We’ve all heard about IRAs, 401ks, certificates of deposit, savings accounts, money market accounts, and all sorts of products to help you save money for retirement, but what about annuities?
An annuity is a contract between you and the insurance company, in which the insurer is required to make payments to you, either immediately or at some point in the future.
Annuities first became popular in the United States during the Great Depression, when people were worried that the stock market’s volatility would endanger their retirement funds, and ever since then, people have sought them as a way to complement other retirement income sources like Social Security or pension plans.
Annuities offer predictable retirement income, protection against outliving your savings, inflation protection, tax-deferred growth, unlimited annual contributions, and death benefit, among other perks.
But how do you choose the right one? Well, here’s a list of a few things to consider when comparing annuities:
ANNUITY TYPE
Just like any other insurance product, there are many types of annuities to choose from, with single or flexible premiums, and fixed or variable interest rates, but insurance companies usually divide them into two main categories: immediate and deferred.
Immediate Annuities
With an immediate annuity, you invest a one-time lump sum, also known as single premium, and the insurance company begins issuing regular monthly payments right away or within a year after the contract begins.
Immediate annuities allow you to choose whether you’d like to receive a fixed amount for the life of the annuity, or a variable amount based on the investments’ performance in your annuity. This type of annuity is best suited for retirees who are concerned about outliving their savings, since it is low-risk. However, one of the main disadvantages of immediate annuities is that once they are purchased, you can’t cancel them for a refund of the principal from the seller. This might be problematic if you need access to a considerable amount of money in an emergency situation.
Deferred Annuities
With deferred annuities, you have the option of single or flexible premiums, meaning you can make a one-time lump sum investment, or multiple investments prior to your retirement date. The main advantage of deferred annuities is that during the years prior to your retirement, your investments have a chance to grow, tax-deferred. This type of annuity is best suited for people under 40, since it is considered riskier than immediate annuities.
Once you reach retirement age (at least 59½), the amount of your monthly checks will be based on the size of your annuity portfolio.
Deferred annuities are divided into three subcategories: fixed-deferred, variable-deferred, and equity-indexed.
Fixed-deferred annuities place your lump sum investments in low-risk asset portfolios and earn a guaranteed annual rate of return until you reach retirement.
Variable-deferred annuities allow you to invest in stock and bond funds offered by the insurer that holds your annuity contract. Once you reach retirement age, your account can be worth more or less than your initial investment.
With equity-indexed annuities, your investment reflects the performance of a broad stock index and the insurance company provides protection against market declines by guaranteeing a minimum return on your investment.
RIDERS
A rider is an amendment to an insurance policy that can add coverage or set some exclusions. Since annuities are issued by insurance companies, and are considered a type of policy, many companies offer different riders that can adjust to your needs.
Some of the most common riders offered for annuities are: long-term care or nursing home insurance, cost of living adjustments, refund or return of premium guarantees, impaired risk coverage, guaranteed minimum withdrawal benefit, lifetime income benefit, and death benefit.
Long-term care or nursing home insurance are usually offered with fixed-deferred annuities, and are designed to help cover the costs of long-term care or nursing homes, in case you end up needing one or the other.
Cost of living adjustments are commonly offered by immediate annuities and are designed to combat inflation by raising your monthly income by a set percentage, so you don't end up short.
Refund or return of premium guarantees are issued as a lump sum (cash refund) or a series of payments (installment refund). These riders are designed to be received by your beneficiary, if at the time of your death, the total of payments received do not equal the amount of premium you paid into the annuity.
Impaired risk coverage is usually available for immediate annuities. If you add this rider to your contract, the insurance company will have to pay you more per month, if you develop an illness that could reduce your life expectancy.
The guaranteed minimum withdrawal benefit essentially guarantees that you’ll get your money back in case your account doesn’t perform well and decreases in value. With this rider, you can withdraw a set percentage from your annuity every year until the original premium paid is withdrawn.
The lifetime income benefit is an increasingly popular feature offered for variable-deferred annuities. This rider is best suited for those who are planning a lengthy retirement. The lifetime income benefit ensures that you’ll never outlive your assets, even if your account balance goes to zero.
