With the stock market “crash” of 2008, annuities have gained a lot of attention in the last few years. But what is an annuity? First of all, annuities are a life insurance product. Second of all, annuities are complicated and difficult to understand. Let me see if I can help clear up the second issue, at least a little bit. But first, I’ll talk a little bit about the life insurance aspects of an annuity.
As mentioned, annuities are a life insurance product. As such, like any other life insurance product any earnings inside the life insurance product grow tax deferred. And since an annuity is a life insurance product any guarantees on returns or getting your money back are based on the solvency of the insurance company and state insurance regulators. Unlike bank accounts or CDs, annuities are not insured by the FDIC. Most states do require insurers to contribute to a pool of funds to cover any losses if an insurer goes under. Finally, if you die prior to starting withdrawals from the annuity, you will receive some sort of death benefit. That handles the insurance portion. Now lets look at the complicated portions of annuities:
- Annuities can be Immediate or Deferred. Immediate annuities start to pay as soon as you deposit the money (most likely the next month). Deferred annuities, on the other hand, start at some point in the future.
- Annuities can be Single Payment or Multiple Payment. Single payment means what it sounds like… you make one payment. With a multiple payment annuity you make contributions over time.
- Annuities can be Fixed or Variable. Fixed Annuities pay a “guaranteed” rate of interest. In a variable annuity, you as the owner, select from mutual funds and earn returns based on the funds you select.
That pretty well covers money going into an annuity. You can also take money out a lot of different ways.
- Single Life. A single life annuity pays a set amount for as long as you live. The amount paid is based on your current age, your life expectancy, and current interest rates. Single life annuities generally have the largest initial payment.
- Joint Life. A joint life annuity pays a set amount for as long as two people live (typically a husband and wife). The variables used to calculate the payment are the same as in a single life annuity except that both people are factored into the calculation.
- Period Certain. A period certain policy pays until death of the insured person(s) (could be single or joint), but if the insured dies prior to a certain time-frame (typically 10 or 15 years) the annuity will continue to pay to the beneficiary for the remainder of the guaranteed time period.
- Amount Certain (or similar name). Like the period certain policy this policy will promise to repay the amount invested if the insured dies before the amount invested is collected. The amount paid will go to the policy’s beneficiary.
- Inflation Adjusted. Inflation adjusted annuities are not easy to find. Depending on the insurer an annuitant may elect to have the annuity payments adjusted for inflation. This will reduce the amount of the initial payments. Which policies are eligible for inflation adjustment varies from one insurer to the next.
With a few exceptions, all the above can be combined in some fashion or another. For example, you could have a Single Payment Variable Deferred Annuity that becomes a Joint Life Inflation Adjusted Period Certain Annuity during the payout period. Or in another instance you may have a Variable Annuity that guarantees a minimum return IF you decide to annuitize the withdrawal. The combination of attributes and the ability to buy “riders” that guarantee certain things make annuities complicated.
You’ll notice I didn’t make any value judgments on annuities. Annuities are neither good nor bad. Just like a hammer is neither good or bad. If you need to drive a nail, a hammer is a good tool. If you need to turn a screw it isn’t that great. Likewise an annuity is only good or bad based on the job you are trying to accomplish. But like every other investment, don’t purchase an annuity if you don’t know why you are doing it and you don’t understand the investment.
Curt Sheldon, EA is a Fee-Only Financial Planner and Enrolled Agent based in Northern Virginia. He can be contacted at (703)542-4000, (800)928-1820 or Curt@CLSheldon.com
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The information contained in this blog is for general financial education and should not be construed as individual financial advice. Please consult your own financial, tax or legal advisor prior to applying any principles discussed here to your own financial situation.