By definition, an annuity is:
Thanks to the kind folks at Dictionary.com.
Explained in my own words: an annuity is an insurance product sold by insurance companies (as explained nicely here by SEC). The primary thing that annuities protect people from is outliving their assets. So, in a nutshell, an annuity is a way to insure against outliving your money.
The problem with annuities, and why many people shy away from them, is that they’re complicated and there are DOZENS of different kinds. I liken the word “annuity” to the term “used cars”: there are all different makes and models.
You can get stuck with a lemon or you can buy a vehicle that will be reliable and last for the rest of your life. Which one you end up with ultimately is determined by your knowledge of the product and the salesman that you meet with.
While there are two main types of annuities – immediate and deferred – I’m going to stick with explaining the different options of deferred annuities of which there are three main types:
1. Fixed Annuities
2. Fixed-Indexed Annuities
3. Variable Annuities
A fixed annuity is very much like it sounds: it’s an insurance product that offers you a fixed rate of return for a specific period of time. For anybody that’s ever owned a CD, a fixed annuity is very similar.
The downside to a fixed annuity is that (1) the rates aren’t very high and (2) there are serious surrender charges involved when breaking your contract. Most fixed annuity contracts (while they vary) are 5 years in length, so if you were to cash out or request all of your money prior to the end of your contract, then you’ll be assessed a penalty. This penalty is dependent upon the company and particular product (make and model of your vehicle), but they can range anywhere from 1-10% depending on how long into your contract you cash out.
Overall though, for people that are comfortable locking up their money for 5 years (meaning they have substantial liquid assets), fixed annuities may be a decent alternative to CDs. For instance, the best rate you’ll find right now on a 5-year CD is around 1.6% whereas a 5-year fixed annuity will be closer to 2.75%.
Fixed-indexed annuities are technically a fixed interest rate product (more-like a fixed annuity/CD as opposed to a mutual fund). These annuities generally offer two benefits:
1. Protection from losing your assets: your value/investment cannot go down due to stock market loss.
2. Participating in part of the stock market’s upside.
Since this is a fixed-interest rate product, you’re investment is not invested in the stock market. However, the interest credited to your account is based on the performance of a particular index (whichever index your annuity allows you to participate in). So, for instance, you can choose the S&P500 and the interest credited to your account will be determined by how that index performs that year.
The tricky part about fixed-indexed annuities is how the insurance companies calculate the actual amount your account gets credited. It gets very complicated but there are 3 main options:
1. Annual point-to-point with cap – it depends on the make/model of the annuity but this is generally capped at 3% in our current interest rate and stock market environment.
2. Participating rates – again, it depends on the annuity company and product but is generally 15%. So if the market gains 20% for the year, you’ll only get credited 3% (or participate in 15%).
3. Monthly Sum – (chart below shows actual performance) this is by far the most complicated method, but also the method that offers the greatest opportunity for gain (especially in a good market). In this particular crediting method, there is generally a CAP on the upside of each month (let’s say 2%/month for example or a total potential of 24% for the year), however there is no cap on the downside in a given month.
So, let’s say in January the market gains 3% of which you’ll get +2%. February was also a good month in which the S&P 500 made 2% of which you were given +2%. However, March was a down month and the market lost 5% where you were credited -5%. …this whole process continues for the entire year and at the end of the year, the totals are summed (hence Monthly Sum) and your account is credited whatever it totals to. In this particular 3-month example, you would have seen a -1% return.
However, here is where the benefit of a fixed-indexed annuity comes into play: despite having a -1% in your Monthly Sum crediting method, your account didn’t lose any value. Go back to benefit #1 that I listed above: your investment cannot go down due to stock market loss. So in this example, you would have gotten credited with 0% and your initial investment would have stayed intact.
With all this in mind, there are some positives and negatives to this type of insurance product:
Pros: (1) no market risk while having some ability to partake in the market’s upside; (2) despite being illiquid, you generally have access to 10% of your investment after the 1st contract year, assuming you’re older than 59 1/2 (called 10% free withdrawals); (3) from all fixed-indexed annuities that I’ve seen, there are no fees associated with them; (4) annual reset (chart below shows example) – whenever your account is credited interest/money in a given year, you cannot lose that money due to market loss in subsequent years.
Cons: (1) limited upside potential, (2) surrender charges (typically 10-year contracts).
The chart below shows the actual performance of a fixed-indexed annuity using the monthly sum crediting method and also illustrates the annual reset prevision well. The RED line is the S&P 500; the DARK BLUE line is the annuity performance; the LIGHT BLUE line is the guaranteed minimum contract value.
Variable annuities are a totally different beast than fixed and fixed-indexed annuities as they are an actual investment and not a fixed-interest rate product such as the ones previously discussed.
Variable annuities are also an insurance product, however your money is actually invested in mutual funds. Generally, your account balance can (and often will) fluctuate based on the performance of those particular funds. Hence the term “variable.”
These annuities did get a bad name for a long period of time for a myriad of reasons, primarily due to the fact that:
1. There are ridiculous fees associated with them. I’ve yet to see any variable annuity that has less than a 2% annual fee. In addition there are also fees associated with each mutual fund you own.
2. Your balance fluctuates! To counteract this deterrent, some variable annuities now offer an annual reset – much like the fixed-indexed annuities offer – and some even have daily or monthly resets. Depending on the reset terms, there are two options (1) your account can fluctuate but can never go below your initial investment or (2) you have the annual reset and your gains for the past year are locked in (forever…in which case your balance could then never go below your initial investment + gains from the previous year).
Where annuities have really gained their fame and become the popular retirement planning tool that they are is due largely to the income rider option that you can attach to annuity policies. When you attach an income rider, there are typically two values people see on the annual statements: (1) the “accumulation/cash” value which is determined based on how your actual “investment” performs and (2) an “income value” which is ONLY accessible if used as a lifetime income stream (see below).
As has been the theme, each income rider also varies based on the company and product you buy. With that in mind, there are annuity products that have great income riders and should be bought with that purpose in mind, and then there are annuities that have been designed to take advantage of the market’s upside (give you a higher crediting method) but offer terrible income riders.
An income rider generally offers two guarantees:
1. A guaranteed interest rate as long as the money is kept in deferral. Annuity companies are tricky though, so buyer beware! Some companies promote a high interest rate but you’ll find out that it’s simple interest only. However, many offer great compound interest rates; there are a few I deal with that are offering 6.5% (up to 20 years of deferral).
2. A guarantee to pay you a LIFETIME income stream. So, once you’ve stopped deferring the money, you then “turn on” your income rider and start collecting paychecks for the rest of your life. The value of those paychecks is determined by (1) your age at the time of “turning on” the rider, (2) whether or not it will be single or joint payout, and (3) the “income value” that’s in your account.
For anybody that’s interested in an annuity with an income rider, check out this handy annuity calculator.
While I’ve done my best to explain the basics of the 3 main types of deferred annuities, the reality is that they’re complicated. However, annuities with an income rider (and even without) can be a great option for somebody nearing (or in) retirement. Insuring that you can’t outlive your assets is a thing many people are looking for and annuities provide that. Always seek a competent professional when designing your retirement plan and find somebody with the heart of a teacher.
The articles are written by personal finance enthusiasts (not certified professionals) based on their personal experience. What works for them may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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