Let’s Clarify An Annuity
Before discussing the pros and cons of annuities we first need to clarify what an annuity is. Even though the financial experts make it seem complicated and you may feel like you need a class on annuities for dummies, annuities are quite simple.
Annuities are long-term investments which offer guaranteed periodic payments. Annuities can help stabilize your cash flow. You can buy an annuity from a bank, insurance company or even some investment companies. When you are ready to start receiving your payouts, the company holding your annuity contract agrees to pay you a periodic stream of income. See, isn’t that simple?
What To Buy
When trying to decide between the pros and cons of annuities be aware that annuities come in all shapes and sizes. You should always analyze your personal financial situation before buying any investment, and that include annuities. You have two basic choices; you can buy a fixed or variable annuity. The payout options vary greatly but the annuity product choices are fixed or variable.
The Fixed Annuity Product
The payouts from a fixed annuity are more stable, they are guaranteed and you lock-in to the same, regular, predictable payout amount. Some investors like that guarantee however dislike the effect inflation can have on their locked-in payout. Of course you can buy the inflation protection option if you too like the guaranteed payout of a fixed annuity but worry about inflation eroding your investment. Remember though that every additional feature you buy increases the cost; therefore weigh the benefit of the inflation protection option before adding it on.
The Variable Annuity Product
A variable annuity payout is less stable than the fixed annuity and the payouts are not locked-in. This is due to the fact that variable annuities are invested in mutual funds. So the potential for a better rate of return is there and you generally avoid inflation risk but you do run the risk of market ups and downs.
When To Use An Annuity
Most investors use annuities to help finance their retirement. Annuities can bridge any financial gaps that exist between the combination of your retirement savings, Social Security and your expenses. Annuities can reduce the risk of outliving your money, since some annuities can be set up to pay out for as long as you live, no matter how long that is.
That longevity benefit offered by annuities is the one great benefit that attract those investors who are close to retirement. The number one concern of most retirees is the risk of outliving their retirement assets. The stream of income offered by annuities ease that concern because they provide the cash flow for as long as you determine you need it. You can structure an annuity payout to continue paying until you or your spouse dies. You can structure it for a certain period of time. You can defer the payout period or start it immediately. The choice is yours and depends upon your personal financial situation.
There is a price to pay for the nice benefits of an annuity. The benefits of a predictable periodic stream of income and the longevity benefit that offsets the risk of outliving your income to name a few. The insurance company is taking a risk on you and that comes at a cost. They are risking that you live a long time which means that they have to pay out more than you paid in. The longer you live, the more money you cost the company. As direct as that may sound, it is a fact.
The fees and expenses charged by insurance and investment companies can add up and they can reduce your rate of return that you would get on your initial investment. The high fees charged for annuities is one of the main reasons many people shy away from, or run from annuities. But annuities can very helpful if used wisely so before you decide whether an annuity is right for you do your homework. Some of the fees you need to be aware of and ask about include those fees charged by the mutual fund companies (for a variable annuity), the monthly maintenance fees, the death benefit fees, early withdrawal fees (sometimes called surrender fees) and finally commissions for the financial advisor.
You pay your annuity premiums and at some point you annuitize your contract; which means that you instruct the insurance company to start your periodic payouts. Once that stream of periodic payments start, there is no chance of a premium refund. Which means that if you set up the annuity contract to payout for the rest of your life and you die prematurely, the insurance company is not obligated to return any money. Work very carefully with your financial advisor on how the annuity is set up when you begin your payout phase.
You can set the annuity up as a life annuity or a term certain annuity. With straight life annuities the insurance company will pay until death; usually with no refunds if you die prematurely. Now, at a price, you can buy a life annuity with a guaranteed term feature. With this option if you die prematurely before the end of the annuity contract, the insurance company will pay your beneficiaries the remaining sum of your annuity. The cost of this option can be high, so shop this feature carefully.
With a term certain annuity, your payouts continue for a predetermined period of time until the expiration of the annuity contract. So if you buy a 10 year or 20 year term certain annuity, the insurance company will pay you or your beneficiaries until the 10 or 20 year term is up, regardless of whether you live or die during the term of the contract.
With either type of payout you get to decide on how often to receive your periodic payments. You can take a lump sum, although not advisable. If you take a lump sum payout, you will owe income taxes on the gains in the year you receive that payout. Your other choices include monthly or quarterly or even annually sometimes.
As Clear As Mud
With all of the choices and decisions you need to make about annuities when purchasing and setting them up it’s no wonder you feel overwhelmed. It’s best to take it one step at a time. Determine what you need the money invested in an annuity for. Next determine when you will start needing the money. And finally decide if you want to gamble on outliving your money or place it safe.