What You Need To Know About Annuities
- Ally Chanel
- Jun 23
- 5 min read
What is an annuity?
An annuity is a contract with an insurance company where you provide funds for a set period in exchange for guaranteed future payments.
Annuities insurance products?
Yes, they are! Many life insurance companies also specialize in offering annuities.
Unlike stocks, which can fluctuate in value, annuities guarantee a return by depositing an investor's money with an insurer, who then sets a rate of return that the investor will earn.
Growing or living off your money
When purchasing an annuity, it's crucial to understand its two main functions: accumulation and distribution.
Accumulation involves deferred annuities, where one grows their money by deferring access to it for future growth through insurer guarantees.
In contrast, distribution refers to immediate annuities, which provide instant income, similar to a pension plan.
There are also fixed-period annuities, which offer payments for a set period, such as 20 or 30 years, but are less common since once the period ends, you have no further income or savings. Additionally, deferred annuities do not pay out immediately upon maturing; they continue to accumulate interest at a lower rate.
Notably, deferred annuities often allow holders to convert into immediate annuities at the end of their contract period, a process known as annuitization.
Why to buy an annuity?
Annuities offer certainty and peace of mind for those who prefer a guaranteed return, making them an ideal choice for risk-averse individuals, such as retirees.
Suppose the thought of a 15-30% decline in your retirement savings causes you significant anxiety. In that case, an annuity might be a suitable choice. However, this will vary substantially from person to person.
The main benefits of annuities
•Guaranteed returns*
•Creditor protection
•Set payments for a specified period*
•At maturity, deferred annuities can provide flexible withdrawal options, allowing for a lump-sum withdrawal, periodic withdrawals as needed, or annuitization
*"Guaranteed" applies only if the annuity provider (insurance company) doesn't become insolvent. There are safeguards for policyholders in such cases, which will be discussed later.
Drawbacks of annuities
•Some annuities are complex and have high fees
•Annuities can have meager performance compared to more traditional investments when an investor can tolerate risk
•Annuities are illiquid, tying up funds for a specified duration or the remainder of one's life.
•Annuities can be complex to cancel early, as they often come with high surrender charges and specific stipulations
•Any gains are usually assessed a 10% penalty if withdrawn before age 59.5
Types of Annuities
Annuities come in three variants: fixed, indexed, and variable.
Fixed and indexed annuities are purely insurance products and do not fall under the oversight of the SEC. Instead, they are regulated at the state level by the insurance commissioner. In contrast, variable annuities are regulated by the SEC, which classifies them as investment products within an insurance framework.
Fixed annuities
Fixed annuities are relatively straightforward: you pay an insurance company in exchange for a guaranteed repayment and interest rate.
With deferred fixed annuities, you commit to giving an insurance company your money for a specified number of years, typically a minimum of three. During this time, your money grows at an agreed-upon interest rate.
Indexed annuities
Indexed annuities, also known as fixed-indexed or equity-indexed annuities, link their interest rates to an index like the S&P 500. They offer protection against loss of principal and guarantee a minimum annual growth rate, providing the potential for returns similar to traditional investments while retaining the benefits of fixed annuities. However, they may limit growth through participation rates and caps on growth.
The participation rate of an indexed annuity refers to how much of an index's gains an annuity will receive. With an 80% participation rate for an annuity that tracks the S&P 500 in a year that the index rises by 10%, an annuity holder grows their funds or payments by 8%.
Lastly, indexed annuities have limits on returns known as caps. Typically, if the index increases beyond a specific threshold, such as 10%, an annuity holder won't receive any gains above that limit.
For instance, if you are capped at 10% with an 80% participation rate, your payments would only increase by 8%, even in years when the index rises by 20% or more.
Variable annuities
Variable annuities are primarily investment products, unlike traditional insurance products, where insurers can manage your money freely. With fixed and indexed deferred or immediate annuities, your funds go into the insurer's "general" account, ensuring a guaranteed growth rate and payouts.
However, with deferred variable annuities, your money is placed in a "separate" account and invested into funds of your choice. This comes with market risks, meaning there is potential for loss due to fluctuations in stock and bond markets despite the opportunity for growth.
When you convert a deferred variable annuity into an immediate annuity, you can choose between fixed or variable payments. Fixed payments provide a set dollar amount for your lifetime, while variable payments fluctuate based on your selected investments.
Choosing variable payments is generally unwise, as immediate annuities are meant to offer income security. On the other hand, fixed payments remain constant, which means they don't increase with inflation, gradually reducing your purchasing power.
Both options have drawbacks, with fixed payments often being the better choice. Once annuitized, your separate account disappears, and the insurer assumes the risk of making ongoing payments if you live longer than average. Thus, a variable annuity primarily serves as an insurance product once converted.
What happens when an annuity company goes out of business?
You may wonder what happens to an annuity if the issuing insurer goes bankrupt. Fortunately, state guarantee associations provide coverage for fixed and indexed annuities, typically up to $250,000 in payments.
This makes it crucial to buy from reputable companies that are likely to remain solvent. If a company fails and an investor reaches the $250,000 limit, they may experience a significant loss. This highlights the importance of diversifying retirement portfolios and utilizing reputable investments and providers.
However, it should be noted that deferred variable annuities are investment products, so consumer protection differs when an insurer goes bankrupt. In these situations, investor funds were held in a separate account that the insurer could not access, meaning that even if the insurer failed, an investor still owns their underlying mutual funds.
Notably, once the variable annuity is annuitized, investors must depend on the state insurance association for protection if the insurer goes bankrupt.
Riders
Riders are optional features that can be added for an extra cost, allowing investors to customize their annuity. However, these enhancements come with additional expenses and complexity, so consider them wisely.
Common examples include cost-of-living adjustments, increased disability income benefits, and guaranteed minimum income benefits.
Closing thoughts
Annuities are primarily insurance products rather than traditional investments. Whether an annuity is suitable for you is an individualized question that depends on your risk tolerance and specific needs.
If you are considering an annuity for your portfolio, we are here to help. At Lundeen Abrams Advisors, we help our clients choose the right investments for their specific situation, and we look forward to helping you out, too. Please call us today so we can schedule a time to learn about your needs and whether or not an annuity may fit into your portfolio.
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