Annuities are contracts with insurance companies, offering guarantees to investors at a cost. They are designed to provide income for life no matter how long you live or how bad the economy gets.
When the income is paid to the owner from the very start they are known as immediate annuities.
When the income is not scheduled to begin until a later date they are known as deferred annuities.
With deferred annuities the premium is invested until the owner decides to begin withdrawals for income.
Money in fixed annuities has no market risk. Your premium is guaranteed and you will earn an interest rate that is guaranteed interest for a set period of time. After that set period of time a new rate will be declared each year. Fixed annuities have a minimum guaranteed rate which assures you that the contract will always earn at least the stated amount and hopefully more.
Most years, a fixed annuity will earn more interest than a CD. So it makes an excellent place for people who want no principal risk to put money for the long term. They have no principal risk and no annual fees.
Money in variable annuities goes into stock, bond, real estate or other sub accounts with market risk. This type of annuity has the most potential for growth since there is no limit to the upside potential. There will also be periods of time when the account may be worth less than the original amount due to market fluctuations.
Normally variable annuities are sold with an income rider. These riders differ between companies but most offer income that is based on the high water mark of the annuity. So if your $100,000 grew to $150,000 but later fell to $75,000 due to a market crash you would draw an annual income based on the $150,000.
It’s important to understand though that they are only guaranteeing you a certain percentage each year of the high water mark. If the contract is only worth $75,000 then the most you can pull out lump sum is $75,000 not $150,000.
Things to look out for
- Most annuity’s have early withdrawal charges called Contingent Deferred Sales Charges (CDSCs). Good annuities have CDSCs for the first 7 years or less. Don’t buy an annuity with a CDSC longer than 10 years.
- Annuities grow tax deferred like an IRA. Whenever you withdraw money, the growth amount is taxed as income. If you purchase an annuity within an IRA account you should have a compelling reason to do so other than the tax deferral.
- Annuities usually have a guaranteed death benefit for your beneficiaries. If a death benefit is your primary concern though, Life Insurance is a better deal. However, if you are uninsurable and are looking to leave money to your heirs, then an annuity may make sense. A typical death benefit rider may guarantee the death benefit to rise each year by at least 5% even if the contract value decreases.
- Variable annuities will never grow as much as a similarly invested mutual fund not inside an annuity. This is due to the annual fees the company charges, sometimes as high as 3.5%. It’s the price you pay for the guarantees. If you are looking for an income that can never go down no matter how long you live then a variable annuity with an income rider makes sense. If you are comfortable with varying income from stock dividends or bond mutual funds as well as the inherent market risk then you don’t need an annuity.