Research Different Annuity Types Before Committing
Annuities can be confusing. There are different basic types, and varieties within each type. It is crucial to understand precisely what you're buying before committing. As millions of baby boomers barrel toward retirement, insurance companies are adding more bells and whistles to their annuities in an effort to attract this group. Ending up with a type that is wrong for you can cost you fees and punitive surrender charges (if you opt out of an annuity in the first few years), another kind can mean that when the final calculations for expenses and earnings are worked out, your annuity could offer poorer average returns than mutual funds or even certificates of deposit.
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Potential Benefits of Annuities
For those who do their research, annuities have their place in a retirement portfolio, particularly for retirees who want the guarantee of a fixed income each month. For investors who are vexed with losing money in the market, this investment option can offer protective features such as a guaranteed death benefit. Annuities can provide tax deferral, an insurance component and the promise of regular payments over a defined period or over a lifetime.
Two Popular Types of Annuities are Immediate and Deferred
When you buy an immediate annuity, you pay a lump sum, say $100,000, and you start getting a payout either for a fixed term or for life. It's called an immediate annuity because the payouts start immediately.
A deferred annuity includes an accumulation phase in which the money builds up over time and you get payouts later in life.
Immediate and Deferred Annuity Subtypes
Both immediate and deferred annuities have two subtypes: fixed and variable.
Fixed annuities offer a fixed rate of return over a certain time frame, while variable annuities are tied to stock funds or bond funds and the returns vary depending on the performance of these funds.
Another Type of Annuity
The most criticized annuity is the variable deferred annuity. The money typically is invested in subaccounts that are tied to stock funds or bond funds. Experts have pointed out that the expenses on these annuities can run higher than 2 % per year. Sales commissions are also high, and the returns are often unattractive. And now, with the reduction in tax rates on capital gains and dividends, variable annuities have to work even harder to catch up to other investments. The tax deferral is not significant enough to offset having to pay all the expenses. Taking into account the taxes, you might be better off buying municipal bonds.
But insurance companies are working to make annuities more appealing by offering options that allow you to split the risk between an immediate annuity and a deferred annuity. They also allow laddering of annuities so that you get a mix of returns.
Questions to Answer before Buying an Annuity
Here are some things to consider before buying an annuity. Do you want a long-term investment like this? Many choices that you make on an annuity are binding, and you may have to incur great costs to alter your decisions. Find out what the costs and penalties are for dropping it.
Experts advise against putting all your money into an annuity; maximizing your 401(k) and other tax-exempt vehicles before turning to this option. Compare annuities to other investment vehicles and find out if you can get better deals elsewhere. For instance, would you get a better return for your money through a mutual fund, which may not have as many expenses?
Knowing that you are going to get a fixed amount of money over a certain term obviously has some attractions for older investors, but currently annuities are not attractive as long-term investments because of the low-interest-rate environment.
If buying a variable annuity, find out if you can buy a low-load or no-load annuity. Determine your flexibility in terms of investment choices in the subaccounts. Are you wedded to the family of funds that you first choose, or can you switch when you want to?
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Think through the implications of inflation. Ask yourself: If I opt for fixed payouts today, will this be enough of a supplement 20 years down the road when my cost of living might be much higher?
Make sure you guarantee income for both you and your spouse. This can be done through "joint" or "survivor" clauses that stipulate the monthly payments go to your spouse when you die. The monthly payout will be lower in such cases because you are spreading the benefit.
Be cautious about when to start taking payments from the annuity. Whether you decide to annuitize at 55 or 65, once those payments begin, the original investment begins to diminish.
The number one planning consideration is the availability of assets. Once you annuitize, you've essentially taken that money to buy a future cash flow.
If you've decided to buy an annuity, the next tough decision is whom to buy from. Financial planners, stockbrokers, bankers and insurance agents sell them, and most earn commissions. Shop for an adviser who is well-schooled in annuities. Check the quality and the ratings of the company that you buy from. These are companies that you will deal with over the long-term - possibly for three or four decades. You don't want to discover at age 80 that the company went out of business. Today's strength rating is by no means a guarantee of future payouts, but experts say at least you can minimize your risk by going with a large, reputable company.