“Thirty to 40 years ago, most financial decisions were fairly simple” — Scott Cook
Annuities are insurance products that are great financial vehicles to use in long term planning and retirement planning. There are different types of annuities. There are fixed annuities, variable annuities, immediate annuities and index annuities. Many insurance companies give their annuities fancy, creative names but they still fall into one of these categories once you start reading the fine print.
So what is an annuity exactly? Before I go into the different types, let me explain exactly what an annuity is. An annuity is an investment vehicle offered by an insurance company. Although annuities are not FDIC insurance like a bank, they are insured by the insurance company that offers it. The interest rates are usually higher than certificates of deposits but they may require longer commitments. Many annuities have a contract of 5, 7, 10, or 15 years. It is also treated as a retirement vehicle which means if you put money in any annuity and you are under 59 1/2, if you take money out, you will be penalized just like a traditional IRA account. (There are ways around it but that is another blog, another time). If you are over 59 1/2, you will not receive this particular penalty. Retired individuals can also set up income streams.
So now that I gave you the generic definition, let’s talk about 4 different kinds
The Fixed annuity
The easiest annuity, but not the most popular, is the fixed annuity. This annuity usually does not have the highest rate of return because the company is giving you a guaranteed interest rate. The rate is usually between 2-5%. The interest grows in the annuity tax deferred. Of course tax deferred means eventually you have to pay taxes. While the money is in the annuity, you do not pay taxes for interest earned at all. Once you take your first withdrawal from the annuity, you do pay taxes on interest withdrawn. This annuity is a great transition for people who love CDs. I had many clients who only knew of bank CDs as the only form of interest accumulation. Many of these people do not really understand the stock index and would prefer not to. With a fixed annuity, they can earn a higher rate, tax deferred.
The Variable annuity
This annuity is different from the fixed annuity because the interest is earned through an investment portfolio. You pick a portfolio of different stocks, bonds, and mutual fund accounts. This means that your principle amount invested in the variable annuity and the interest earned fluctuates. Of course since this is a market driven policy, this means that there are service charges associated with this account as well. The charges vary with each company. The variable annuity also has a payout phase where you can set up how you want to receive your money. It can be a fixed amount each month regardless of the performance of the annuity or you can receive payments based on the annuity interest gained. The latter will have different payments each month. You can also set up certain payout time period or lifetime time period, depending on your goals and planning. In my opinion, this is not the product for people who want to leave a legacy; it is mainly for people who need additional income in their retirement years and do not mind higher risk for higher return.
The Indexed annuity
Indexed annuities have so many names to this type of annuity. Some common names are equity-indexed annuity, hybrid annuity, or fixed indexed annuity. This is the most complicated annuity to explain so get ready. This annuity follows the market so it has a portfolio of stocks, bonds, mutual funds that you choose from. The reason that it is considered a hybrid annuity is that if the market increases, you gain the interest earnings. (Some companies cap the amount of interest earnings you receive, that means if your portfolio has a 20% gain, you will only receive 7%, so check the fine line). The flipside is that if market decreases, the insurance give you a flat fixed rate instead of losing interest. So that means if the market is down -15%, you receive a flat rate between 1-3%, depending on the company, instead of incurring a loss. Also with the indexed annuity, there is a rider where you can lock in rates. Some companies handle this differently. Some companies give you an average on your anniversary date and if you want to lock the amount in on that date, you can. If you had a good year of returns in 2014, say 10%, you can lock in this amount for the following year so your gains will never go below 10%. Other companies give you an average each month and you can choose when to lock it in. For example, you see in January the rate is 5% and then by April it is 8%, you can lock it in the April’s rate. The downside is if you lock in your 8% in April and in August you receive 15%, you can’t lock it in again. You have to wait until April of next year to lock in a new rate. This is an annual option you have for the life of the annuity. This is a great feature of the annuity. I introduced this annuity to people who want to experience the excitement of market gains but are afraid to accept loss.
This type of annuity was used often before many companies started creating their long term care products. With this annuity, you place a lump sum of money into it, and it pays you an income stream immediately. The rate of return is usually fixed but the income stream could be set up to last for a lifetime. This means that the income stream will continue even when the initial money has been exhausted and will last until the owner has passed away. I have offered this solution to clients who had parents in retirement homes and had to pay a monthly bill but did not know if they had enough money to care for their loved ones 3-5 years from now. With the lifetime income stream, there is a guaranteed amount to pay for long term care for the life of the patient.
Annuities are a great addition to anyone’s retirement planning. You just have to understand which annuity fits your needs. Now I explained the basics of annuities. There is so much more to these annuities but I can only fit but so much into one blog. I did not really get into the income stream part of the annuities or the tax deferred part but I will cover that another time.