Initially I was thinking this would be yet another “back to basics” article, but then I realized that I’ve met with numerous families and I think I’ve only come across a handful of individuals that actually understood exactly how annuities worked. Sure, you get a lot of folks who were told by their friend’s uncle that an annuity  is “good” or “bad”, but this third-hand information is sketchy at best.

So let me clear the air a little and provide some basic information about annuities that everyone ought to know…annuities are a type of insurance contract. The contract allows an individual to exchange money for guaranteed income payments either immediately or at some point in the future.

All annuities are issued by insurance companies, although some are sold through banks or brokerage houses.

Types of Annuities

SPIA

A single pay deferred annuity, or SPIA for short, is the most basic kind of annuity. A SPIA requires you to deposit a lump sum of money with the insurance company. That money is then converted to guaranteed monthly payments, plus a fixed rate of interest, for a set number of years up to and including lifetime payments. You can’t get access to your savings once it’s converted to monthly payments.

Deferred Annuity

This type of annuity acts more like a long-term savings vehicle. Money is deposited into the annuity and interest is credited to the account value. Depending on the type of annuity, interest may be credited either on a guaranteed or variable basis.

Three common types of annuities are fixed, variable, and equity indexed. Fixed annuities pay a fixed rate of return, usually comparable to a bank CD. Variable annuities pay a variable rate of return by allowing you to invest money into subaccounts, which are essentially just mutual funds. The rate of return depends entirely on the performance of the mutual funds you select. Equity indexed annuities offer a blend of variable and fixed annuities. The interest credited to an equity indexed annuity is based on the upward movement of a specified stock index – usually the S&P 500. All interest earned and principal are guaranteed against loss. How equity indexed annuities work is quite simple, yet often misunderstood.

Tax & Probate Advantages

Annuities offer tax advantages that are difficult if not impossible to recreate outside of the annuity. Money that is held in an annuity is tax deferred. When you draw money out of the account, the money is taxed at ordinary income tax rates.

Annuities also bypass probate if there is a named beneficiary (provided that you do not name your estate as the beneficiary). This is a provision of insurance that has often been overlooked by investors as a relatively inexpensive way to quickly transfer money to heirs at death.

Costs

While fixed and equity indexed annuities are typically fee-free (or can be structured to be fee-free), variable annuities often carry fees because of the mutual funds inside the contract along with account maintenance fees. If the the fund fees are substantial, variable annuities can eat away at any gains made inside the contract, so be careful.

The least favorite (and most misunderstood) aspect of annuities are the surrender charges. Every annuity carries a surrender charge. These surrender charges are built into the contract for several reasons. Agents and advisers who sell annuities are paid by the insurance company and although none of your money goes to the agent selling an annuity, the insurance company does need a way to recoup the costs they pay to their sales force.

But, surrender charges also serve another important role. They keep you in the annuity for a long time. Annuities derive most of their benefits from a simple “buy-hold” strategy, and thus being a long-term savings vehicle, you benefit most by holding onto an annuity. The surrender charge encourages and reinforces this behavior by charging fees for early termination before the maturity date.

Maturities can vary from 1 year, CD-type annuities, to 5 years, or to longer terms of 10 or 15 years. To compensate you for your patience, a typical provision on all deferred annuities is a 10% free withdraw of the account value every year.

Annuities are also subject to IRS regulations concerning withdrawals from a non-qualified retirement account. Any withdrawals made before 59 1/2 are subject to a 10% penalty in addition to ordinary income tax rates.

I know that the jury is hung on this issue. You can talk to one financial adviser and he’ll say that annuities are a good buy. You talk to someone else, and they’ll say “don’t do it, ever.” The truth is that, like all things in finance, it depends. Whether an annuity is good for you depends on your financial goals and what you’re trying to accomplish.

You might also like

1. Arbitrary Retirement Plan Rules, Part 3: Annuities
2. What’s Wrong With Indexed Annuities?
3. Equity Indexed Annuities Get A Bad Rap, But Do They Deserve It?

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This entry was posted on December 18th, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Insurance & Savings, Retirement Planning