When it comes to investing, everyone has the same basic goal: use money to make more money. However, not everyone has the same risk tolerance. Whether it’s because they are nearing retirement or they lost money in the recession, many people don’t feel comfortable with the inherent risk of the markets. For these risk-averse investors, one option is annuities.
What are annuities?
Annuities are a type of financial insurance that pays out incrementally over a period of time. The annuitant (the investor) puts money into the annuity in exchange for a guaranteed stream of income at a later time. While annuities are often used to provide a steady source of income during retirement, they’re actually very flexible products that can be used in a variety of ways. However, you should discuss annuities with a financial professional to find out if they’re right for you. While this article breaks down annuities into the basic categories, the truth is all annuity products are different and include a complicated set of terms and conditions.
There are two main forms of annuities: immediate annuities and deferred annuities. Immediate annuities provide regular payments after a lump sum is contributed to the account. The payments can be a fixed amount or variable depending on your type of annuity. On the other hand, deferred annuities provide retirement income after the annuitant has paid into the account over a period of time. The contributions grow tax-sheltered until the income is withdrawn.
Once the annuitant starts the distribution phase, the insurer will determine the payment amount based on a few primary factors, such as the dollar value of the account, the annuitant’s age, the expected returns from the account’s assets in the future, and life expectancy. Generally, the longer an annuitant waits to withdraw payments, the higher the payments will be.
Often the annuitant will elect to receive monthly payments for the remainder of their life and their spouse’s life (if included in the policy). If you end up living longer than expected, it’s possible you will withdraw more than you contributed. However, if you and your spouse pass away earlier than expected, you may end up having paid more than you received from the annuity. In any event, the main benefit of purchasing an annuity is knowing you will have a guaranteed income for the rest of your life.
Annuity types
There are three main subsets of annuities: fixed annuities, variable annuities, and indexed annuities.
For the most risk-averse investors, the fixed annuity offers the safest option. The annuitant is guaranteed a certain rate of return on their contributions, regardless of how the market is doing. This means that if you have a fixed annuity at a rate of 4 percent, you’ll receive the same rate of return. Generally, this means you’ll receive a much lower return on your investment than if you stuck with the markets long term (E.g., The S&P 500’s average annual return over the last century is 10%)
Variable annuities allow the annuitant to receive a varying rate of return depending on the performance of the annuity account’s assets. If the portfolio performs well, then the annuitant will receive higher payments – if it performs not-so-well, then the payments will be not-so-high. Federal law considers variable annuities as securities, meaning they are regulated by the Securities and Exchange Commission (SEC).
Finally, indexed annuities allow annuitants to have increased returns based on the performance of an index, like the S&P 500. At the same time, they can also guarantee a minimum return. In this way, you can reap some of the rewards of the stock market while not incurring all the risk. However, regulators aren’t completely sold on indexed annuities with FINRA issuing an investor alert about them in 2010. Their main concern is the complex and confusing way the gains in the indexes are calculated.
Are annuities right for me?
Some experts are wary of annuities, citing the high fees, surrender charges (early withdrawal fees), and their lower rate of returns than the stock market. It’s true that over the long term, you will probably have better returns through the stock market than through an annuity. However, annuities do guarantee a steady stream of income in retirement. The cost of lower returns may be well worth the guaranteed income for people who are nervous about near-term dips in the stock market.
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https://www.investopedia.com/investing/overview-of-annuities/
