The Simple Truth About Annuities
This article appears at the following website: uncommonwisdomdaily.com
As a retirement and income specialist, I regularly get asked for my thoughts on annuities.
It’s a pretty big topic so there’s no way I can cover everything today. But I CAN give you a quick take on the subject...and as you’ll see, I view annuities pretty much the same way I see insurance policies.
That makes sense since annuities are essentially the reverse of a life insurance policy — a wager that you’ll continue living!
By handing over a lump sum of money (or installments), you secure yourself regular payouts — either immediately or starting at some point in the future — for a set period of time, even for as long as a named person or people stay above ground.
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In the United States, all annuities (except for private ones) are sold by insurance companies and the terms and labels have mushroomed in recent years.
Here are the most popular ones:
Immediate annuities start paying out right away, though the length of the payouts can vary from a fixed number of years to the lifetime of you or your spouse.
Deferred Annuities allow you to save money and begin withdrawing the amounts later, either in installments or as a lump sum. While the account is growing, you will not pay taxes on the gains.
Fixed annuities make set payments at a guaranteed rate. If your account is earning interest, it will do so at a guaranteed minimum amount. It’s akin to holding a certificate of deposit (without FDIC insurance).
Variable annuities allow you to choose how your lump sum will be invested, and the interest rates and payments are generally dependent on how those investments perform. Mutual funds are most common investment choices. Variable annuities are considered securities, and as such are regulated by the SEC.
Equity-indexed annuities are another unique category. The money you put in is linked up to an equity index like the S&P 500. But the insurance company will also typically guarantee you a minimum return (rates can vary substantially). Thus, while they sound like variable annuities, they are often categorized as fixed annuities and not registered with the SEC.
To make matters even more confusing, some of the titles above are used in combination!
For example, you could buy a deferred, variable annuity...which is arguably the type of annuity marketed most heavily to investors.
But If It Were My Money, I Would Mostly Stick to Simple Fixed Annuities...
Just like more complicated types of life insurance, different flavors of annuities can work for certain people with very specific needs and lots of time to do their own research.
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However, I think most folks should stick to simple fixed annuities.
Reason: Unlike variable annuities, they remove much of the uncertainty about the future income stream you’ll be paid.
In my opinion, this is precisely what most annuity buyers want in the first place!
When it comes to immediate, fixed annuities, the buyer is more likely a retiree or near retiree looking to get the same kind of income they’d receive from a defined benefit pension plan.
In fact, for someone who is worried about outliving a nest egg, and has very limited investments elsewhere, an immediate, fixed annuity might be a good part of a bigger financial plan.
Just realize that today’s interest rate environment doesn’t exactly make these arrangements a killer deal.
If you want to get a sense of how much income you could generate from an immediate, fixed annuity, I suggest you start with an online calculator like the one found at http://immediateannuities.com/.
I ran a quick hypothetical on a 65-year-old male. For $50,000 upfront, his average monthly payment would be around $260, with or without various types of survivor benefits.
However, these investments are not usually indexed to inflation. Most do not offer rising payments at all. And every layer of that kind of protection you add will lower the base amount of money you get back month in and month out.
Obviously, there are other ways to take the same $50,000 and generate relatively predictable income streams — including my favorite dividend stocks, bonds, or even rental real estate.
So it really boils down to your risk aversion and big-picture investment plan.
But should you decide an annuity has a place in your overall retirement approach, consider these four things:
#1. Your health. This is probably the biggest factor, especially when it comes to fixed annuities. Remember, you’re betting on your own lifespan. If your mom and dad both lived to 100, a fixed annuity might make sense as part of your overall financial plan.
#2. The insurer’s credit rating. In this market, this has never been more important. While state guaranty associations regulate and cover annuity losses, there are caps in place. Note that assets in sub-accounts of variable annuities are legally separated from the insurer’s assets, so that money is never at risk in the event of company failure. Still, these are the last things you want to worry about with an annuity.
#3. The fees involved. I would start your search with the usual low-fee suspects such as Vanguard, Fidelity, T. Rowe Price, and TIAA-CREF as good starting points.
#4. The terms of the contract. Remember, many annuities come with a whole slew of add-on options, coverage limits, important dates, and more. Plus, the payouts on fixed annuities can vary considerably from company to company.
Bottom line: Like insurance policies, I believe most people are best served by the simplest type of annuity arrangement possible. And if you decide an annuity makes sense for you, be sure to shop around and carefully review all of the annuity’s materials before you sign anything.