What is an Annuity?
An annuity is a contract between you and an insurance company that promises to pay you income. Different types of annuities are sold by a variety of institutions and professionals, such as insurance companies, banks, and financial advisors. You can purchase an annuity by making a lump sum payment, or making multiple payments--called premiums--over time. In return, the insurance company invests your money and typically gives you a series of payments, which is called annuitization. If your payments start right away, it's called an immediate annuity; if they're delayed until sometime in the future, it's a deferred annuity. The income you receive from an annuity can be paid out monthly, quarterly, yearly, or even as a lump sum payment. A big advantage of annuities is that you can contribute as much as you want for retirement. Unlike other tax-deferred vehicles—such as a workplace 401(k) or an IRA—annuities have no annual contribution limits. Having the option to put away more money is critical, especially if you’re close to retirement age and need to catch up. Annuities were created to provide an income stream that lasts a certain period of time, or even for as long as you live, so you never run out of money in retirement.
Most Common Annuities
A fixed or guaranteed annuity gives you a minimum rate of return that never changes, no matter what happens in the financial markets. The insurance company handles all the backend investing and agrees to pay you a minimum, pre-determined rate of return and payout. In other words, the insurance company assumes all the risk, and you receive a stable cash flow.
On the other hand, a variable annuity does not give you a stable payout. The rate of return depends on the performance of the financial markets. You decide how to invest your money in investment sub-accounts held within the annuity.
Unlike fixed annuities, variable products are securities that must be registered with the Securities and Exchange Commission (SEC.). They do give you the potential to earn more than a fixed annuity, but the cash flow is much less stable, and you can lose money.
The value of using variable annuity products for retirement income is hotly debated. In addition to having higher risk, they also come with higher commissions and fees compared to fixed products, which may make them unsuitable for many investors. Therefore, for the purpose of this article, I’m just going to focus on fixed annuities.
Annuity Riders (Extensions)
Other features of annuities that you should be familiar with are optional benefits called riders. Just like you can add a rider to a home insurance policy to protect valuable jewelry, you can add a rider to an annuity and receive additional value above the standard contract.
Here are some common annuity riders:
• Income rider: provides guaranteed income for a certain period of time that you can turn on in the future. This is a popular option for retirees who want to make sure that they don’t run out of money during their lifetime. I’ll give you an example of how this works in a moment.
• Death benefit rider: ensures that if you die, your beneficiary will receive the balance of your annuity—not the insurance company. For example, if you purchase an annuity for $100,000, but die after receiving only $20,000 in distributions, your beneficiary would receive the balance of $80,000.
• Nursing home rider: helps pay for expensive long-term care, either in a nursing facility or at home. For instance, it may double your monthly income, or allow you to withdraw more of your annuity balance to cover your added costs.
• Terminal illness rider: allows you to access some or all of your annuity balance, without having to pay early withdrawal fees or surrender penalties, if you’re diagnosed with a terminal illness that reduces your life expectancy. I’ll tell you more about surrender charges coming up.
It’s important to remember that adding a rider to an annuity gives you extra financial protection, but it comes with a cost, because it reduces the amount of income you’ll receive.
Information provided by Laura Adams
Further questions about an annuity & whether it is right for you? Call or email today!
jake [at] bp-ins [dot] com