Fixed Annuities
The idea 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 of time, either a fixed period or for your lifetime (the concept of 'annuitization'). So essentially you are converting a lump sum into an income stream. Whether you choose period-certain or annuitization, the payment does not change, even to account for inflation.
If a fixed-period is chosen (also called a period-certain annuity), the annuity continues to pay until that period is reached, either to the original investor or to the investor's estate or heirs. Alternatively, if the investor chooses to annuitize, then payments continue for a variable period; namely until the investor's death. For an investor who annuitized, the insurance company pays nothing further after the investor's death to the estate or heirs (neither principal nor monthly payments), no matter how many (or how few) monthly payments you received.
Fixed annuities allow you some access to your investment; for example, you can choose to withdraw interest or (depending on the company etc.) up to 10% of the principal annually. An annuity may also have various hardship clauses that allow you to withdraw the investment with no surrender charge in certain situations (read the fine print). When considering a fixed annuity, compare the annuity with a ladder of high-grade bonds that allow you to keep your principal with minimal restrictions on accessing your money.
Annuitization can work well for a long-lived retiree. In fact, a fixed annuity can be thought of as a kind of reverse life insurance policy. Of course a life insurance contract offers protection against premature death, whereas the annuity contract offers protection for someone who fears out-living a lump sum that they have accumulated.
Variable Annuities
A variable annuity is essentially an insurance contract attached to an investment product. Annuities function as tax-deferred savings vehicles with insurance-like properties; they use an insurance policy to provide the tax deferral. The insurance contract and investment product combine to offer the following features:
1. Tax deferral on earnings.
2. Ability to name beneficiaries to receive the balance remaining in the account on death.
3. "Annuitization"--that is, the ability to receive payments for life based on your life expectancy.
4. The guarantees provided in the insurance component.
A variable annuity invests in stocks or bonds, has no predetermined rate of return, and offers a possibly higher rate of return when compared to a fixed annuity. |
A variable annuity is an investment vehicle designed for retirement savings. You may think of it as a wrapper around an underlying investment, typically in a very restricted set of mutual funds. The main selling point of a variable annuity is that the underlying investments grow tax-deferred, as in an IRA. This means that any gains (appreciation, interest, etc.) from the annuity are not taxed until money is withdrawn. The other main selling point is that when you retire, you can choose to have the annuity pay you an income ("annuitization"), based on how well the underlying investment performed, for as long as you live. The insurance portion of the annuity also may provide certain investment guarantees, such as guaranteeing that the full principal (amount originally contributed to the account) will be paid out on the death of the account holder, even if the market value was low at that time.
Unlike a conventional IRA, the money you put into an annuity is not deductible from your taxes unless it is qualified. And also unlike an IRA, you may put as much money into an annuity as you wish.
A variable annuity is especially attractive to a person who makes lots of money and is trying, perhaps late in the game, to save aggressively for retirement. Most experts agree that young people should fully fund IRA plans and any company 401(k) plans before turning to variable annuities.
Important Facts You Must Know If You Already Own An Annuity Or You Are Considering An Investment!
Other types of annuities
All of the following types of annuities are available in fixed or variable forms.
Deferred vs. immediate annuities
A deferred annuity receives premiums and investment changes for payout at a later time. The payout might be a very long time; deferred annuities for retirement can remain in the deferred stage for decades.
An immediate annuity is designed to pay an income one time-period after the immediate annuity is bought. The time period depends on how often the income is to be paid. For example, if the income is monthly, the first payment comes one month after the immediate annuity is bought.
It’s possible to get a high fixed return on your money with an immediate annuity. An immediate annuity is simply the payment of a premium to an insurance company. This lump sum will provide you with a regular, guaranteed income over a specified term ranging from 1 year to 25 years and even a lifetime. It allows you to use a lump sum amount from either personal savings or superannuation money. The income you receive will depend on how much money you initially invest and the frequency of your payments each year. The interest rates you receive are generally set at the time of investment and will not change over the period of the annuity. (Monthly payments are based on the claims-paying ability of the insurer, so picking a financially solid insurance company is important.)
Here’s a hypothetical example. A 76-year-old gentleman paid $50,000 in premium to an insurance company. He now receives $388 per month, every month. That’s $4,656 each year of checks in the mail. For $50,000 where else can you get guaranteed $4,656 every year for the rest of your life?
Regardless of how long a person lives, he gets his check every month. If he dies early, his beneficiaries will receive the $388 monthly until $50,000 in payments have been received in total. This is called the “installment fund” provision. If the owner does not need or does not elect the installment refund provision for his beneficiaries, the monthly payments would be even higher at $473 per month.
Fixed period vs. lifetime annuities
A fixed period annuity pays an income for a specified period of time, such as ten years. The amount that is paid doesn’t depend on the age (or continued life) of the person who buys the annuity; the payments depend instead on the amount paid into the annuity, the length of the payout period, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the pay-out period.
A lifetime annuity provides income for the remaining life of a person (called the “annuitant”). A variation of lifetime annuities continues income until the second one of two annuitants dies. No other type of financial product can promise to do this. The amount that is paid depends on the age of the annuitant (or ages, if it’s a two-life annuity), the amount paid into the annuity, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the expected pay-out period.
With a “pure” lifetime annuity, the payments stop when the annuitant dies, even if that’s a very short time after they began. Many annuity buyers are uncomfortable at this possibility, so they add a guaranteed period—essentially a fixed period annuity—to their lifetime annuity. With this combination, if you die before the fixed period ends, the income continues to your beneficiaries until the end of that period.
Qualified vs. nonqualified annuities
A qualified annuity is one used to invest and disburse money in a tax-favored retirement plan, such as an IRA or Keogh plan or plans governed by Internal Revenue Code sections, 401(k), 403(b), or 457. Under the terms of the plan, money paid into the annuity (called “premiums” or “contributions”) is not included in taxable income for the year in which it is paid in. All other tax provisions that apply to nonqualified annuities also apply to qualified annuities.
A nonqualified annuity is one purchased separately from, or “outside of,” a tax-favored retirement plan. Investment earnings of all annuities, qualified and non-qualified, are tax-deferred until they are withdrawn; at that point they are treated as taxable income (regardless of whether they came from selling capital at a gain or from dividends).
Single premium vs. flexible premium annuities
A single premium annuity is an annuity funded by a single payment. The payment might be invested for growth for a long period of time—a single premium deferred annuity—or invested for a short time, after which payout begins—a single premium immediate annuity. Single premium annuities are often funded by rollovers or from the sale of an appreciated asset.
A flexible premium annuity is an annuity that is intended to be funded by a series of payments. Flexible premium annuities are only deferred annuities; that is, they are designed to have a significant period of payments into the annuity plus investment growth before any money is withdrawn from them.
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