What are Annuities?

Annuities are offered by insurance companies and are a contract between the insurance company and the annuity owner.  The owner deposits a sum of money (premium) with the insurance company, the insurance company then invests the money.  The idea of an annuity can be attractive because you can receive regular scheduled payments.  When payments start depends on the type of annuity.  Immediate annuities begin payment after a lump sum is deposited.  Deferred annuities begin payment at an age specified in the contract.

Annuities generally include an accumulation phase and annuitization (payout) phase.  During the accumulation phase, the money invested grows tax deferred and you may be able to change your mind and invest in something else after the penalty period is over.  During the payout phase, regular scheduled payments are made to the investor.  Earnings may be subject to taxation.  Once the payout phase begins you are generally locked in and changes to payment frequency and amount are not possible.  Before the payout phase, many contracts allow you to take 10% per year with no penalty, beyond that amount any withdrawals are subject to significant penalties for early withdrawal.

Fixed vs. Variable Annuities

Fixed annuities provide a fixed rate of return, similar to a bank CD.  Index annuities fall under the umbrella of fixed annuities.  When bond returns and interest rates were low, index annuities were developed.  They give participants the ability to participate in an index or indices to give them some upside potential during accumulation period. The downside is usually capped at zero or some other fixed downside, and the upside participation is capped as well.  While it may be marketed as the best of both worlds, with no downside risk and the upside of being invested, the reality may be different when you dive into the actual returns, cost of fees, and other limitations.  Just like all annuity contracts, index annuities have complex actuarial data that ensures the insurance carrier is not taking undue risk with its money.

Variable annuities deposit the premiums in sub-accounts, similar to mutual funds, that are invested in the stock or bond markets.  Payments are tied to investment performance, not a fixed rate.  When the sub-accounts mirror mutual funds, they have all the inherent up and downsides of mutual funds as well as money manager fees. 

Pensions

When your employer pays out a pension income, those pension payments are a form of annuity. They are commercial contracts purchased by a company or entity for employees.  Pension payments are considered taxable distributions as earned income.  Payments commence after a specified time or date (retirement or other date specified in the contract).  The assets used to purchase an annuity, or your pension payments are no longer yours, they are contractually disbursed to you or your heirs based on the terms of the contract. Pension annuitization (or payout) may be a scheduled payment for life, term certain, or joint life (such as your spouse continuing to receive payments after you die).  Payment amounts are set and don’t appreciate with time or cost of living.  Early death of the contractual owner or owners will cause all future payments to stop and any “left over” assets are retained by the insurance carrier.  The opposite is true in the case of exceptional longevity of the owner.  If an owner outlives the life expectancy, payments will continue for the term of the contract, even if all the money has been “used”.

Why might someone want an annuity?

If you’re looking for a steady source of retirement income with minimal risk, an annuity may sound like a tempting option. When you buy an annuity, you agree to deposit a sum of money with the insurance company. They’ll invest it on your behalf and then return it to you through a series of regular payments.

Like pensions, you can create your own income stream via annuities.  But keep in mind that money in an annuity is not liquid without paying surrender fees during the accumulation period and not liquid at all during annuitization and there are contract limitations, fees, and charges that might not be present in other investment options.

This is general information and not contract specific.  If you are considering an annuity, give us a call and we can explore the features, benefits, and limitations and whether it would be a good fit for your financial goals.