What is an Annuity?
Very few topics in the world of personal finance generate as much heat as annuities do. If you listen to the personal finance experts on TV, annuities are the very devil. If you listen to many financial advisors and insurance salesman, they are the greatest thing since sliced bread.
The reality, however, isn’t as black and white as some would paint it.
Annuities are tools, just like mutual funds, or CDs, or savings accounts. You pick a tool based on the job you want it to do. You aren’t going to use a screwdriver to pound in a nail; and you aren’t going to use a hammer to screw in a screw. Annuities can work great in the right situation. In the wrong situation, they are horrible. I plan to write soon about when to use annuities and when not to use them. But, in this article, I thought perhaps it may help to review the basics.
Annuities fall into two categories: immediate annuities and deferred annuities.
Immediate Annuities are basically like a pension. You give your money to an insurance company, and they promise to give you an income (which starts immediately) in exchange. The first important point to make is that once you invest your money in this annuity, the lump sum is no longer your money. In most cases, you can never get it back. I am aware of only one company that will allow you to “commute” the annuity and get your money back. This illiquidity is probably the main reason why immediate annuities aren’t very popular.
While you don’t have a right to the lump sum anymore, you do have a right to income off of it. This can be an income that lasts as long as you live, known as a Life Only annuity. It can last as long as you and your significant other live, known as a Joint and Survivor annuity. Or, it can be an income that lasts for a guaranteed number of years, typically 5, 10, 15, or 20. What happens if you choose a Life Only annuity, and then die the next day? Well, unfortunately, you just gave your insurance company a windfall, because they aren’t obligated to mail out a single income check.
For this reason, most people combine the Life only or the Joint and Survivor option with a guaranteed number of years. So for example, if you want to make sure that income checks are paid out for at least ten years, you would choose a Life and 10 years certain annuity. This way, you will get an income for your lifetime, regardless of whether you live two years or 200 years. But, if you die before ten years is up, your beneficiary will collect for the remaining timeframe. So, if you pass away after two years, your beneficiary will receive an income for eight more years.
The second category is deferred annuities. These annuities don’t provide an income stream immediately. They are designed to grow your nest egg. At some point down the road, you can turn them into an income stream by converting them to an immediate annuity, or by adding a lifetime income benefit rider. We will cover that later.
There are three types of Deferred Annuities:
- Fixed Indexed
Fixed annuities are similar to CDs. They don’t lose money. Insurance companies promise to pay a specified interest rate for one year, or for multiple years, called multi-rate guaranteed annuities. After the initial guaranteed period is up, the insurance company will declare the rate they will pay for the coming year. But this rate will never be lower than a certain guaranteed minimum. For example, say an insurance company offers a product that has a rate of 3% for the first year, and a minimum guaranteed rate of 2%. That means that for the first year, you will get 3%. The second year, you may get 3%, or something higher or lower than that, but definitely not lower than 2%. Fixed annuities also carry a surrender charge typically. This means that for a certain number of years, usually five to ten, you will get hit with a surrender penalty if you withdraw your money. Usually, however, the insurance company will allow you to withdraw up to 10% of your money after the first year, without a penalty.
Variable annuities are similar to mutual funds. They fluctuate up and down depending on what the underlying investments are doing. They offer a handful of subaccounts that invest in a variety of stocks, bonds, and sometimes even real estate and commodities. Variable annuities also come with a death benefit. This means that the insurance company will give your beneficiary a certain amount, often equal to the amount you originally invested, if something happens to you. For example, let’s say you invest $100,000 into the annuity, and it drops to $50,000. Just when you think it couldn’t get any worse, it does—you die. Because of the death benefit, the insurance company will give your beneficiary $100,000, not $50,000. As you can imagine, the insurance company doesn’t do this out of the kindness of their heart. They charge you for this, which is called a mortality and expense charge. In addition, you will incur management fees for the investment subaccounts as well. Variable annuities also have surrender charges just like fixed annuities and fixed indexed annuities do.
Fixed Indexed Annuities
Fixed Indexed annuities are a hybrid annuity. They combine aspects of the fixed and the variable annuities. They are similar to fixed in the sense that you can’t lose money. However, your return will fluctuate. These annuities track an underlying index, such as the Standard and Poor’s 500. The insurance company gives you the option of determining how you want to track the index. The most common way is to give you the index’s return, up to a certain amount called a cap. Let’s say you choose the Standard and Poor’s index with a 5% annual cap. If the market does three percent for the year, you will get three percent. If it does ten percent for the year though, you will get the cap of five percent. But, if the market goes down ten percent, you won’t lose any money for the year. These annuities also come with surrender charges, and they can last from five up to 20 years.
Many of the variable and fixed indexed annuities sold today have something called lifetime income benefits. These benefits can be added as a rider to the annuity for an additional cost. They give the primary benefit of an immediate annuity, which is a guaranteed lifetime income. But, they come without the primary drawback of an immediate annuity, which is the lack of liquidity. Every company has their own spin on these riders. But, the concept remains the same. During the deferral period, your account value grows based on the subaccounts it is invested in or the indexes it is tied to. When you want to turn on the income stream, the insurance company calculates how much income they can give you for life. This is guaranteed, and may increase if the investments continue to grow. Often, the insurance company will make sure that your account value grew by at least a specified amount, say five percent per year. If at any time, you decide you want the lump sum, you can stop the income stream, and withdraw whatever remains in your account.
As you’ve probably gathered, annuities are complex investment vehicles. Just like any other insurance contract, research is required so that you can make an informed decision. Hopefully, I’ve shed some light on the basics.