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What Are The Main Types Of Annuities?

When the market gets a little volatile, I notice an increase in the number of questions I receive on annuities.  Fear is often a motivator for people considering purchasing an annuity; however, I find a vast majority of investors have a limited understanding of the products they are being offered, or worse, investments they already made.  As such, I thought it would be useful to address the issue and discuss the different types of annuities available to investors today.  We do not sell annuities at Capital Investment Advisors, but my goal as a fee-only financial advisor is to better educate our clients and the general public on the products that are available to them.

Fixed Annuities

A fixed annuity is the most basic annuity and easiest to understand.  A fixed annuity is a lot like a tax-deferred money market account.  Your contributions grow tax-free at a specified interest rate that is guaranteed by the insurance company you invested with.  Insurance companies will usually offer a “teaser” rate for the first year then drop down to a lower rate for the remainder of the contract.  Fixed annuities are often promoted in banks where the financial advisor located within the branch is trying to sell an alternative for investors with CDs.  Since we are near historically low interest rates, fixed annuities may not be an attractive option for investors at this time.

Related: Income Investing And Your Retirement

Immediate Annuities

An immediate annuity is very similar to buying yourself your own personal pension plan.  Many traditional pension plans are disappearing as corporate America tries to put the risk of saving for retirement back on the employees through the use of qualified retirement plans.  As such, retirees can create their own pension plan by investing in an immediate annuity through an insurance company.

As the name suggests, an immediate annuity will typically start making payments to you immediately.  You invest a lump-sum of money with an insurance company and they agree to pay you a minimum amount of money for as long as you live.  In addition, you decide how you want those payments made and for how long.  You can specify a minimum length of time and even add your spouse as a recipient of the annuity payments.  If you are a retiree or pre-retiree who is looking to supplement your retirement income with a guaranteed income stream similar to a pension plan, an immediate annuity might be right for you.  Something to consider when investing in an immediate annuity is that you lose control of the assets and it does not offer any flexibility once you’re in the distribution phase.  As such, careful consideration should be made when deciding how much to invest in an immediate annuity and what type of payment schedule to select.

If you are a retiree or pre-retiree who is looking to supplement your retirement income with a guaranteed income stream similar to a pension plan, an immediate annuity might be right for you.  Something to consider when investing in an immediate annuity is that you lose control of the assets and it does not offer any flexibility once you’re in the distribution phase.  As such, careful consideration should be made when deciding how much to invest in an immediate annuity and what type of payment schedule to select.

Variable Annuities

A variable annuity is an insurance contract that is a tax-deferred retirement vehicle that allows you to choose from a selection of investments.  These investments are similar to mutual fund investments, only they are called sub-accounts.  The contract value of the annuity is determined by the underlying investments held in the stock or bond sub-accounts.

Many investors will invest in a variable annuity for the numerous “bells and whistles” that are being offered by insurance companies.  They use acronyms like GMIB, GMWB, GMPB and GMDB.  In addition, insurance companies use terms like “ratchet, roll-up, step-up or pro-rata and dollar-for-dollar.” Some variable annuity contracts promise minimum guaranteed income payments and income for life. Although the idea of receiving income for as long as you live may be an attractive proposition, there are huge pitfalls that many investors fail to fully understand.  Variable annuities can be extremely complex and I find a majority of investors fail to fully understand how their contract works.  Second, there are numerous layers of fees associated with these types of annuity contracts, which can reach as high as 4% of the annuity account value.

If you’re going to invest in a variable annuity contract be sure to understand exactly how the contract works and how it fits into your overall plan.

Related: How much am I really paying for my variable annuity?

Indexed Annuities

A key feature of an equity-indexed annuity is the credited interest rate being partly based on a stock index, such as the S&P 500 Index.  The goal of an equity index annuity is to realize a gain that is higher than cash equivalents while still maintaining principal.  The ability of these products to achieve this goal is arguable. An important feature of equity-indexed annuities is the cap rate, also known as the participation rate, which is a limit to the amount you can earn in a given period.  Equity-index annuities are complex in their calculations and typically have high surrender charges for a long period of time.  In addition, the annuity salesperson typically earns a high commission for selling these products.

Conclusion

When it comes to deciding on whether an annuity is right for you, it is wise to use the KISS principle.  Annuities might work for you if it is kept simple rather than made complicated; therefore, simplicity should be a key goal in your decision and unnecessary complexity should be avoided.

 

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Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.


 

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