Annuities: What you should know
By Eric Henderson
COLUMBUS, Ohio (MainStreet) -- The risk of outliving one's retirement savings is growing. Increased life expectancies coupled with declines in the financial markets and home equity over the past few years have made it much more challenging for Americans to create adequate, lifelong income. In fact, the Employee Benefit Research Institute has found that nearly half (47%) of workers near retirement are predicted to run out of money and won't be able to cover their basic expenses and uninsured health care costs.
To overcome these challenges, many are turning to annuities. In June, the Government Accountability Office issued a report advocating the use of immediate annuities to protect one's retirement portfolio against underperforming investments, inflation and longevity risk. But how many Americans really understand annuities? What does one need to know?
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| Fear of outliving retirement savings has many turning to annuities, but these tools have pluses and minuses. |
Annuities offer unique benefits and can be an important component of a sustainable income-producing, diversified retirement portfolio. And, according to Insured Retirement Institute research, 92% of investors who own annuities have a higher confidence in the financial stability of their retirement compared with those who do not.
Creating a predictable stream of retirement income can be a daunting task, though, one that requires a comprehensive income plan and careful analysis. Many will find it's easier to develop such a plan with the help of a qualified financial professional. Yet even when working with a financial professional investors should understand some of the fundamentals of annuities.
Here are the basics:
First, an annuity is a contract with an insurance company designed to protect the investor from the risk of outliving his or her income. With annuities one's investment is converted into periodic payments that can last for a specified period or life.
Annuity types
There are a wide variety of annuity products available, but really four basic types. Their differences revolve around when payments begin and how the money is invested. So there are immediate and deferred annuities as well as fixed and variable ones. With an immediate annuity the payments begin right away, while the payments with a deferred annuity begin later. The growth of a variable annuity is based on the market performance of its underlying investments, while the growth of a fixed annuity is pegged to an interest rate.
Options and riders
Like most products, annuities have evolved over time to address consumer needs, so there are now various options and riders.
- Some variable annuities have riders that allow investors the option of higher income payments if the value of the underlying securities rises, yet lock in a minimum payment if they fall.
- There can be options to withdraw without penalty some, or in certain cases all, principal if it's needed for medical or long-term care expenses. (Withdrawals reduce the principal value of the annuity, though.)
- Some options enable the payments to continue after the original owner's death, or allow the owner's beneficiary to get a lump-sum payment.
Special features and add-ons usually cost extra, but they can be worth the expense if they're right for your particular financial situation and retirement goals.
Tax treatment
Annuities are tax-deferred investments, so you don't pay taxes on accumulated earnings until you withdraw your money, and then only your earnings are taxed as ordinary income. Annuities also don't have contribution limits, like IRAs and 401(k) plans.
While there are no additional tax advantages to holding an annuity outside an IRA, many investors are doing this because of the benefits they provide.
If you decide to take your money out early, you may face fees called surrender charges,. And if you're not yet 59.5, you may also have to pay an additional 10% tax penalty on top of ordinary income taxes. A death benefit is available with most variable annuities, but if you do take an early withdrawal, your death benefit and the cash value of the annuity contract will be reduced.
An annuity is a contract between you and an insurance company, and it's sold by prospectus. While it may take some time, read that prospectus; it describes risk factors, fees and charges that may apply. Variable annuities have fees and charges that include mortality and expense, administrative fees, contract fees and the expense of the underlying investment options.
Rates and performance
An annuity is an investment and it should be evaluated, in part, on its performance. Consider the historical returns of the underlying investments for variable products and check not just the current rate, but the rate history for fixed and indexed annuities.
Fees
Like all investments, annuities charge fees. These fees vary greatly by product, though. Investors should understand and ask their financial adviser about the fees and charges they will incur. Some common ones include:
Mortality and expense risk charges. These charges compensate the insurer for the annuity guarantees and benefits.
Surrender charges. These charges help reimburse the insurer for sales expenses such as commissions if the investor withdraws money from the annuity early. Investors should check the length of the surrender period when evaluating annuities, since they vary by product.
Investment fees. These expenses are deducted from an annuity's underlying investments, and pay for the management and distribution of those underlying investments.
Strength of the insurer
An annuity is a promise to pay income, but that promise is only as good as the company making the promise. Investors need to look into the reputation and financial strength of company offering the annuity.
One of the benefits of an annuity is the guaranteed retirement income. Whether the economy is good or bad, an annuity pays a minimum amount every month, a predictable stream of income in uncertain times. But it's important investors take the time to understand these products and carefully evaluate their options.
While annuities contain guarantees and protections subject to the issuing insurance company's ability to pay, these guarantees don't apply to any variable accounts and investments subject to investment risk, including possible loss of your principal. Eric Henderson is senior vice president of Individual Products and Solutions for Nationwide Investment Services and a FINRA member.
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