expert on annuities either. So this question could be way off base.

    Is it possible to manage your investments to produce income like you get from an annuity? I think has some advantages: no annuity fees, more control, and your spouse or estate keeps the corpus at death.

    What do you think?

    • Anonymous says:

      Hunter there are annuities out there that allow you to take income for life yet keep the control. What i mean by that is if 5 years into the term and you dont want the income for life you can turn it off and allow it to grow again. This option can be turned off and on unlimitedly.

    • sophomore says:

      An alternative to an annuity is to manage your own assets – think of a bond ladder with equities. You can read the Stein and DeMuth “Yes, you can …” series to understand the mechanics. At the end of the day, the insurance company offering the annuities is working with the same financial products (although in larger amounts).

      Your basic choice is to pay dearly for someone else to manage your money (an annuity) or to learn and execute on your own. Always ask an annuity salesman his commission and the annual fees. You can then say “really?” and walk away.

  3. billsnider says:

    I have hardly ever read an article that was favorable about annuities. Be real careful before buying.

    My favorite is the delayed annuity for seniors. You get a higher annual payout, but have to wait till someting like 75 before you can collect. You also lose if you die before that age.

    As to a guaranteed income…. How much do you in fact get and is it enough by the time you retire? I have looked at many and the answer is a strong NO.

    Also be careful about tieing your money up with any old company. You lose if they go bust! Don’t forget that this is a very long term investment.

    Bill snider

    • NateUVM says:

      I think the “guaranteed income” that they refer to isn’t “Guaranteed to Cover you No Matter What,” it’s “Here’s what your payment is and we guarantee to send it to you for the period you’ve selected.”

      Again, your payout is determined by how much is in your account at the time you annuitize (whether you’ve held the account for a long time or are opening an immediate annuity), how old you are and how long you want to receive payments for.

      Clearly, if you are 55 and open an immediate annuity with $1,000 and chose a life payout, your retirement expenses are NOT going to be covered by that payout.

      As for the guarantee… It’s a promise by the company and is only good as long as the company is in business. So be sure that you are comfortable with their ratings, etc…

  4. Can'tThinkOfACleverName says:

    I’ve researched annuities because I wanted somewhere to invest after putting the max into my 403(b) and IRA. I have many colleagues that invest in them and they have referred me to their “financial advisors”. After a lot of research and digging, it appeared to me that the fees were very steep and the “advisors” appeared to be sales people. In addition, the “advisors” were selling a “tax shelter”. The description of the “tax shelter” seemed to be convoluted accounting. It was a little too complicated and a ran away from the “advisors”. However, my interest re-emerged and I looked into the annuities offered by some big brokerage firms (TIAA CREF, Vanguard and Fidelity). The big firms have lower fees and do provide a means for tax-deferred savings. I have not yet invested in one. However, I am still considering it. Bottom line, if you need a place to stash more money beyond the typical tax deferred shelters (eg, 401(k), IRA), it can be a reasonable option. Also, I would consider purchasing an immediate annuity at retirement to provide myself with a steady income, if the company is financially strong and has a good track record.

  5. cubiclegeoff says:

    I can see the benefit of purchasing one if the fees are right and you want a steady income stream for the rest of your life. But I don’t think for most people it should be the only thing you depend on.

    I’d be curious to hear about annuities being offered as part of retirement savings plans for companies (in addition to or part of a 401k). Investing long-term that way could be like investing in a personal pension, and again, a steady stream of income would be beneficial to most for retirement.

    Having said that, I rarely hear positive information about annuities, but usually it’s the fees and the people selling them that are the problem, not the concept itself.

  6. Strebkr says:

    This is one of those areas I dont fully understand right now because I haven’t spent the time to even try, but I’m getting the vibe that it is a very high pressure sales environment. Make sure you take the time to understand what you buy.

    This is right up there with life insurance salesmen.

  7. Ryan says:

    How much are these fees?

  8. Mike says:

    Annuities are part insurance/part investment. The extra expenses associated with these are the insurance portion. The basic premise of the annuity is to assist you in liquidating a sum of money that you have accumulate. It can provide either a guaranteed income or guaranteed payout period.

    It solves the question of, I have x amount of dollars.. How much can I afford to pay myself monthly or yearly and how long will it last. Annuties take the guesswork out and can give some piece of mind to those not comfortable with the major ups and downs of stocks and equity markets.

    I’m in insurance and although I don’t sell these, they are a really good fit for many people or as a supplement to an investment portfolio.

  9. Dave says:

    I had the same concerns with them as everyone else but I believe that they are great tools for the right situation. A relative of mine bought an immediate fixed annuity a couple of years ago with a fixed rate of 6 percent. As Jim mentioned, since it is fixed rate, the fees are baked into the rate. The term was for 10 years but at the time the going rate for 5 year CDs was around 3 percent. She is also over 60 and currently need to withdraw any of the funds, so she benefits from compounding the interest. Like I said, I had big concerns but I think in her situation it was a good idea.

  10. Strebkr says:

    I just don’t like the idea of mixing insurance and investing.

    • Jim says:

      I’m the same way, I like keeping them apart because there are good enough vehicles in each respective category. It’s one reason why I don’t like whole life policies.


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