If you want to start a debate among financial professionals, just bring up the subject of annuities. It doesn’t matter whether the parties involved have ever bought them or even investigated them. There are simply strong opinions about this investment option.
So let’s talk about what they are and how they work.
What is an Annuity?
An annuity is an investment contract between an investor and insurance company. The investor pays a lump sum in exchange for future periodic payments immediately (known as an immediate annuity) or at some future date (a deferred annuity) that can continue as long as your lifetime if you choose.
Many experts think that putting a lump sum of money-no more than half your assets-in a guaranteed annuity that will pay you monthly until you die allows you to free up the rest of your money to invest (and spend) more aggressively.
Where does the controversy come in? Over fees, investment mission, the flexibility of the agreements, and tax issues. Some people wonder whether an annuity is a better choice than a Roth IRA invested in conservative no-load funds. But everything depends on the type of annuity and whether it fits your needs. Before you invest in an annuity, you should consult a financial expert who knows your entire tax and retirement picture.
There are ever-changing flavors of annuities that deliver steady income, growth, and savings opportunities. Annuities are purchased with lump sum payments, typically $5,000 or greater. Yet once you’re in an annuity, prepare to be in for the long haul- it’s very expensive to get your money out in an emergency.
Types of Annuities
Most discussions of annuities begin with the following important distinction: fixed vs. variable.
Fixed annuity. This type of annuity guarantees the principal (the amount you invest) and a minimum rate of interest for the term of the agreement, assuming the insurance company that issues the annuity stays financially healthy. That’s why it’s always important to check the insurance company’s A.M. Best rating before you invest. For all fixed annuities, the growth of the money invested is tax-deferred, but annuities can be purchased with pretax income and be tax-deferred, or they may be purchased with money that has already been taxed.
Variable annuity. The money you put in a variable annuity is invested in a fund, similar to the way a conventional mutual fund operates. The fund has a particular investment objective and your money-less fees and expenses-will move with the market. There is no guaranteed return as with a fixed annuity.
The following types of annuities come in fixed or variable forms. Deferred annuities. Deferred annuities tend to be the most frequently chosen annuities because investors put in their money well before they need it and they accumulate value-more or less guaranteed-over time.
Immediate annuities. Immediate annuities begin paying you an income from the moment you invest for as long as you designate. These annuities provide pension advantages to the retired employees, and you’ll often see them offered to teachers or other public or non profit employees.
Life annuities. There are many flavors to this type of annuity, but in its simplest form, it gives the person who buys one payments for life. The differences come in the way the annuity contract is structured. Life annuities get more expensive as you add features. For example, a life annuity that designates a beneficiary-someone to collect the remaining payments of the annuity if the original holder dies-costs more than a “straight life” annuity that simply pays the holder until he or she dies.
Term certain annuities. This annuity has a fixed payment with no opportunity for adjustment and only for a specific period. If the investor dies before the term of the annuity is up, the insurance company gets to keep the money.
Single premium annuities. This form of annuity is funded by a single payment and usually invested for the long term.
Flexible payment annuities. A flexible payment annuity allows for many payments over a particularly long period of time for the maximum chance of growth.
What questions you should ask?
1. What’s the health of the insurance company offering the annuity? Check with A.M. Best to see how the company is rated.
2. How have the investments performed within the annuity you’re thinking about?
3. Are there surrender charges for this product? How much are they and when do they disappear? (Many annuities don’t drop surrender charges until your eighth year of ownership; bad news if you need the money in a hurry.)
4. What are the initial fees and annual fees on the annuity? Have the annual returns exceeded the fees you’ll pay on the annuity? If they don’t, there go your gains.
5. How much do you pay in extra fees for extra features? If your annuity has a guaranteed minimum income benefit, for instance, what will that cost you?
6. If you have a few years until retirement, how does an annuity choice compare to a competing investment vehicle, such as the coming no-income-limit Roth or other choices?
7. If there’s a bonus credit feature on a variable annuity-which adds more to your contract value if you pay certain amounts in-are there additional fees that might offset those gains?