An annuity is an insurance product that helps ensure a steady stream of income is available to the recipient. It is also a tool for accumulating wealth. Yes the two prior statements are a bit overly simplified, but let’s build on that to better understand annuities, what they are, and how they are useful.
Today there are fixed and Variable annuities. I tend to only like the fixed annuities since variable annuities can easily lose value where fixed annuities don’t lose value, however if they are cashed in before the contract is complete, it is possible to get less out than was put in as premium. Keep in mind the early surrender fees when you consider an annuity.
Fixed annuities can be single premium or multiple premiums based. They can be annuitized immediately or held in accumulation phase for some time after which they can be annuitized. Those held in accumulation phase can even be paid out as a lump sum at a future point in time, with no penalties as long as the cash in date is past the surrender period, or as per the insurance contract other situations occur. Some of these early out situations include death or entering a nursing home. Each policy will spell out exactly what these early out provisions allow.
The fixed annuities which are annuitized immediately are primarily used for those who have a lump sum of money that want set up to pay out over a set period of time or for life. The distribution period is determined as part of the variable parts to the insurance contract, by the purchaser of the annuity. Thus, if you buy an annuity with a lump sum of money you will have to choose how long you want it to pay you back. The length of time for the payments to occur will directly impact how much of your principal you get back each month. This is a good time to take a moment to step back and talk about the annuity payments.
As you annuitize the contract you begin receiving payments that are a set amount. The payment includes both a principal (part of the premium you paid initially) and earnings. You will pay taxes on the earnings coming out of the account (as long as you used post tax money to purchase the contract) only. If you used pre-tax funds the entire payment is subject to taxes. The contract application will track if the money is pre/post taxes and as you receive payments the non-taxable and taxable income will be calculated and an IRS form 1099 will be issued each year.
If you chose to purchase an insurance contract using multiple premium payments or hold the contract in a stage where more money accumulates as you defer payment, then you have to look at the various options for growing the value of the policy while it is in deferral. You can choose from set amounts specified by the insurance company or you can pick a bit more risky strategy and go with an indexed annuity. The fixed rate annuities will grow at a know rate per year so you can more easily calculate where the value will be at a given point in the future. Of course the exception is if the deferral lock in period is longer than the guaranteed rate period, then a few years out you are looking at a new rate being announced.
Usually most annuities give you several buckets from which to choose when putting the money in, and those that don’t often offer an interest rate that will be locked in as long as the surrender period so it is not a total shot in the dark that at the interest rate reset time you could go down to a much lower interest level. These are all general terms because ultimately each contract is unique and when buying that is what you must look at to decide if the annuity is good for you or not.
If you choose to go with an indexed annuity, you are able to put some portion up to all of it into a bucket where the income is based on a specific market. The nice feature with annuities being insurance contracts is there are guaranteed minimums, and on a fixed annuity platform you can’t lose your initial/subsequent premiums due to market losses. In fact in a negative return year for that index, you don’t lose money you just end up with zero income added to your accumulation value.
The buckets described above are a simple way to understand the process of assigning income to the premiums paid for the policy. There are various moving parts which can affect the final amount deposited into the buckets each year. Included are how often the income is recorded, when the accumulated income becomes part of the accumulation value on which new income is based. Percentage of the gain, when looking at indexed buckets, as measured thru maximum income percentages and participation points. These are critical to know and understand for these kinds of contracts.
Now that you have some education about how annuities are designed and how they work, let’s talk about why an annuity can be a good purchase. First I want to share that not everyone or every situation is right for an annuity, so if you think I want to convince everyone they need an annuity that is not the case. Annuities are very good for those who want to distribute accumulated money in a manner that guarantees distribution thru death of the annuitant. You can also add a period certain onto the annuity to ensure at least for a set number of years someone gets the money in the event of an early death for the annuitant.
Another circumstance where an annuity can be a good option is where putting money away is important but where that money has to be safe from loss of value for any reason. In these cases a fixed annuity, depending on the method of earning an income within the annuity can be a good way to guarantee the premium while growing the value of the money. There are tradeoffs to consider such as can I risk some loss for possibly more return or not, and if no loss of premium is acceptable then an annuity may be the answer.
If you flip it around and decide you need a set amount of principal for retirement, an annuity with periodic premiums can be used to pay into the policy to ensure a value of a set amount at some future point in time. It can then be taken as a lump sum or even as a annuitized payment, so using it as a planned savings tool is yet another option when it may be a good choice.
Another situation where an annuity may be a good option is those who want to have some protection against long term care needs without the premiums of a traditional long term care policy. There are a few annuities that have a rider for long term care under which the value of the annuity grows substantially when being used to pay for long term care needs. In these cases if the annuitant dies without ever using long term care the money can be paid to a beneficiary, or it could have been drawn out anyhow for non-long term care living needs.
The key when you are considering an annuity is to lay out the specific need for the annuity before you start talking with your insurance broker. Knowing up front why you want an annuity will help prevent you from getting the wrong annuity, or even getting one when it does not really serve your needs. Of course situations change so the next thing to know is the early contract termination penalty, which is a part of most annuity contracts.
Probably the biggest take away from this overview on annuities is that each annuity buyer must know and have explained well the product(s) they are buying and make sure the product being purchased meets their needs. There are so many products one or more likely fits your needs while a hundred others may sound good but don’t really fit your needs. A good broker who is properly licensed and has appropriate annuity training can help with the process. We are certainly willing to chat with you about your annuity needs, give us a call.
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