Did you know that over the last four decades, life expectancy has increased in the U.S.? While there was a concerning decrease in 2020, mainly because of the pandemic, life expectancy is expected to rebound and increase in 2021. As such, building and maintaining your retirement savings is more important than ever if you want to enjoy a long and healthy life.
Understanding Annuities: A Quick Read Guide
Of course, that means understanding and maxing out retirement plans like defined contribution plans, 401(k)s, IRAs, and pensions? But have you considered annuities?
For a lot of folks, probably not. That’s not a knock against them — after all, annuities are complex and some come with a lot of fees. Moreover, they’re usually not offered by employees meaning individuals have to purchase them on their own.
At the same time, annuities have their advantages — mainly a guaranteed income stream for a specific time period or until you die. Additionally, you can name a beneficiary so the remaining value can be passed on to them.
But, to determine whether or not an annuity makes sense for you, here’s a quick read guide so that you’ll better understand them.
What Exactly Are Annuities?
An annuity is simply a contract between you and an insurance or annuity company. The main selling point of an annuity is that it offers principal protection, lifetime income, legacy planning, or long-term care costs.
When shopping for annuities, they might be marketed as investments. The investment is in your future income during retirement. It is a contract — not a regular retirement
“It’s important to understand that annuities are contracts, not investments,” explains Stan “The Annuity Man” Haithcock. “Comparing the two is a colossal waste of time, in my opinion. It’s apples and oranges.”
I’ve come up with an acronym that covers what annuities contractually solve for. That acronym is P.I.L.L.
- P = Principal Protection
- I = Income for Life
- L = Legacy
- L = Long Term Care/Confinement Care
Because you’re locked into a contract, if you break any contractual obligations, expect hefty penalties. Unfortunately, this also makes annuities not as accessible as the money you have in a savings account.
How Long Have Annuities Been Around For?
Even if you weren’t familiar with annuities doesn’t mean that they’re a recent financial product. Believe it or not, annuities have been in existence for centuries. In fact, annuities can be traced back to Ancient Rome. Back then, people would make a single payment in exchange for annual lifetime payments.
However, annuities didn’t become popular until the Great Depression. Then, because of the volatility of the stock market, many people were anxious about how this would affect their retirement. What’s more, the New Deal emphasized savings.
These annuities weren’t that drastically different from their early Ancient Roman cousins. People bought them with a lump sum to receive a series of fixed payments. As the 20th Century progressed, variable and indexed annuities were introduced.
If you want to learn more about the history of annuities, check out our A Brief History of Annuities.
How Does an Annuity Work?
Annuities involve transferring risk from the owner, known as the annuitant, to the insurance/annuity company. The company offering the annuity assumes the risk on the owner’s behalf by charging a premium. Depending on the type of annuity, premiums can come in the form of a single payment or several payments. It’s during the accumulation phase that premiums are paid.
In contrast to other types of insurance, you aren’t required to continuously pay premiums on the annuity. In time, you’ll cease making annuity payments and will receive payments instead. When this occurs, your contract enters what is called the payout phase.
Annuity payments can be handled in a variety of ways. For example, it’s possible to design an annuity so that you’ll receive payments for your lifetime or those of your heirs. Another option is to combine a lifetime income stream with a guaranteed “period certain” payout.
What’s a “life with the period certain annuity?” First, the annuity promises income for life. Then, if you die within a specific timeframe, the annuity will pay your beneficiary the remaining value of the account you were supposed to receive.
Annuities are paid over a long period of time. They’re also based on the recipient’s life expectancy, which is similar to Social Security. So you can also expect payments to be smaller if you begin receiving income when you’re younger or if the specific term is longer.
There are many annuity payment options, including monthly, quarterly, annual, or even as a lump sum. In addition, they can be initiated immediately or postponed for years.
What’s the Difference Between Annuities and Life Insurance
Is there a difference between a life insurance policy and an annuity? Absolutely. So, let’s quickly run down the differences.
If you pass away, life insurance provides your loved ones with financial security. With an annuity, you can grow money while earning income at the same time. Both should be considered as part of a long-term financial plan.
While there are similarities, the purpose of each is vastly different. Again, life insurance is designed to help protect your loved ones against financial loss upon your death. This money can be used for daily living or mortgage expenses. Additionally, life insurance can cover funeral costs or college funding.
On the other hand, the main goal of an annuity is to provide you with a guaranteed income. You have the option to receive these payments for a specific period of time or for your entire life. Additional benefits include;
- An opportunity to grow an account’s value tax-deferred
- Future income that cannot be outlived
- Survivors may qualify for a lump sum payment
The Five Main Types of Annuities
You might think that a pizza is all the same. But, in reality, there are a wide variety of tasty pizza types like Neapolitan, Sicilian, New York-Style, Chicago Deep Dish, Detroit, California, and Greek. And that’s not even taking into account all of your toppings options!
While there aren’t as many annuity types, there are five different types of annuities.
- Fixed annuities. Annuity owners receive a fixed interest rate for a designated period of time. For example, with Due, you’ll receive 3% on everything that you have deposited. As such, this makes this type similar to a certificate of deposit. Even though the rate won’t increase when the market performs well, it’s a safe and predictable option.
- Variable annuities. Unlike a fixed annuity, a variable annuity is a contract whose returns fluctuate with the stock market. That means gains and losses are determined by that performance making it a riskier and less predictable option.
