If you could purchase a product that promised to give you a steady income for life and take the worry out of outliving your assets, would you jump at the chance? An annuity is a product typically used to achieve this goal. While purchasing an annuity may sound like an easy decision, an annuity may not be appropriate for everyone.
An annuity is an insurance contract that is designed to provide a guaranteed income and is primarily used for retirement planning. In the world of personal finance, however, the guarantees associated with insurance products can carry hefty price tags, and they can also come with a lot of risk. Annuities are no exception. It is important to fully understand the pros and cons of these products before deciding whether or not an annuity is right for your investment portfolio. Additionally, these products are sold by brokers who receive sizeable commissions for selling these products. Before buying, it may be in your best interest to consult a fiduciary financial advisor before entering a contract subject to a surrender charge period.
Annuities are designed to offer a reliable stream of income for retirees, ensuring peace of mind and security against the possibility of outliving their savings and assets. Recognizing that retirement funds may fall short of maintaining their desired lifestyle, some people opt to explore annuity contracts offered by insurance companies or other financial institutions. Upon activating the income stream, annuity contracts transfer some of the risk of a down market to the insurance company. This means the income stream, once activated, should be protected from market risk, and the income stream could always be there for the annuitant.
Typically, annuities go through two different phases: the accumulation phase and the annuitization phase.
The accumulation phase is the period when an annuity is being funded, but before payouts begin. Money invested in the annuity grows based on the type of money that was entered into the contract. Traditional IRA assets grow tax-deferred, Roth IRA assets grow tax-free, and non-qualified assets grow as such. However, annual taxes are usually avoided in non-qualified annuities because there are not ongoing dividend payments and capital gains distributions, such as with a non-qualified brokerage account.
The annuitization, or “pay out,” phase, is the period when your income stream begins. The income stream could be through actual annuitization, where the owner and annuitant give up access to liquidity in exchange for an income stream. However, some annuities offer living benefit riders, where the owner still has access to the remaining cash value until the income stream depletes the balance.
There are two basic types of annuities – immediate and deferred.
An immediate annuity provides a guaranteed stream of income right away. The owner puts a lump sum to an immediate annuity contract that can pay an income monthly, quarterly, or annually.
If someone wants to generate an income stream at a later date, they can get a deferred annuity. The assets are invested in a number of ways, depending on the type of deferred annuity, and the future income stream is affected by a variety of factors. This investment can be made as a lump sum or a series of purchase payments.
There are four major types of deferred annuities: fixed, fixed index, variable index and variable. These different types of contracts invest the assets differently.
Annuities typically come with a surrender charge period, which is the amount of time an investor must wait before they can withdraw funds without being charged a penalty. This period generally spans anywhere from four to 12 years, and some are even longer. It’s important to consider there is an inherent liquidity risk when entering into a contract with a surrender charge period. If you encounter any events that require significant amounts of cash during this period, and you need to surrender the annuity, you could lose significant principal. If this is likely, you might also want to evaluate if you’ll still be able to afford to make the requisite annuity payments.
What’s more, annuity contracts may come with a living benefit rider, which is an optional feature that you can use with deferred annuities. The rider has a shadow account, typically referred to as a benefit base or income base, which is not a value that the owner has access to as a lump sum, but, rather, it is used in the calculation of a guaranteed income stream. The income still comes out of the contract value until that value is depleted, at which time the insurance company continues to make the payments. When purchasing a product with a living benefits rider, it is important to consider:
As with any contract you sign or any financial product you buy, it’s always wise to ask questions and thoroughly understand what you’re buying. It is important that you should never feel rushed to purchase a product with a surrender charge period.
So, before you buy an annuity, make sure you understand what you’re buying and do your research, if you believe you are a good candidate for the product. If you need assistance with this, talk to a fiduciary financial professional. Also make sure you are buying a product that is suitable for your needs and matches your goals, and that you’re buying it from the best possible source, taking fees and risks into consideration.
Here are a few questions to ask as you perform research:
If you are considering purchasing an annuity, make sure you are aware of the potential benefits and drawbacks and how the annuity fits into your overall retirement plan. Being fully informed is crucial.
