Annuities are an excellent way to generate lifetime income, save for retirement without the worry of market risk, and leave something to your family or a favorite charity after you die. However, like many financial products, where was once a marketplace with a few simple products there are now a diverse and confusing array of products and features. The upside of this is that consumers have a lot more choice, and products that are much better suited for specific needs. In this article, I outline the five main types of annuities: fixed-indexed, variable, fixed, immediate, and deferred income. I will also suggest what to look for in each, as well as what questions to ask before you invest.
A fixed-indexed annuity, also often referred to as a hybrid annuity, is an annuity that grows in value according to a specified market index. This value is referred to as the cash accumulation value, and what investors think of as their account value. While the standard index is the S&P500, there are many other index choices, including blended indices. The insurance company that issues the fixed-indexed annuity may also guarantee you a minimum return, the amount of which will vary from one insurance company to the next. Most fixed-indexed annuities have caps on the index gains, although there are some that do not (as of this writing we know of three without caps, and index gains credited to the cash value are averaging 5% per year). The prevailing interest rates at the time of purchase have no effect on this type of annuity.
The most important benefit of a fixed-indexed annuity is the single or joint guaranteed lifetime income benefit rider. The amount of lifetime income you can receive is based on a value called the income benefit base. This is not the same as the cash accumulation value or the account value think of it more as a reference number used solely for the purpose of calculating lifetime income when and if you are ready to take it. The insurance company typically guarantees some minimum compounding increase each year to the income benefit base. You can calculate to the penny the minimum amount of guaranteed lifetime income you will receive based on various ages at which you may start taking lifetime income. This is extremely useful for retirement planning and financial piece of mind.
The withdrawal rate from the income benefit base is typically higher than with a variable annuity. The income may begin at any time, immediately or in the future, and does not require a specific age to be declared on the application like a deferred income annuity. The owner may chose income in an annual lump sum, and may have income electronically deposited into a checking or savings account on a regular monthly basis.
It is important to note that lifetime income with a fixed-indexed annuity is not annuitization. The huge difference is that lifetime income allows the owner access to the accumulated cash value, which continues to be credited gains, even subsequent to consistent income withdrawals. Cost of living adjustments are also available.
There are no fees for a fixed-indexed annuity itself, but any additional riders, such as a guaranteed lifetime withdrawal benefit, comes at an additional cost, typically 0.75% to 1%. With this type of annuity, one can either make a one-time premium deposit, or a series of premium deposits from different sources and at different times. Many have bonuses added to premium deposits, which are typically 5% to 10%. The principal, bonus, and all gains are protected and will never lose value.
Here are some additional benefits of a fixed-indexed annuity:
- The owner may use the account to build up the retirement funds on a tax-deferred basis (you pay the taxes as the funds are withdrawn). Each withdrawal on tax-qualified money is subject to taxation based upon standard deductions and personal exemptions. The withdrawals on non-qualified money are compared to the cost basis, and the gains are subject to taxation based upon standard deductions and personal exemptions.
- The owner may typically withdraw up to 10% of the cash value each year of the prior contract anniversary value without incurring surrender fees.
- The owner may have the standard death benefit, where a named beneficiary will inherit the value and avoid probate, or add an enhanced death benefit.
- When ill health or convalescent situation requires the funds, the owner may typically withdraw the entire balance of the annuity without incurring a surrender fee.
A variable annuity is a contract between you and an insurance company in which you make a one-time premium deposit or a series of premium deposits into a variety of mutual funds subaccounts. In this sense, variable annuities can grow like mutual funds. Without selecting additional riders, the principal is not protected, nor are the gains — the account is subject to market risk. Most variable annuities have principal protection riders, although these may not be selected when an income rider is chosen.
A variable annuity has two phases, accumulation and payout:
During the accumulation phase, the owner has a variety of investment options, ranging from a balanced fund (a type of mutual fund that holds preferred stocks, bonds and common stock to obtain income and growth) to money markets and international funds. The money that you put in the investment options will increase or decrease depending on the funds’ performance. The best information you can get about the investment sub-accounts in a variable annuity is in the prospectus. The prospectus will describe the risks, volatility and whether the fund contributes to the diversification of the investments in the annuity.
If you elect to start receiving payouts, the payments are based on the income benefit base, which, as in the previous case of a fixed-indexed annuity, is not the same as the cash value. Most variable annuity issuers guarantee an increase to the income benefit base of 3% to 5% per year. The income benefit riders on variable annuities come in two flavors: a guaranteed lifetime income benefit rider, or annuitization. The withdrawal rate from the income benefit base is generally lower than for a fixed-indexed annuity. The income may begin at any time, immediately or in the future, and does not require a specific age to be declared on the application like a deferred income annuity. The owner may chose income in an annual lump sum, or may have income electronically deposited into a checking or savings account on a regular monthly basis.
A fixed annuity is a written contract offered by an insurance company that guarantees you a set interest rate over a specific period of time. There are typically no fees for a fixed annuity. For some fixed annuities, the insurance company guarantees a set increase to the account value (for example, 4% per year for 10 years). In other cases, the rate varies from year to year, but has a minimum guaranteed rate. With fixed annuities, the insurance company assumes all the risk and guarantees that you’ll make the contractually promised interest rate. Unlike fixed-indexed annuities, fixed annuities are not tied to stock market performance in any way. At the end of the term, the owner must sign up for another term, a new interest rate, and a new schedule of surrender fees.
