Posted by Elliot Kravitz, ATP

Annuities 101: Things you need to know

Annuities 101: Things you need to know

An annuity is a contract that exists between you and an insurance company to cover specific objectives, such as lifetime income, principal protection, legacy planning or care cost for a long term.

Although annuities may be advertised as investments, annuities are not investments; they are contracts. They place you and the insurance company into a contractual task,  and failure to maintain them may be costly. 

Annuities gained popularity in the U.S. during the Great Depression, when concerns rose about stock market volatility endangering their retirement. Today, with pension plans becoming less common, several retirees are considering annuities as an option to take over income streams.

How does an annuity work?

An annuity function by taking the risk off the owner called the annuitant and transferring it to the insurance company. Similar to other types of insurance, you pay the annuity company premiums to carry this risk. Incentives could be a onetime lump sum or a series of payments, based on the type of annuity. 

The premium-paying period is referred to as the accumulation phase.

Different from other types of insurance, annuity premiums are not paid indefinitely. A point comes when you stop paying the annuity, and the annuity begins paying you. When this takes place, your contract is said to enter the payout phase.

Annuities could be organized to trigger payments for a particular length of years to you or your heirs, for your lifetime, until yourself and your spouse are no more, or a blend of both lifetime income having a guaranteed period certain payout. A "life with certain period annuity" pays you income for life, but if pass on during a specified time frame the annuity will pay your beneficiary the remainder of your payments for the contractual period, chosen by you at the time of application.

Just as Social Security, annuity lifetime income streams are based on the life expectancy of the recipient, with small payments received over more extended periods. So when begin earning the income at a younger age, the longer your life expectancy is, or the longer the period-specific term is, the smaller your payments will be. Payments can be scheduled to be monthly, quarterly, annual, or even a lump sum. They can commence instantly, or they can be adjourned for years, even decades.

Fixed annuity for maximum protection

Fixed annuities pay a specified minimum rate of return and provide a unique series of payments under conditions that are determined when you purchase the annuity.

During the phase of accumulation, the insurance company invests the premiums in fixed-income investments like bonds. Because of your guaranteed rate of return, the insurance company bears all of the investment risk associated with the fixed annuities.

A multi-year guarantee annuity (MYGA) is a kind of deferred fixed-rate annuity that is great for conservative investors who want to guarantee maximum protection.

It functions more like a certificate of deposit by ensuring a rate over a fixed period. However, differing from CD interest, the interest rate on an MYGA is not taxed annually, but instead, they are allowed to grow tax-deferred until they are withdrawn.

A variable annuity has investment risk

A fixed rate of return is not guaranteed by all annuities. With a flexible annuity, your premiums are invested in a diversity of subaccounts, just like mutual funds. Every subaccount has an investment objective and charges a management fee in addition to the insurance company's expenses.

The annuity's rate of return is dependent on the outcome of these subaccounts. The insurance company does not assure variable annuity rates, so the annuitant bears all of the investment risks.

A variable annuity is similar in some ways to the 401(k): You choose the subaccounts where your premiums are kept and thus the overall returns on your annuity. There is an opportunity for higher returns than in a fixed annuity. But markets are volatile,  and as well involve downside risk.

The upside to a variable annuity if you have a lot of regulation. Variable annuities were made to allow investors to participate in the stock market and still have the benefit of tax-deferred, lifetime income benefits of annuities and insurance. They are not to be regarded this way. 

Ensure you don't purchase an annuity for market growth, even though that is the way they are sold. If you desire market growth, you don't require a pension. You'd be better off just holding low-cost mutual funds instead of incurring the high fees of variable annuities.

Annuity fees vary, but all have commissions

Several annuities have no annual fees, but variable annuities are not included

Variable annuities often have [annual] costs in the range of 2½ percent to 3 percent.  All annuities have commissions. These are typically built into the policy, so you won't notice the fees taken out yearly. Commissions can vary from 1 % to 10 %, based on the annuity.

A more straightforward annuity has a lower commission. Likewise, the longer the surrender period and a complex annuity will attract higher commission. Enquire about the commission before buying. The commission exists, even if you don't see it.

Elliot Kravitz, ATP
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