What the Heck is…an Annuity?

Everyone speculates about winning the lottery jackpot. One of the first decisions lottery winners have to make is whether they are going to take their winnings as a lump sum payout or an annuity. Take the lump sum, and you get less money, but all at once. You can spend it immediately on whatever you want. Blow it, and it’s all gone. Take the annuity, and you get more money, but you get paid in installments over time.  It’s tied up and you can’t get to all of it, but you know that you won’t have blown it all in 5 years like a lot of winners.

An annuity is a financial product that pays you a steady income stream at some time in the future. They are generally sold by insurance companies and other financial institutions and aimed at retirees, but may be used to pay court settlements and of course, to pay lottery winners. For that matter, Social Security and pensions are basically annuities.The size of the installment payment that you receive from an annuity varies by how much you have put into the annuity, over what period of time you will receive it, and other factors. Fixed annuities give you a guaranteed payment. Variable annuities give you a payout that can vary according to how well the investments supporting the annuity do. So variable annuity payments adds uncertainty due to market fluctuations, while fixed annuity payments are certain but will not adjust to compensate for inflation or other factors.

Annuities can also be immediate or deferred. Immediate annuities are better for retirees, who would give the annuity company a large amount up front, and begin receiving payments shortly after. Those with more time to retirement would purchase a deferred annuity, where payments would begin well after the purchase of the annuity, giving the money time to grow over time through compounding and further contributions. An investor with a deferred annuity can choose when to annuitize, or begin taking payments, and may even withdraw all of their funds without ever annuitizing them.

There are several ways to structure your annuity. You can guarantee income for a certain period, say 20 years for example, and if you die before the time is up the money goes to a beneficiary. You can receive lifetime payments, and be paid a certain amount based on how much you contributed and your life expectancy. You won’t outlive the annuity, but once you die, your heirs have no claim on it. There is a combination product known as Life with Period Certain, which sets a time period during which a beneficiary can receive payments if you die before it is over. And there is a joint and survivor annuity, which allows a surviving spouse to collect payments after you die.

I’m going to concentrate on annuities for retirement (unfortunately, most of us aren’t going to win the lottery). Like most financial products, there are some advantages and disadvantages, although the type of annuity you are considering can influence each factor.

Advantages:

  • Annuities provide a steady stream of income. Having a steady income that is insulated from market shocks can be useful, especially in years when the markets are down, and make budgeting easier.
  • Fixed rate annuities protect principle. While not entirely without risk, they are safer than stocks and many other investments.
  • Growth inside the annuity is not taxed until you withdraw funds, when you pay capital gains.
  • Unlike 401K or IRAs, there is no annual contributions limit for an annuity. If you need to catch up on your retirement savings, and have already maxed out your 401K and IRAs, annuities can be a good way to do so.
  • If you set up an annuity that is something other than a lifetime annuity. it can be an option to leave money for heirs if you cannot qualify for life insurance at reasonable rates..

Disadvantages:

  • Annuities tend to have a lot of fees and commissions, both to set up and to continue. To avoid higher fees, you can purchase a direct-sold annuity, which does not have an insurance agent and therefore has lower fees. Fixed rate annuities also tend to have lower rates than variable annuities.
  • Similar to the 401K or IRA, there are penalties for withdrawals before age 59 ½ for retirement annuities.
  • Money is tied up in the annuity. It may not be possible to get at needed funds without taking a large loss due to tax penalties and surrender fees. If you sell your annuity to a third party, which may be your only choice once you begin receiving payments, you can take a huge loss.
  • If the insurance company holding the annuity goes down, you may lose your money. There are state guaranty funds that protect annuity owners, but like FDIC insurance, they only allow for limited coverage. These guarantees vary by state and range from $80,000 to $500,000. If you are really risk averse, you may not want to purchase any annuity larger than your state’s guarantee.

One option is to ladder annuities. This is similar to other laddering techniques, such as CD ladders and bond ladders, where you purchase CDs or bonds with different maturity dates as opposed to one large CD or bond with the same amount of money, so that you receive the total principle invested over time rather than all at once. In an annuity ladder, you use a portion of your investments to purchase an immediate annuity, then purchase an additional annuity later after other investments have had time to build up over time or after interest rates go up. . You can also ladder annuities by purchasing an immediate and one or more deferred annuities at the same time, which will also take advantage of any rising interest rates.

Annuities can be a really good product for people who don’t have heirs, or are concerned that they will spend their retirement savings too quickly. They are certainly a tool for adding regular income in retirement, and can be part of a more diverse retirement portfolio rather than the recipient of your entire retirement savings.

This article is for information purposes only. An investor interested in an annuity should proceed with caution and do lots of research before putting their money in any investment.

Image courtesy of Mister GC at FreeDigitalPhotos.net

References and Further Reading:

Annuities: The Good, The Bad and The Ugly-from Forbes

Are Annuities Right for You? and Safety and Income: Guaranteed-Income Products-from Investopedia

Hedge Bets With an Annuity Ladder-from Kiplinger

How to Determine if You Need an Annuity-from About.com

PERSONAL FINANCE; Deciding How to Cash In an Annuity-from the NY Times

Rescue Retirement with an Annuity. The Nerdy Insurance Product Offers Peace of Mind-from Bankrate

Ultimate Guide to Retirement: What is an Annuity?-from CNN Money

What You Don’t Know About Annuities-from US News

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