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Retirement 101: What Are Annuities?

Dec. 13, 2013
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As pensions have become all but extinct, the allure of annuities has grown ever stronger. These tax-deferred investments sold by insurance companies allow you to grow your nest egg and then, when you’re ready to retire, trigger an income that you can’t outlive. Who wouldn’t like that: your own personal pension? While annuities can be an important part of your retirement savings strategy, there are many things to consider, including what kind, when, and how much?

Fixed annuities

This is the grandpa of annuities. A fixed annuity takes your contribution and the insurance company invests it. You have no say in how the money is managed. Once you trigger the income stream, called annuitization, a fixed dollar amount is paid to you. All annuities allow you to determine the payout option when you sign up. It can be for a single life (perhaps yours), or for joint lives (such as for as long as you live, and then for as long as your spouse lives). There are many variations in the payout options, your insurance agent can explain them all – hopefully with some visual aids.

Variable annuities

Even more popular are variable annuities, which allow you to choose from a number of investment options, including mutual funds, bond funds and money market accounts. Some VAs have a guaranteed minimum death benefit feature, which will set a “floor” for investment losses, or a minimum percentage growth rate.

Equity-indexed annuities

A newer spin on the variable annuity is the “equity-indexed annuity” which will track, to some degree, the performance of a stock index like the S&P 500, but also provide guaranteed minimum interest earnings.

It may sound like the ultimate investment deal, but these types of annuities are complicated, so much so that FINRA, the self-regulatory agency for the securities industry, issued an investor alert on them a few years back. Now, that doesn’t mean they’re bad – just hard to understand.

When to consider an annuity

Because annuities offer you an investment that can grow without the impact of taxes until withdrawals are made, they can be a good alternative to consider when other tax-deferred investments are maxed-out.

Say you’re putting the legally allowed limit into your 401(k) and you make a full contribution to your IRA every year, too. You also have a regular investment account with tax-efficient holdings, perhaps in municipal bonds or low-turnover exchange-traded funds (ETFs). That’s the account you can tap when you really need to, prior to drawing on your tax-deferred investments. If you have all of that, but you’re still really flush and have more money to sock away, annuities might be a good choice.

The downside of annuities

And now the reality check.  As good as they sound, here are the drawbacks to annuities:

  • They can be very expensive. Annuities are investments wrapped inside an insurance policy. There are fees for the insurance, charges built into the investments, and fees if you try to get out of the annuity (called surrender charges). Insurance agents and stock brokers can make a lot of money selling annuities, and that’s always a good reason to be wary.
  • Annuities are hard to understand. You must read the paperwork before you sign. All of it. And it’s going to be very dry reading. Good advice: never buy anything you don’t completely understand. Hey, the Securities and Exchange Commission even says most financial advisors don’t understand what they’re selling when it comes to annuities.
  • As an insurance product, the guarantees offered by annuities are only as strong as the financial capacity of the issuer. And insurance companies have also been known to withdraw benefits — even years after a contract has been issued.

Annuities are long-term investments with a lot of moving parts. If you are considering one, consult with a trusted advisor and ask plenty of questions.

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