Annuities Overview

What are Annuities

At their most basic, annuities are contracts between investors and insurance companies. The investor provides the insurance company with either one lump-sum premium, known as a single premium, or multiple premiums over time. The time during which the annuity owner makes multiple premium payments is known as the accumulation phase. In exchange, he or she receives guaranteed payouts for life. This is known as the distribution phase. The payouts can be distributed monthly, quarterly or annually, depending on the needs of the annuity owner. When the payouts begin and the amount of each depends on what type of contract is purchased.

Annuities can be fixed, variable or indexed. Each of these three can then be either immediate or deferred. The type of annuities that may be right for an individual investor will depend on a number of factors, including the number of years until retirement, the amount of income that will be derived from other investments and the amount of other assets such as savings and retirement accounts and real estate.

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What are the Different Types of Annuities

There are three types of annuities: Fixed, variable and indexed. The premium for each kind of annuity is invested in the stock and/or bond market. But the risks incurred by each are different depending on the type of annuity chosen.

Fixed annuities pay a fixed return, regardless of gains or losses in domestic and foreign stock and bond markets. The premium paid to the insurance company by the investor is invested in extremely conservative mutual funds. The mutual funds are bond funds that purchase United States Treasury bonds and bills. The funds may also include state and municipal bonds, along with highly rated corporate bonds. Some life insurance companies offer a guaranteed fixed payment that can be anywhere between 3% and 5% of the invested principal. While this can seem advantageous when the yields on treasury notes are low, it may not be enough to outpace inflation.

The return on variable annuities depends on how the investor chooses the premium to be invested. He or she can typically choose among a number of different mutual fund types, from a highly conservative or highly aggressive fund, or a combination of the two, depending on his or her risk tolerance. As with most financial investments, a higher reward usually means assuming higher risk. Those interested in investing in variable annuities should always be aware that principal might be lost in a market downturn. However, it’s also possible that the amount of the account can grow at a much faster pace that will provide a higher monthly payout.

Indexed annuities are tied to a specific index such as the Standard and Poor’s 500. The S&P 500 is the broadest measure of the largest companies by capitalization in the United States. Because it is so broad, S&P 500 indexed annuities spread the risk of loss over all market sectors. The premium for an indexed annuity is placed in an index fund and the returns are based on the overall return of the entire index. For example, while stocks in the “Information Technology” sector might be down, those in the “Consumer Discretionary” category may be up. Investors in indexed annuities should always be prepared for losses, as the loss of principal can occur with a market decline. And, most insurance companies will cap the maximum amount that will be paid as part of the payout. If the cap is 6%, only 6% will be paid out even if the S & P 500 increases by 8% for the year.

Fixed annuities are almost always sold as immediate annuities, meaning that payouts begin within 12 months of the purchase of the contract. Immediate annuities are also usually funded with after-tax dollars from a savings account, an inheritance or with the proceeds from the sale of property. Indexed and variable annuities can also be immediate annuities, but are more often than not deferred annuities. A deferred annuity is one for which the taxes and distributions are deferred until a later point in time, usually after retirement. Deferred annuities can be part of a company sponsored defined contribution plan such as a 401(k) or they can be purchased by an individual directly from an insurance company. Deferred annuities are a great way for investors who have maxed out their defined contribution plans to save additional money for retirement.

What Financial Need Do Annuities Satisfy

The primary financial need satisfied by annuities is guaranteed income after retirement. As Americans are living longer, outliving their savings is often cited as the single most important risk of retirement. All annuities grow tax-deferred. This means that the interest that is earned on the premium is allowed to accumulate faster because none of the earnings are deducted to pay taxes. And, once distributions begin, only the earnings are taxed. The portion of the payout that represents the return of the premium is not taxed. Therefore, annuities enjoy tax status that is far superior to other types of investments.

Who Should Invest in Annuities

While most insurance companies offer a “free look” period during which annuity investors can choose to cancel the contract, once the contract is in force, it cannot be cancelled. The premium will not be returned to the investor except in the form of distributions as specified in the contract. Therefore, annuities are best suited for those investors who will be able to maintain enough cash to meet additional needs that may not be covered by the payouts. Financial advisors, including those who are independent and those who work for insurance companies, will often advise investors to ensure that they have at least $20,000 to $50,000 in additional cash reserves after funding an immediate annuity.

Aside from retirement savings, professionals such as doctors, attorneys and business owners who are subject to being sued are sometimes advised to purchase annuities. Most states consider annuities or life insurance policies to as part of a person’s assets if a financial judgment is entered against him or her.

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