With the near disappearance of defined benefit pension plans, many retirees must rely on their own efforts or those of a financial professional to create an ongoing income stream in retirement. One way to do so is by purchasing an annuity.
These financial vehicles are designed to pay out regular income, either for a set period of time (such as 20 years), or for the remainder of the income recipient’s lifetime – regardless of how long that may be. This can help to reduce the worry about running out of money in retirement.
But not all annuities are the same. In fact, they can come in many different shapes and sizes, as well as with a lot of moving parts – so purchasing the wrong annuity for your particular objectives could actually put your retirement at risk.
There are also many misconceptions that surround annuities. So, it is essential to have an understanding of how these financial tools work, and why one type of annuity over another could be the right choice for your retirement portfolio.
While many investors and retirees are at least somewhat familiar with how stocks, bonds and mutual funds work, one financial vehicle that is still a mystery to some is the annuity. For this reason, there are many misconceptions about them. This can oftentimes lead investors to put the wrong type of annuity in their portfolio, or possibly even to forgo the purchase of one altogether.
Just like most other financial vehicles, though, if the right annuity is used for the right reasons, it can be extremely beneficial, both before and after retirement. Knowing the most common misconceptions about annuities can help you to defrock the myths so that you can make a more informed decision regarding whether or not an annuity is right for you.
The five biggest annuity misconceptions include the following:
At first glance, annuities may appear to be a bit complicated. They can also have a lot of “fine print” that is associated with them and that goes in-depth on various topics like how the return is calculated, what income options are available, and whether or not any optional “riders” can be added to the contract.
Annuities are actually an insurance product – which is why they can offer some enticing guarantees. There are different ways to categorize annuities. For example, these financial vehicles can be either immediate or deferred. With an immediate annuity, an income stream can begin immediately (or typically within 12 months of purchasing it).
Oftentimes, retirees will “roll” or reposition money from an IRA (Individual Retirement Account), a 401(k), or other retirement savings plan into an immediate annuity so they can begin receiving income from it.
If retirement is still a long way off, a deferred annuity may be a better choice. There are two “phases” in the life of a deferred annuity. These are the accumulation phase and the distribution – or income – phase.
During the accumulation period, the funds that are in the account grow on a tax-deferred basis. This means that there is no tax due on the growth until the time of withdrawal – which could be many years in the future. This, in turn, allows the account to grow and compound much more than that of a comparable account that is taxable.
In addition to being either immediate or deferred, an annuity can also be categorized based on the way the returns are generated. These include:
Fixed annuities are considered safe. These financial tools provide a set rate of return – either for a stated period of time, or for the entire life of the annuity. There is typically also a guaranteed minimum return below which the rate will never fall.
While the interest rates on fixed annuities are usually low, there are also no losses incurred in the account – no matter what happens in the stock market. So, given their principal protection and tax-advantaged growth, fixed annuities can be attractive to retirees and those who are preparing for retirement.
A fixed annuity may also include some additional features, such as a:
Many annuities offer a death benefit that will be paid to a named beneficiary if the annuitant (i.e., the income recipient) had not yet received back all of the contribution before they pass away.
Annuities may also include a waiver of surrender charges if the owner or annuitant is diagnosed with a terminal or chronic illness and/or if they must reside in a nursing home for a minimum period of time (which is typically 90 days or more).
If a fixed annuity is annuitized (i.e., converted to an income stream), there are typically several payout options to choose from. These may include:
One type of fixed annuity – the fixed index annuity, or FIA – offers the option of a higher return, but without worry about loss in a downward moving market. These annuities track the performance of one or more underlying market indexes, such as the S&P 500.
If the index performs well during an annuity contract period, then the account is credited with a positive return – typically up to a preset minimum, or “cap.” However, if the underlying index or indexes perform in the negative, there is no loss incurred in the annuity. Rather, it is still credited with a guaranteed “floor” rate.
Fixed index annuities also provide tax-deferred growth, as well as several different income payout options to choose from. Likewise, they may also include additional features like a death benefit, waiver of surrender charges and guaranteed income riders.
Variable annuities differ from fixed and fixed index annuities – also in the way that the return is calculated. That is because it is based on the performance of an underlying portfolio of equities – primarily mutual funds.
In this case, a variable annuity could produce a significantly higher return than a fixed annuity. But just the opposite is also true in that poor performance of the underlying investment vehicles could lead to losses.
Income can also be generated from a variable annuity. Due to the volatile nature of these annuities, though, the dollar amount of that income stream could vary. So, it can be difficult to know whether or not the income from this type of annuity will cover your ongoing expense needs in retirement. Unlike fixed annuities, variable annuities are also known for their fees.