- Fixed indexed annuities. This type of annuity combines the features of both a variable and a fixed annuity. Like a fixed annuity, it offers a minimum guaranteed rate of return to investors so that the principal is protected. But it also tracks an underlying index, such as the S&P 500). As such, higher gains are possible when the stock market rises. Of course, there are caps, spreads, and participation rates that will affect the upside, so you should always read the fine print.
- Immediate annuities. Here you would pay a lump sum to the insurance company and start receiving income payments, well, immediately. Payments typically begin within 30 days of the payment. Some immediate annuities offer lifetime payments, while others are designed to pay out over a fixed period of time. Annuity income is often affected by interest rates, which will most likely affect payouts.
- Deferred annuities. With this type of annuity, you’ll also make an upfront payment. However, the annuity company won’t issues payments until a later date. Payouts from deferred annuities may be higher than with immediate annuities since they have more time to grow. The trade-off is that it’s difficult to make early withdrawals.
Why Buy an Annuity?
The short answer? You purchase an annuity because it provides a guaranteed income for the rest of your life –no matter how long you live. That can be a major selling point if you’re concerned about outliving your savings.
Moreover, after you’ve maxed out your 401(k) and IRA, annuities can be a more tax-sheltered way to save for retirement. The reason? You can save as much as you want with annuities since there aren’t any contribution limits.
And, because of the guaranteed income you’ll receive from your annuity, this allows you to be slightly more aggressive with your other assets.
Annuity Fees and Penalties
Perhaps the most common complaint regarding annuities is the fees and penalties associated with them. And, to be fair, that is a valid argument. However, fee schedules vary from company to company. As a result, an annuity policy owned by one provider may have entirely different costs than annuities owned by other providers.
Generally speaking, the more complex an annuity is, the more expensive it is to own. Consider these costs on a percentage basis that’s based on the entire value of the annuity. This will help you keep these charges in perspective. In a way, it’s kind of the same as looking at the cost of a mutual fund or exchange-traded fund (ETF).
The most common annuity fees and penalties you can anticipate include;
- Administrative Annual Fees. You pay a baseline charge to maintain ownership of your annuity contract.
- Annuity Riders. With riders, you can customize your annuity so that it fits your specific needs. For example, adding a death benefit.
- Commissions with Annuities. Regardless of the company or type, you’re going to have to pay a commission when you buy an annuity.
- Fund management. If your annuity has mutual fund investments, you’ll be charged management fees.
- Investment Expense Ratios. If your money is attached to an underlying investment, an expense ratio will be carried with each mutual fund, ETF, or index fund.
- Mortality and Expense Risk Charges (M&E). Annuity fees will never be changed as a result of this fee.
- Annuity Penalties Fees. The IRS will receive 10 percent of your withdrawal if you are under age 59 ½. Furthermore, you’ll also be charged a surrender fee. This typically ranges from 5 to 15 percent. The longer the annuity is held, the lower the charge will be.
- Surrender Charges. If you withdraw before the beginning of your regular payments, you’ll be charged surrender fees.
- Tax on Annuity Beneficiaries. If your annuity has gained any value, your beneficiaries will be taxed.
- Underwriting. These fees go to the actuarial risk-takers on the benefits.
Aside from contract fees, you may also encounter distribution charges, redemption charges, and transfer charges as an annuity owner.
Taxes and Annuities
An annuity is tax-deferred. That means you don’t pay taxes on the money while it is in the annuity. As with a 401(k) or an IRA, your taxes are only due when you withdraw the money.
An annuity funded with pretax dollars, or a qualified annuity, is subject to ordinary income tax. As such, you’ll pay everything you withdraw. However, when you fund your annuity with after-tax dollars, you have a nonqualified annuity. As a result, you won’t owe taxes on the part of your withdrawal that represents your original principal. Instead, you’ll owe taxes on your earnings.
In nonqualified annuities, the exclusion ratio helps determine which parts of your withdrawal are principal and which are considered earnings. Essentially, the exclusion ratio reduces your principal return over the course of your actuarial life.
What Happens to Your Premium When You Die
That depends on how you structured the annuity. If you went with a life-only option, payments would stop upon your death. If you’re married, you might want a joint-life structure where payments will continue until the second person passes away.
- Life with a refund. Payments will keep coming to you so long as you live. The minimum amount you put in is guaranteed for you or your beneficiary. After you die, your beneficiary will receive payments up to the cost of the annuity.
- Life with period certain. Payments will be issued until your death. They’ll continue, though, for some period of time, say, 10 or 20 years, after you die. Your beneficiary will receive the payments if you pass away before the period ends.
- Period certain only. After a certain number of years, the income ceases. Your beneficiary gets the payments if you die before the end of the specified period. In the event that you outlive the term, your payments stop.
Annuity Terms to Know
- Cap. The maximum amount an investor can earn annually. There are usually different cap choices available on each contract.
- Spread. Amount deducted before an insurance company credits annuity gains. For example, if the S&P 500 increases by 6% and the spread are 2%. The resulting gain to the investor would be 4%.
- Participation rate. The investor is credited with a percentage of index gains. For example, let’s say there’s a 50% participation rate and a 10% increase in the S&P 500; the investor receives a 5% gain (50% of 10%).
- Surrender charge. The investor will be charged an early withdrawal penalty if they withdraw more than the predetermined free withdrawal amount. It’s common for the first five to ten years of a contract to feature surrender charges.
- Income rider. There are annuities with income riders that use a second, separate value of the account to determine a future income stream. It has no lump-sum value and cannot be transferred to anyone besides a spouse. In most cases, income riders will grow at a fixed rate every year and are not affected by market fluctuations. While some companies charge a fee for income riders, most do not.