(It’s time again for that classic of investment information, Investing 101! This time, we’re going to take little look at annuities, a type of investment (if you can even call it that) which you normally acquire from insurance companies. They tend to be rather complex, so we are going to just skim the surface of annuities, rather than try to dig deep into them, which could easily take a week’s worth of posts or more.)
Q: What exactly are annuities?
A: Annuities are contracts with an insurance company, in which you pay money to them in exchange for a guarantee. Depending on the type of annuity (and there are quite a few of them), this guarantee might be for protection of the money you put into the annuity, a set rate of growth, financial protction for your family, or lifetime income. With all these possible objectives, there are any number of possible reasons why an annuity would make sense for a particular investor.
Q: Alright, that’s interesting. How do they work?
A: In nutshell, it goes like this: you give money to the insurance company, either in one lump sum (in what’s known as an immediate annuity) or over the space of several years (a deferred annuity). In return, the insurance company with hold and invest your funds, and allow you the option of getting regular payments for the rest of your life. (This is called annuitization.) These payments tend to be higher than you could safely pull from your investment amount without using the annuity.
Q: Okay, how would I use an annuity?
A: The primary use of an annuity is to provide income during retirement. With an immediate annuity, you can turn a single lump sum into a flow of cash for the rest of your life. This is one way to access the money in your nest egg, and as mentioned, it will allow you to take out more than you could if you tried to manage your savings on your own.
A deferred annuity has a bit of savings plan built into it; because you deposit money regularly, it’s bit more like an IRA than an immediate annuity. (In fact, similar to an IRA, the taxes on the growth of the money in the annuity are deferred, allowing you to delay paying taxes until you start receiving money from the insurance company; then it will be taxed at your ordinary tax level, though.) Deferred annuities are sometimes promoted as a means of tax-deferred saving, especially when you’ve maxed out your 401(k) and IRA accounts.
Q: Any other annuity distinctions that I should know?
A: Well, in addition to be divided into immediate and deferred, most annuities also fall into one of two classes: fixed or variable. Fixed annuities provide an amount of income that is, well, fixed. The amount you receive each month is determined by how much you put into the investment, and then typically does not change during the entire time you are receiving payments from the annuity company. The advantage of fixed annuities is that the payout is fixed; the disadvantage is that inflation will gradually decrease the value of your fixed payout. (Although, some companies offer annuities whose payment will be stepped up each year, either by a fixed percentage or according to inflation; you will pay for this advantage, though, with lower initial returns on your money.)
Variable annuities are a much different beast; you invest in buckets of stocks and bonds, similar to mutual funds. However, rather than directly own these securities, you attempt to determine whether the accumulation unit value (AUV) of the annuity will increase. Your payout will increase or decrease based on the performance of the assets to which the annuity is tied. If the investment rises, so does the amount you receive each month; if it falls, so does the payout. As a result, over time the pay out on variable annuities should increase along with the performance of the stocks or bonds in which it invests. The disadvantage, of course, is that your payout in retirement could end up going down.
Q: This is getting complex; what should I do if I want to invest in annuities?
A: If you think this is complex, you should know that in reality, annuity contracts have significantly more details and ‘moving parts than we’ve talked about here. This is just an overview. If you want to invest in annuities, it’s important to read carefully, consider all your options, and study, study, study the annuity contract! If you are confused on anything, make sure it’s made clear to you; given how much annuities cost, as well as how hard they are to leave (significant penalties are usually attached), you don’t want to make a bad investment.
That’s pretty much it for annuities; they are rather complex, but can have benefits if you know what you’re doing when you invest. Hopefully, you’ve learned a bit more about these arrangements and how they can benefit you. See you next time!