What is an Annuity?
Annuities are generally reserved for the most modest of investors – those that plan retirement, but would rather have the fixed income payments post retirement than to manage their own wealth when they reach retirement age.
While annuities are not the first investment choice of most active investors, they do make up a large portion of retirement investing. The comfort of investing in an annuity is warranted; investors make a lump sum investment on the premise of receiving monthly payments in the future for a specified amount. For just a lump sum now, someone is offering to “pay the bills” in the future. All you need to do is front a few payments in the meantime – something that couldn’t be more from true.
Protect from the downside, produce long term profits
Annuities are a great investment in bear markets as many protect capital downside , even in the case of collecting on death benefits. Annuities usually operate by accepting either a lump sum or predetermined investments over time during the accumulation phase. It is at this point that investors place their bets and build up equity, and thus, the promise of future monthly returns. Then in the annuitization phase, the investments made in an annuity flow outward to its investors in the form of the promised monthly checks. However, there is much to consider as many annuities are affected by a wide range of variables and outcomes that cannot always be foreseen.
Death benefits work in the favor of investors
Annuities offer a death benefit – though this should not be mistaken with the benefit offered by insurance companies. While it may be too pessimistic to consider what would happen in the case of death, it is something that must be carefully considered to pick the annuity and investment that is right for you.
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In fact, the death benefit works more in the favor of investors than it does the brokerage or insurance company that offers the annuity. In the case of death before the annuitization period, the funds are either paid out in a lump sum for the current cash value of your annuity or the amount you have paid into it. Investors receive the amount that is greater, and thus, this does work out in the favor of investors. If you had invested $20,000 into an annuity now worth $30,000, your beneficiary would receive a check for $30,000. If your investment had instead lost money – i.e. an investment of $20,000 is now worth $15,000 – you’ll receive $20,000 because it is equal to the amount you invested.
Once you begin to receive monthly payments, the death penalty is erased on most contracts. The overwhelming majority of investors die during this period, and thus, annuity brokers make a large amount of money keeping the remains of a failed investment. “Term certain” annuities have become popular, where payouts are guaranteed for a number of years. In many cases, “term certain” accounts cost more to maintain than basic life insurance and are more of a drain than an investment. Remember, insurance companies don’t make money by paying out more than they take into their coffers.
There are three types of annuities, all with different goals and objectives. The three main options are fixed annuity, variable annuity, or equity-indexed annuity.
With a fixed annuity, buyers are given a fixed interest rate for their investments. Regardless of how good or bad the stock market or any market returns, you will receive the same interest payment year in and year out.
In many cases, this is a bad proposition, as the fixed rates are purposely set lower than the market average. On the upside, there is no possibility for loss, as the company promises to pay the same amount of money regardless of market returns. This is certainly a benefit, though it must be considered that a fixed rate will be considerably lower than average returns, with no potential for upside and no risk to the downside.
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Variable annuities are great for investors who like more control over their own money. A variable annuity allows investors to place money in many different “sub accounts” that work similarly to mutual funds. The investor’s picks are very important, as the future return of the annuity depends on the ability of investors to select profitable investments. If investments do poorly, the value of the annuity drops. If done correctly, the value rises, and along with it, the payouts. For the seasoned investors, variable annuities give security with the ability to buy and sell what sectors or investments are seen to be fit.
The downside is that variable annuities are known to have high fees for moving money between various sub accounts. This is a detail that should be worked out with the broker to obtain lower fees for moving money. It’s your money – let them know that and work towards no fee account management. Variable annuities do well because investors are allowed to invest in what they want with the guaranteed payment feature in the future. For the active investor, this is it.
Equity indexed annuity
EIA annuities are invested in funds that are used for the basis in considering returns. The S&P500, NASDAQ, DJIA or the Russell 2000 are all commonly used as reference funds. Your accumulation amounts will be invested in these indexes to benefit from the rise in the overall market; however rather than receive the full returns of the market, returns are adjusted to protect against loss.
EIAs work like a fixed annuity, but their returns can be adjusted up and down. If you are entered into an EIA with an interest rate of 8% and the market returns 15%, your annuity may be adjusted to 13% per year. The difference between actual returns and your annuity return is the cost for protection; if the market were to turn sour, you would still obtain the minimum of your new adjusted market return of 13% per year. These annuities often represent the best of both worlds for the casual investor looking for returns on par with the overall market, while desiring a long term monthly payout.
Tax-deferred status pays off
In any case, annuities grow entirely tax-deferred, which is one reason for their overwhelming popularity. It is important to remember, however, that annuities are practically a gamble against your own life. Do you take an annuity on the hopes that you live to be a century old, or should you favor more traditional investments at the risk of outliving your portfolio?
A proper balance of annuity payments and a classic portfolio should be obtained. Many investors look to earn enough from annuities to cover their fixed monthly expenses, such as a car or house payment, throughout retirement and allowing their portfolio cover the remainder of the expenses. Just a few hundred dollars each month goes a long way for retirees, especially with rising health care costs and the looming threat of outliving your own retirement funds. Annuities are simply pre-death life insurance, with the benefit paid before you die rather than after. They make great insurance against losing your standard of living while in retirement and ensuring you don’t pass the burden to your children or grandchildren. Even the smallest of portfolios should consider an annuity investment.