The New Annuities Investor: What You Need to Know

An annuity is like a financial agreement, or contract with an insurance company. The investor, or annuitant, pays the insurance company a lump sum of money, or a certain amount through periodic payments. In return, the insurance company provides income to you, at a fixed or variable rate, as agreed to with them.  An annuity is a way for people to create a reliable stream of income as they plan for retirement.  It is the only type of investment which is designed to outlive the investor.  Annuities can be powerful tools for building retirement security, especially for those wanting guaranteed income or for those needing tax-deferred growth. For first-time buyers, the key is understanding the costs, payout options, and tax implications, and balancing the pros and the cons based on your personal needs.

Like with most things, there are costs associated with annuities.  Some of the common costs are administrative fees, which are usually a small annual percentage to cover the cost of managing your annuity contract; mortality and expense (M&E) fees, which compensate the insurer for taking on a financial risk; and management fees for variable annuities with investment options which require managing the underlying assets in subaccounts.  Not all annuities contain all the fees listed.  Fixed annuities are generally simpler and less expensive to manage, while variable annuities often include more features and therefore cost more.

Annuities pay out income in different ways.  It depends on the type of contract you choose. You may decide upon an Immediate Annuity, where you pay in a lump sum amount and begin receiving income almost immediately, often within 30 days to a year, and payments can be monthly, quarterly, or annual; Deferred Annuity, known as the most flexible type of annuity where you invest now, allow the money to grow tax-deferred, and receive income later, when you are in a lower taxable bracket;  Fixed Annuity, which provides a non-fluctuating, guaranteed interest rate and therefore steady and predictable income; Variable Annuities, where payments depend on investment performance; and Indexed Annuities, which provides investment returns linked to a stock market index (such as the S&P 500), but typically include caps or participation limits.  With these annuities, payment options often include lifetime income (payments continue as long as you live), joint life (married people), or period-certain payments (such as 10 or 20 years).  More risk provides the potential for higher growth but come higher market risk can translate into substantial losses.

The tax rules vary depending on how you purchase the annuity and how you withdraw from it.  Here are a few common tax treatments with annuities: Tax-Deferred Growth, where your investment grows tax-deferred until you begin withdrawing earnings, at which point you are taxed; Taxation of Withdrawals, which are funded with retirement accounts like IRAs or 401(k)s), and the entire withdrawal is taxable in a qualified annuity; a Non-Qualified Annuity (funded with after-tax dollars), where only the earnings portion is taxable, and your original investment comes back tax-free; and Lifetime Income Payments, which provides income payments from a lifetime annuity, and include both taxable and non-taxable portions of income, spread out according to IRS formulas.  With all three investment strategies, withdrawals before age 59½ may trigger a 10% IRS penalty, unless there is an exception.

PROS

There are very popular reasons that people want to invest in annuities.  A few key reasons are guaranteed income, which provides stable and predictable payments, you cannot be outlived by you, by design; tax deferred growth, where investments grow without any annual tax obligation, and as a result, which can accelerate long-term growth; protection from market turn downs, where fixed and index annuities offer downside protection, making them more appealing to those who tend to be more risk averse; optional features such as riders that guarantee income, enhanced death benefits or long term care features but come at an additional cost; and long-term planning, which protects against the risk of outliving your savings.

CONS

Annuities are not for everyone. There are some disadvantages to them such as limited liquidity, which happens as your money may be tied up for years and early withdrawals can trigger surrender charges and tax penalties; high fees, as sometimes annuities, particular variable annuities, contain layers of fees that can eat away at the income the annuity earns, and lower returns on certain products, such as fixed annuities, which may provide the least amount of return when compared to variable annuities. Fixed annuities may not keep up with current interest rates, which can be a detractor since rates are locked in for a fixed period. Annuities are not ideal for short term investment goals or as emergency funds.  Annuities can work for this with moderate to substantial sums to invest.  They are less appealing to those who enjoy even greater market risks, and other investment vehicles that provide even greater returns.

A consultation with a knowledgeable advisor can help you determine whether an annuity fits your long-term financial plan and which type is most appropriate for you.