What You Need to Know About Annuities
Annuities are an appealing option for investors because they provide guaranteed income for the rest of your life.(GETTY IMAGES)
WITH THE RETIREMENT playing field littered with crushed investments and dreams, the safety ofguaranteed income streams looks more attractive each day. Some annuities can provide such a guarantee.
If you ask an insurance company to define annuities, the marketing phrase the insurer will probably use is: “Annuities can produce an income stream you can’t outlive.” Annuity payments can last for as long as you live – or even longer – because the payments are based on your life expectancy.
Here are 4 things you need to know about annuities:
1. What is an annuity?
An annuity is a contract between you and an insurance company to cover specific goals, such as principal protection, lifetime income, legacy planning or long-term care costs.
Even though they may be marketed as investments, “annuities are not investments,” Haithcock. “They’re contracts.” They lock you and the insurance company into contractual obligations, and breaking them – if that’s even possible – can come at a steep cost.
“Annuities work by giving you limited access to your funds annually much like how income is received from Social Security,” Bender says
2. Why buy an annuity?
You buy an annuity because it does what no other investment can do: “provide guaranteed income for the rest of your life no matter how long you live,” says Walter Updegrave, editor of RealDealRetirement.com, a site offering retirement planning advice.
This makes annuities popular retirement planning strategies. Annuities can provide more tax-sheltered ways to save for retirement if you’ve already maxed out your 401(k) and IRA. Since annuities have no contribution limits, you can save to your heart’s content.
And since your annuity will provide guaranteed income later on, you may be able to take a more aggressive investing strategy with your other assets.
3. How does an annuity work?
An annuity works by transferring risk from the owner, called the annuitant, to the insurance company. Like other types of insurance, you pay the annuity company premiums to bear this risk. Premiums can be a single lump sum or a series of payments, depending on the type of annuity. The premium-paying period is known as the accumulation phase.
Unlike other types of insurance, you don’t pay annuity premiums indefinitely. Eventually, you stop paying the annuity and the annuity starts paying you. When this happens, your contract is said to enter the payout phase.
There’s great flexibility in how annuity payments are handled. Annuities can be structured to trigger payments for a fixed number of years to you or your heirs, for your lifetime, until you and your spouse have passed away, or a combination of both lifetime income with a guaranteed “period certain” payout. A “life with period certain annuity” pays you income for life, but if you die during a specified time frame (the period certain years), the annuity will pay your beneficiary the remainder of your payments for the contractual period you chose at the time of application.
As with Social Security, annuity lifetime income streams are based on the recipient’s life expectancy, with smaller payments received over longer periods. So the younger you are when you start receiving income, the longer your life expectancy is, or the longer the period certain term is, the smaller your payments will be.
Payments can be monthly, quarterly, annual, or even a lump sum. They can start immediately or they can be postponed for years, even decades.
“Annuities are highly customizable,” Haithcock says. Finding an annuity to meet your needs comes down to two questions, he says: First, “what do you want the money to contractually do? And second, when do you want those contractual guarantees to start?
4. A fixed annuity for principal protection.
Fixed annuities pay a guaranteed minimum rate of return and provide a fixed series of payments under conditions determined when you buy the annuity.
During the accumulation phase, the insurance company invests the premiums in high-quality, fixed-income investments like bonds. Because your rate of return is guaranteed, the insurance company bears all of the investment risk with fixed annuities.
A multi-year guarantee annuity (MYGA) is a type of deferred fixed-rate annuity that’s “great for conservative investors who want guaranteed principal protection,” Nuss says.
It works much like a certificate of deposit by guaranteeing a rate over a fixed period. However, unlike CD interest, the interest on a MYGA isn’t taxed annually but rather allowed to grow tax-deferred until withdrawal.