With an immediate annuity, you pay an insurance company a lump sum or one-time payment, and in return the insurance company pays you within a short timeframe (30 days to 12 months) monthly, quarterly or yearly annuity payments. You can elect payments that last for your entire lifetime or you spouseâ€™s entire lifetime, including guaranteed return of principal to your beneficiaries regardless of when you pass away, or payments for a specific period of time. Cost of living adjustments are also available. The income generated by this type is typically lower than a fixed-indexed annuity until an individual is near age 80. Additionally, this type of annuity requires the owner to forfeit future access to the premium. Generally, one would buy this type of annuity if certain select situations: when near age 80 or older, in conjunction with a fixed-indexed annuity, funding life insurance, or to generate a safe, consistent income without concern over access to the premium or rising interest rates.
Deferred Income Annuities
A deferred income annuity is an income-producing annuity funded by a lump sum or one-time payment, and then at least 12 months later to decades later, one begins receiving monthly, quarterly or yearly annuity payments. These payments can be for single or joint life only with or without a beneficiary, single or joint life and a certain number of years, single or joint life and an installment refund (paying out at least the deposited premium), or for a specified number of years. Cost of living adjustments are also available. The income generated by this type is typically lower than a fixed-indexed annuity, but occasionally exceeds that of a fixed-indexed annuity. A deferred income annuity requires the owner to forfeit future access to the premium. Generally, one would buy this type of annuity when you have a period of time when the income may be postponed, creating an income increasing segment, or ladder; to combat inflation; in conjunction with a fixed-index annuity; or to generate a safe, consistent income without concern over access to the deposited premium or rising interest rates.
Before You Purchase an Annuity
There are several questions that you should ask to gain a greater understanding of any annuity you are considering.
What am I going to use this annuity for?
If you are retired or nearing retirement and need a consistent income, you may want to consider using a fixed-index annuity. If you are building up for retirement, you may want to consider a fixed annuity, fixed-index annuity, or variable annuity. If you are going to be leaving your annuity to your children or grandchildren, you may want to take a look at a fixed-index or variable annuity with a death benefit. Additionally, an annuity may be used to generate premium funding for a life insurance policy, requiring less funds than just writing premium checks.
How much access to the funds do I need?
What you really need to know is whether access up to 10% (the standard withdrawal amount without incurring surrender fees for most annuity contracts) is sufficient, or if you will need more than that amount. This is an important factor to consider, as some annuities do not have surrender fees. However, most annuities have a decreasing surrender fee schedule that disappears at the end of the contract term.
What is the minimum guaranteed return?
A guaranteed minimum return is a stated return that you will make no matter what. In the case of fixed and fixed-indexed annuities, they will state the minimum guaranteed return. This will allow you to see what you will make yearly in a worst-case scenario.
What is the annual cost deducted from my account?
In some cases, there are fees paid to the insurance company. There are no fees for a fixed-indexed annuity itself, but riders do come at additional cost. A typical cost for a variable annuity is 3.5% to 4%, which includes several fees such as mortality expense, administration fees (referred to as product fees), income rider fees (joint is usually higher), and sub-account fees (mutual funds within the product). This information is usually found in the brochures, but sometimes only found in the prospectus. On some immediate annuities, there are upfront fees of 2%-3% that the insurance company will charge, to essentially buy the payout rate. However, typically immediate annuities and fixed annuities have no cost. This information is usually found in the prospectus.
What are the surrender fees if I get out early?
While some annuities have no surrender fees, most do. The surrender fee is assessed only if you withdraw more than 10% each year, during the term of the contract. These fees vary from insurance company to insurance company, and decrease each year until they disappear completely. Fixed-indexed annuities and variable annuities with a guaranteed lifetime income benefit continue the income benefit after the initial term in years of the contract without signing up for a new term, completely avoiding surrender fees ever again. While some fixed annuities do not require signing up for a new term once the initial term in years of the contract have passed, the interest rate is subject to change at the end of the term. Most fixed annuity contracts require an owner to sign up for a new term at the conclusion of the initial term, beginning a new surrender fee schedule. Surrender fees do not apply to immediate annuities as they are irrevocable, meaning access to the deposited premium is forfeited, unless stipulated differently by a specific contract.
What different types of death benefits are available to me?
A death benefit is provided to beneficiaries if you die. This is a stated amount. In some fixed-indexed and variable annuities, you can use an â€œenhancedâ€ death benefit (a guaranteed percentage increase in the benefits, which has an additional cost). This increase is the result of a guaranteed percentage rise in the death benefit each year (either compounding or simple) or based upon the accumulation value gains. This feature will allow a death benefit to be established for your beneficiaries. Most contracts limit the maximum age the enhanced death benefit may be selected; limit the age at which the benefits stop increasing; limit the death benefit (either 200% or 300% of premium); and require a cash value in the account for the death benefit to be payable. Often, an enhanced death benefit may not be selected when an income rider is selected. The standard death benefit is the residuary cash value of the annuity, and may be subject to tax. Another option for a death benefit is to use a portion of the generated income to fund a life insurance policy to leave tax-free money to the beneficiaries.
What waivers are available if I have a health problem and need the money?
A waiver is used when you may need the money for an emergency, such as a medical condition or if you have to go into a nursing home. Nearly all annuities will waive the surrender fee if you need the money for a situation such as this. Before you buy the annuity, find out what types of waivers are available.
Are there assisted living or nursing home benefits?
While not a common benefit, there are insurance companies that will double the income from the guaranteed lifetime income benefit under specific criteria. Typically, to qualify for the benefit, a person needs to be unable to perform 2 of 6 activities of daily living. The benefit duration is limited to five years when available, and at that time reverts back to the original income figure. This benefit is payable even if there is no cash value remaining in the annuity.
There are several different types of annuities, each with its own benefits. The major benefit of an annuity is that it allows one to create a personal pension-like income for retirement, whether prior to or after retirement begins. The annuity will provide and guarantee the consistent steady check for life just like a pension. This is a pension the owner controls, and maintains access to the cash balance. You should examine and determine which annuity will work the best in your personal situation to create your very own personal pension.
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