Is an annuity good or bad?
First and foremost, know that an annuity is an insurance product. As soon as you see the word insurance, you should ask what am I insuring? With an annuity you are insuring income that you can’t outlive, future income, or your principal.
According to Investopedia, an annuity is defined as a contract between you and an insurance company in which you make a lump sum payment or a series of payments and, in return, obtain regular disbursements beginning either immediately or at some point in the future. Definition of an Annuity
Single Premium Immediate Annuity
A single premium immediate annuity is also known as a SPIA. This is an annuity contract where you pay a lump sum of money to an insurer and in return you receive an income stream. The income stream can be for your life, multiple lives, or for a period certain. Let’s discuss each.
Single Life Annuity
With a single life annuity you will receive income for the rest of your life. This is an income that you can’t outlive whether you live one year or thirty years. When you die, the income stops. Many companies will also sell you a life annuity with refund. Some people find this attractive because no one knows how long they will live and if they die early, their heirs get the remaining money rather than the insurance company.
Most married couples want to insure that their spouse is taken care of in the event of their death. When you purchase a SPIA for multiple lives it means the income will continue until both of you have passed away. The income will be lower for multiple lives than it will be for one life.
Rather than insuring income for life, a SPIA for a period certain does exactly that. An example would be for a 10 year period certain. The annuity will pay income for 10 years to someone whether you live or die. You can also buy one with a period certain and life. That simply means that the income will be paid to someone for a minimum period of years, but if you live beyond that, they income will continue for the rest of your life.
Think of a CD. The advantage of a fixed annuity over a CD is that the interest accrues tax deferred. With a CD, you will pay taxes on the interest every year whereas the growth inside of the annuity will not be taxable until it is withdrawn.
The fixed annuity can also be known as a fixed deferred annuity. It provides principal protection with some interest deferring the income until you need or want it.
Most fixed annuities will come with a surrender period. Pay close attention to this detail because this is how long you must stay in the product before you can withdraw the entire amount without paying a penalty.
Fixed Index Annuity
A fixed index annuity works similar to the fixed annuity to protect your principal, but does not usually come with a guaranteed interest rate. Often they are tied to an equity index such as the S&P 500. These products can be extremely complex and understanding them is a must if you consider buying one. You might want to seek the advice of someone that understands these products and isn’t getting paid to sell the product to you. Paying a couple hundred dollars could save you from making a big mistake.
Is there a place for a fixed index annuity. Yes, but understanding how they work is a must. Your expectations should be reasonable. Such as anywhere from 0-6%. Above that is unusual. As with the fixed annuity the growth is tax deferred.
Variable annuity contracts can be extremely complicated and can come with a multitude of different riders. The gist of a variable annuity is that your rate of return will vary depending on the performance of the sub-accounts that you choose. Think of a sub-account as a mutual fund. The growth in a variable annuity is also tax deferred.
Most variable annuities will come with a mortality and expense ratio. These typically range from 1-2% each year based on the value of your account. In the event of your death, your beneficiaries can expect a return of principal or your account value minus any withdrawals as a death benefit.
There are a multitude of funds available within a variable annuity and they will vary depending on the company your contract is with. Each of those funds will come with an additional layer of costs. What I’ve seen is somewhere between .5% to just over 1%. The prospectus provided will show you exactly what those charges are for each fund. Just as with the fixed index annuity, seeking help from someone that understands these products and isn’t getting paid to sell it is probably a good idea.
There may be other riders that you can add to your variable annuity. Some are available on a fixed index annuity. Each of these comes with a cost
- Guaranteed Income Benefit or Withdrawal Benefit – These vary from company to company, but they are designed to give you income despite the performance of the sub-accounts. They can be a benefit, but they also come with a price. Usually at least 1% of the benefit base. Repeat that. Of the benefit base not the account value. Know what this means!
- Guaranteed Death Benefit – For an additional cost, many variable annuities will guarantee a growing death benefit. In certain cases, this can be a very good idea.
- Nursing Home or Assisted Living Benefit – Again for an additional cost, but in the right circumstances, the benefit may be worth the cost.
Are annuities good or bad? Based on your individual needs, they can serve a valuable purpose in your life. If properly aligned with your goals and needs, they are good. When they are not properly aligned with your goals and needs, they are bad.
The difficulty comes when you don’t understand the annuity you’ve been shown. Or, if you are seeking higher returns and volatility is something you can handle, the annuity is probably not the right investment vehicle for you.
Before you sign, stop, and reach out to someone with experience for advice who isn’t being paid to sell the annuity. This is not an indictment on the person selling the annuity but it can weed out the salesmen who aren’t aligning their suggestion with your goals and needs.
When used correctly, an annuity can be great. When an annuity doesn’t match your needs, the annuity can become an extremely expensive mistake.