The death benefit can be added to most variable-deferred annuities, and works as a guarantee that upon your death, the total premiums invested are paid to your beneficiaries.
COSTS
One of the most important things to consider when shopping for an annuity is its costs. Some of the most common expenses include administrative fees, surrender fees, underlying fund expenses, insurance charges, rider fees and tax penalties. Costs and fees vary from one annuity contract to the next, so it’s important to have a basic understanding of what they are, to choose the annuity that best fits your financial needs.
First, let’s talk about administrative fees. Administrative fees cover expenses such as funds transfer, recordkeeping, issued account statements, and customer service, associated with servicing your account. These fees may be charged as an annual flat fee, or a percentage of your account value, depending on the issuing company.
Underlying fund expenses are charged by the company to cover the costs of managing mutual fund investments in your annuity portfolio, and the percentage charged can be found on the annuity prospectus provided by the issuer.
Insurance charges, also known as mortality and expense fees, pay for guarantees included in the annuity. These charges are equal to a certain percentage of your account value, and sometimes are used to pay the commission of the seller.
Some companies will offer consumer additional coverage for protection against inflation, long-term care, and lifetime income, among others. These additional features, known as riders, also come at an additional cost.
Usually, there is a limited amount of penalty-free withdrawals that you can make during the first years of an annuity contract. Once you go over that limit, the company will charge you a surrender fee (also known as contingent deferred sales charge), which is usually a percentage of your account value. Additionally, since annuities are meant to be a source of income for retirement, if you make a withdrawal before the age of 59 ½, you’ll have to pay a 10% tax penalty to the IRS on top of any taxes you owe on the income.
PAYOUT OPTIONS
One of the many perks of annuities is that you can choose the way you would like your payments to be calculated. However, it should be noted that once the contract is signed, the payout option is locked into the annuity, and companies usually don’t allow you to change it. Some of the most popular payout options available are: fixed period, life with period certain, joint and survivor life, life contingency, lump sum payment, and lifetime payments.
Fixed period payouts allow you to choose the monthly amount you would like to receive, and the payments continue until you stop them or run out of funds.
Life with period certain guarantees you income for a determined period of time, meaning that even if your account runs out of money during that time, you (or your beneficiaries) will continue to receive payments until the end of the selected period.
The joint and survivor life payout is great for those who want to make sure their spouses or partners are taken care of after their death. This type of payout guarantees you and your spouse, or partner, payments for as long as either of you live.
Life contingency or death benefit payout stipulates that if you die before the payment phase kicks in, your beneficiary will be paid the annuity amount in full.
With the lump sum payment, you’ll have access to your annuity’s full amount, which is great for those who want to manage their money as they please, without waiting for monthly payments.
Lifetime payments, also known as life-only, guarantees you income for as long as you live. The payments can be fixed or variable. However, this type of payout doesn’t have a survivor benefit, meaning that if you die before running out of money, the company will keep the rest.
FINANCIAL STRENGTH
Annuities are issued by insurance companies, but are also sold by banks, brokerage firms, independent agents, and mutual funds companies, which is why sometimes they are mistaken as investment products.
That being said, since annuities are insurance products, they are not insured by the FDIC, SIPC, or any other federal agency, meaning that if the insurance company goes under, the federal government is not responsible for protecting you against any losses.
However, states have guaranty associations that are part of a larger network known as the National Organization of Life and Health Insurance Guaranty Associations (NOHLGA), which protect policyholders when a life or health insurance company fails. Guaranty associations have protection limits that can range anywhere between $100,000 and $500,00, depending on what’s offered by the state. So, it’s important to check if the insurance company is a member of a guaranty association in your state before purchasing any contracts. Additionally, you can look up the company’s financial stability ratings on organizations like Standard & Poor’s, among others, so you have an idea of how well the company is doing prior to your purchase.
At the end of the day, when it comes to annuities, there is not a “one-size-fits-all” contract, since they are highly customizable products. So, we encourage you to read through our Top Ten annuity company reviews, in case you need additional help on your quest to find the annuity that’s right for you.