3 Annuity Questions Answered
As millions of American move swiftly into their senior years, their focus turns to their financial condition and how to continue to live out their remaining years in relatively the same lifestyle as that to which they have previously enjoyed. This situation is compounded by the fact that, as a nation, we are living longer than earlier generations. Better healthcare and nutrition have extended most of our lives by years–if not decades. According to a study cited by USA Today in 2014, the average remaining lifespan for a U.S. citizen who was 65 years of age in 2012 is another 19.3 years. In many cases, Social Security alone will not provide enough annual income for a married senior couple to live on in the future.
One of the financial instruments that many people use to supply life-long retirement income is called an annuity. In combination with other savings vehicles, annuities help form the foundation for a well balanced, long-term financial plan.
1) What is an annuity?
An annuity is basically a contract with an insurance company. An interesting way to view an annuity is this: whereas a typical life insurance policy provides financial safety against dying too soon, an annuity policy can help protect an individual or family from financial woes if they happen to live too long.
2) How do annuities work?
In return for a series of payments or a large initial contribution, an annuity pays out a stated rate of return for a defined period, or for the remainder of the life of the annuitant or beneficiary. Annuities can be fixed, variable, or tied to an index. With fixed rate annuities, an annual interest rate is spelled out in the policy. Then, fixed annuities pay out the same amount every month for the duration of the annuity until the entire principal and accrued interest is paid. Variable rate annuities are typically indexed to stocks or bonds and fluctuate with the markets so the payouts will vary with the performance of the market. Fixed indexed annuities (FIA) share a combination of performance features from both fixed annuities and variable annuities. FIAs guarantee a base annual rate like a fixed annuity. FIAs also provide the opportunity to participate in stock market gains like a variable annuity with the decided advantage of protecting both principle and credited interest from stock market loss.
Annuities can also be structure as immediate or deferred. Immediate annuities start paying out right away and continue for a defined period, or for life. A deferred annuity doesn’t pay out until some future event such as retirement or a particular age. Deferred annuities have two phases call accumulation and distribution. Accumulation occurs when the principal or the growing balance in the account is earning interest and remains untouched. The distribution stage follows when the annuity starts paying out the accrued interest and principal.
It is extremely important to make sure the financial institution issuing the annuity is strong and will remain so for the duration of the payouts. Annuities are not federally insured so it is critical to assess the condition of the issuer. Furthermore, an annuity is meant to be a long-term financial vehicle so certain limitations exist that should be fully considered before purchasing. For example (unless specifically specified), an annuity owner may not be able to access the principal or the periodic premiums paid in before the payout without incurring substantial penalties. These are called surrender penalties and are imposed by the insurance company. In addition, depending on the structure, tax penalties can be assessed for early withdrawal.
3) What are annuity riders?
Just like any other financial product, annuities–specifically riders that provide additional benefits–carry certain fees and costs that should be clearly understood prior to purchase. Typical fees for annuity riders include mortality fees, maintenance fees and investment advisory fees. The total amount of these fees on an annual basis will lower the overall annual return of the annuity so it is important to shop and compare different products.
Because of their structure and long-term focus, annuities are typically best suited for older people getting closer to–or are already in–retirement. As part of a diversified retirement strategy, annuities can be a smart option that delivers the one thing most retirees find themselves worrying about–how to maintain their lifestyle and peace of mind while enjoying a guaranteed, steady income stream they cannot outlive.
It is always wise to seek the advice of your financial advisor or tax consultant before purchasing any financial product.
This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice. Please consult with a professional specializing in these areas regarding the applicability of this information to your situation.
Annuity product guarantees rely on the financial strength and claims-paying ability of the issuing insurer.