As you search for the right annuity, you can quickly narrow down your options by asking yourself just a few questions, which can make your decision much less complicated. These questions include:
Most any investment or financial vehicle will have some type of charges or fees. While some of these may be difficult to decipher, others make an obvious (and sometimes significant) difference in the overall return that you attain.
As an example, many mutual funds will either charge an up-front commission when you purchase the investment, or you will incur a back-end load upon the sale of the fund. Likewise, the purchase of stocks and bonds could also come with a commission – and this, in turn, goes against the ultimate return on the investment.
There are also some financial vehicles that have “early withdrawal” penalties. These include CDs (certificates of deposit) and permanent life insurance policies. There are even some bank checking and savings accounts that will charge fees if you do not maintain a minimum monthly balance and/or if you incur “too many” transactions in a given time period.
Unfortunately, annuities have obtained a “reputation” for charging high fees. But in reality, this is only partially true. In this case, most annuities will hit you with a surrender penalty if you either cancel the contract entirely or access more than a maximum amount per year. Typically, the percentage of annuity surrender charges will decrease over time until they eventually disappear altogether.
If you add various “riders” (i.e., optional benefits) to an annuity contract, it is possible that you will be charged an additional amount of premium. So, it is important that you weigh out the difference between the added cost and the potential added benefit.
This is typically where the fees on fixed and fixed index annuities stop. However, variable annuities can have an added list of charges and fees to be mindful of because they have the potential to reduce your return – and in times where the underlying investments perform poorly, they can bring the negative down even more.
The most common variable annuity fees include:
These fees are in addition to any taxes that you would have to pay on the gains that are accessed from the annuity. In addition, if you make such withdrawals from an annuity before you have reached age 59½, you may also incur a 10% “early withdrawal fee” from the IRS. So, the amount of money that you actually net out could be miniscule.
As mentioned above, many annuities have a surrender period. This signifies an amount of time where you will be charged a fee if you either cancel the contract entirely, or if you take out more than a maximum amount – such as 10% – in one or more years during the stated time frame.
With that in mind, annuities should always be considered a long-term financial commitment. Therefore, funds that may need to be accessed in the near future for emergencies or other financial needs should not be placed in an annuity. It can also help if you have a separate emergency fund in place to provide a financial “cushion” when unexpected emergencies occur.
When you deposit money into a bank, FDIC insurance will cover your accounts dollar-for-dollar if the bank goes under, up to $250,000 per depositor, per FDIC-insured bank, per ownership category. These categories include:
FDIC insurance does not cover funds that are invested in stocks, bonds, mutual funds, life insurance policies or annuities – even if these financial vehicles are purchased through a bank. But that doesn’t mean that money in annuity is not safe.
For instance, annuities are guaranteed by the claims paying ability of the offering insurance carrier. This is why it is important to review the ratings that are given to insurers by A.M. Best, Standard & Poor’s, Moody’s and Fitch.
In addition, each state has a guarantee association. An insurance guarantee association protects policyholders and claimants in the case of an insurance company’s impairment or insolvency. Member insurers pay assessments into the fund that – together with the assets of the insolvent insurer – can be used for paying the covered claims (up to statutory limits).
Another misconception regarding annuities is that of the “right” age. In this case, some may feel that they are too young or too old to purchase an annuity. Although most annuities will have some age restrictions, though, they typically encompass a wide range of allowable annuity purchasers.
There are literally thousands of annuities available in the marketplace today. By working with an annuity or retirement income specialist, you can more easily narrow down the right annuity for your specific situation and needs.
While all types of annuities can have both benefits and drawbacks, the fixed index annuity tends to offer a “best of all worlds” benefit suite. This is because these annuities offer the opportunity to earn a higher return than regular fixed annuities, but without concern about losses in a down market.
Without any losses to make up for, the account value of a fixed index annuity can continue to grow and compound on its previous gains. These advantages are coupled with tax-deferred growth, along with guaranteed income options that can last for a stated period of time, or even for the remainder of your lifetime, no matter how long that may be.
Fixed index annuities have become more popular over the past decade or so with those who are seeking the ability to grow their funds, while at the same time keeping principal safe from a volatile stock market.
But even so, these annuities come with a plethora of “moving parts,” so it is essential that you have a good understanding of how the annuity will work. That way you will know what you can and can’t anticipate from it.
Talking with an annuity or retirement income specialist can help with narrowing down what type of annuity – if any – could fit in with your retirement plan. So, if you have any additional questions about whether or not an annuity is right for you, feel free to call Alliance America.
Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.