What is an annuity?

An annuity is a contract with an insurance company to guarantee income payments at regular intervals in return for a premium. Annuities are most often bought for future retirement income. An annuity is the only vehicle that can guarantee an income to last as long as you live. It protects you against the risk of outliving your income.

Annuity properties

Every annuity has a few basic properties:

  • Either the payout is immediate or deferred.An annuity with immediate payout begins payments to the investor immediately after it is purchased.A deferred payout means that the investor will receive payments at some later date.
  • Either the returns are fixed (guaranteed) or variable (changing value).An annuity with a fixed return offers a guaranteed return by investing in low-risk securities like government bonds, and is commonly known as a fixed annuity. Click here for more details regarding fixed annuities.An annuity with a variable return offers results that vary with the performance of the funds (called sub-accounts) where the money is invested, for example stocks. Click here for more details regarding variable annuities.
  • An annuity has two phases: an accumulation phase and a payout phase.During the accumulation phase of a deferred annuity, you make payments and your money (less applicable charges) grows.In a fixed annuity your account earns interest at rates set by the insurance company or in a way spelled out in the annuity contract. The company guarantees that it will pay no less than the minimum rate of interest stated in the contract.In a variable annuity, the insurance company puts your money in a separate account. You decide how the money is to be invested or allocated depending on how much risk you are comfortable taking.For example, you could designate 40% of your purchase payments to a bond fund, 40% to a U.S. stock fund, and 20% to an international stock fund. The money you have allocated to each mutual fund investment option will increase or decrease over time, depending on the fund’s performance. In addition, variable annuities often allow you to allocate part of your purchase payments to a fixed account.The Payout phase is the period in which you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals (generally monthly). Sometimes referred to as annuitize which means you are telling the company that you want activate the contract.

How long do payments last?

If you choose to annuitize, you may have a number of choices of how long the payments will last.

  • Life Only

    Based on the balance of your account the insurance company tries to calculate how long you will live and divides your account in a number of payments. If you live longer that expected you will receive more money in which the insurance company pays income for your lifetime. It does not make any payments to anyone after you die. If you die after receiving just one payment, then the company keeps the balance.

  • Life with period certain

    The company pays income for for as long as you live and guarantees to make payments for a set number of years even if you pass away. This period is usually 10 or 20 years.

  • Joint and Survivor

    In this case the company pays income as long as you or your beneficiary lives. Generally payments are smaller since the company is making payments until both people die.

What to be aware of

Surrender or Withdrawal Charges

This is perhaps the most important aspect of an annuity contract. A surrender or withdrawal charge is a penalty that you will pay if you need to access your money before the contract has expired or you annuitize the contract.

A withdrawal fee is a penalty for removing a portion of the value of your account.

A surrender charge is a penalty for removing all of the assets in your account. In either case the company may figure the charge to be a percentage:

  • of the value of the contract
  • of the premiums you have paid
  • or of the amount you are withdrawing

The company may reduce or eliminate the charge after the contract has been in force for a state period. Not all companies have the same fee structure, which is why you need to do your homework.

Other Charges

Some contracts have other charges that you need to be aware of such as:

  • Contract Fee

    A flat dollar amount charged either once or annually

  • Transaction Fee

    A fee that is charged for each premium payment or transaction

  • Percentage of Premium Charge

    A charge deducted from each premium paid, this fee may decline after the contract has been in force for a period of time

What is a fixed annuity?

The basic premise of a fixed annuity is that you give a sum of money to an insurance company, and in exchange, they promise to pay you a fixed monthly amount for a certain period. In the case of a single premium immediate annuity (SPIA), the payments begin immediately. In the case of a single premium deferred annuity (SPDA), the payments begin at a date of your choice, for example at your retirement. Therefore, these vehicles can be used as tax-deferred investments, or can be seen as a way to convert a lump sum into an income stream.

Once annuity payments begin, they do not change, even to account for inflation. A fixed-annuity investor has two choices for the term of the payment stream:

  1. You can specify a fixed period, for example 10 years, meaning that payments will be made for 10 years to you (or your heirs). These payments generally are a combination of principal and interest. If instead of immediate payout you choose deferred payout, the investment grows with taxes deferred on that growth, and of course the payments begin at the chosen date.
  2. You can annuitize. To annuitize means you are telling the annuity company that you want to receive payments until death (i.e., specify the period to be your time on earth). And after that time is done, your heirs do not receive anything back. It doesn’t matter if the payments are made for 1 month or 40 years, they stay the same provided the company stays in business, and they stop at the investor’s death. Annuitization is optional but arguably the most important angle to these investments, and explains why these investments are sold by companies with experience in figuring out how long the investor (sometimes called the annuitant) will live.

A fixed annuity may have various surrender provisions that prevent you from withdrawing money for a period of 5, 10, or more years. However, depending on the company, fixed annuities may allow you some access to your investment; commonly the investor can withdraw annually the interest and up to 10% of the principal. An annuity may also have various hardship clauses that allow you to withdraw the investment with no surrender charge in certain situations, so be sure to read the fine print.

What is a variable annuity?

A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.

A variable annuity offers a range of investment options. The value of your investment as a variable annuity owner will vary depending on the performance of the investment options you choose. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.

Although variable annuities are typically invested in mutual funds, variable annuities differ from mutual funds in several important ways:

  1. Variable annuities let you receive periodic payments for the rest of your life (or the life of your spouse or any other person you designate). This feature offers protection against the possibility that, after you retire, you will outlive your assets.
  2. Variable annuities have a death benefit. If you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount – typically at least the amount of your purchase payments. Your beneficiary will get a benefit from this feature if, at the time of your death, your account value is less than the guaranteed amount.
  3. Variable annuities are tax-deferred. That means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals

If an annuity is something that you are considering, Optimized Benefits will help you determine if an annuity makes sense for you. We will also help determine which type of annuity and company will provide the best return and protection for your assets.

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