Annuities are suddenly the topic of conversation.
For one thing, many investors are weary from the up-down-up-down stock market and are fleeing to "safety". Then there's the push from the Obama administration. One proposal would encourage employers and IRA providers to offer deferred annuities in 401(k)s, other workplace plans and IRAs. Another proposal is meant to urge employers to encourage employees who have traditional defined benefit pension plans to annuitize.
The goal is clear: minimize the risk of people outliving their money by providing a guaranteed monthly income. That's the attraction of annuities -- knowing what you're going to get, when. But annuities are not nearly so simple.
Here's what you need to know to sort out some of the mysteries surrounding annuities.
What is an annuity?
First and foremost, it's essential to understand what an annuity is. It's an insurance contract. An annuity offers some form of a guarantee. There are different types of annuities -- immediate, variable, fixed, and indexed. While a whole book could be written just trying to explain the features of each, in a nutshell, an immediate annuity is when you give the insurance company a lump sum of money. They then pay you a set amount of income, explains Mike Krise with the Krise Wealth Management Group of Raymond James. This payment could be guaranteed for your lifetime, or a set period of time. With a variable annuity, you deposit money into the contract, the money is invested and your final yield varies according to how well these investments perform. All growth is tax deferred.
On the other hand, with a fixed annuity, you deposit money into a contract and you receive a stated amount of interest -- kind of like buying a CD or a corporate or treasury bond. There is no chance of loss with this annuity, unless the insurance company fails or becomes insolvent, says Krise. A fixed index annuity has a guaranteed interest rate, but has higher earning potential. You can tie your money to the upside of a market index such as the S&P 500. This offers potential for higher return, without any market risk. If the index goes down in value, you do not not take any loss, though the upside has a cap, says John McNamara of McNamara Capital Investment Group.
The appeal of annuities
The major plus of annuities are the guarantees associated with them. When you buy an annuity, you are typically buying them for the guarantees they offer. Guarantees come in a couple of flavors -- sometimes in the form of lifetime income, or the guarantee of your principal (your money) coming back to you, there can also be a death benefit guarantee. They offer tax deferred growth.
Annuities in various forms can be used to complement other retirement income and social security. A "bucket strategy", utilizing fixed, variable and single premium immediate annuities whereby a retiree draws from each, can create a steady retirement income stream, says Jeffrey Duncan, a MassMutual agent with Lee, Nolan & Koroghlian.
Then too, Krise has seen clients who may not have been able to get life insurance, buy an annuity with a death benefit rider, so they can leave money to heirs. There is typically no medical underwriting.
But, annuities are not a retirement panacea. For sure, you want to have a sit down with your financial advisor before you purchase one. There are several reasons to proceed with caution.
Fixed annuities are based on interest rates. With interest rates as low as they are, payouts aren't worth tying up your money, says Matthew Tuttle, CEO of Tuttle Wealth Management. Indexed annuities are based on interest rates and volatility. He says that with interest rates low and volatility high, they don't offer much return potential. And while variable annuities appear tempting with their guarantees, he says they are often very confusing and not worth the extra expenses you have to pay to get them.
Fees can be tricky. For example, typically a variable annuity's fee can range from 2.5-4%, says McNamara. Furthermore, those fees are often not listed on quarterly or monthly statements. McNamara says he had a 60 year-old widow come in with several variable annuities totaling about $400,000. When they contacted the company they found out that the fees were 3.6% annually, about $14,400 in fees. The fees, he says, come out of the account each year, whether the account is going up or down.
Know too that although annuities are offered through insurance companies, they are taxed very differently than a pure life insurance policy. Any gains in an annuity contract are subject to tax, and, if you take out proceeds from an annuity contract before age 59 1/2, you could be subject to taxes and penalties, says Krise.
Annuities are not particularly liquid. A typical annuity contract has a surrender period of seven years. That means during the first seven years, you could be charged 7% or higher to take money out (this is before taxes and penalties), explains Krise. Read the fine print and make sure all your questions are answered before entering into a contract.
Krise says while most investors could most likely find a niche for annuities as part of their overall investing picture, it's not the place for all your money. In fact, he leans harder, "If you have no need for the guarantees that an annuity contract offers, don't buy."