What Are Annuities For?

In theory, annuities are simply contracts in which an insurance company agrees to provide you with future income, in return for cash, or premium, now.

But that’s like saying a car is a generally four-wheeled transportation device equipped with an internal combustion engine, a steering mechanism, and brakes.

Both of these items come in a wide variety of colors, shapes, sizes and purposes – and you can get one tailored in almost any way you want.

But let’s look at the purpose of annuities.

The basic purpose

The primary reason to own an annuity is for retirement income security. Because of the 10 percent penalty on withdrawals prior to age 59 and a half, they aren’t well suited to meet financial needs before that time, except under certain circumstances.

Immediate Income

The simplest annuity, of course, is the immediate lifetime income annuity: You transfer a lump sum to an insurance company, and in return, they send you a guaranteed income every month or every year, for the rest of your life.

Customization Options

Does that not quite meet your needs? You can tailor a lifetime income annuity in a number of ways:

  • You can have it pay out a minimum number of years, even if you die before those years are up (a period-certain annuity).
  • You can have it pay out for as long  as either you or your spouse are alive (a joint-and-survivor annuity)
  • You can have it pay out for as long as either you and a child or grandchild are alive.
  • You can have it pay a lump sum to a beneficiary after you are gone.
  • You can have it pay a cost-of-living adjustment, to keep up with inflation.

With the lifetime income annuity, each of these arrangements is contractually guaranteed. The insurance company is still on the hook, even if the markets collapse. They must make the payments to you regardless of what happens in the market, or go bankrupt trying. These contractual guarantees are a key difference between annuities and mutual funds. Mutual funds have no contractual guarantees on your returns. You get what the market delivers, minus the expense ratio you pay to the fund company.

Deferred Annuities

Deferred annuities are annuities that you can let grow for a while – with taxes deferred – until you are ready to begin taking out income. Like immediate annuities, deferred annuities can also be tailored in similar ways: You can buy a guaranteed minimum income in the future (provided you make contributions as agreed), or secure a guaranteed minimum withdrawal benefit.

You can choose a fixed annuity, which provides modest but guaranteed returns, or you can pick a variable annuity. With these, you direct your investments into one or more mutual-fund-like investment vehicles, called “subaccounts.” These can and do lose money, if your subaccount does poorly, but they can also outperform fixed annuities, too.

Tax Deferral

Annuities also provide tax-deferral. You contribute premium with after-tax dollars (unless you hold your annuity in a traditional IRA or similar retirement account). Taxes on the growth are deferred until you actually take the money out.

The primary tax disadvantage to annuities is that when you do take the money out, you must pay income taxes on the distribution. You also pay a 10 percent penalty on most withdrawals prior to age 59 ½.

Annuities are popular among those who have already maximized their traditional and/or Roth IRA contributions, 401(k) plans and other retirement plans, or are not eligible for these plans, and who wish to take advantage of the benefit of tax-deferral.

With mutual funds and stocks, you may have to pay a sales load of as much as 6.2 percent to your broker. You don’t pay commissions to the agent with annuities, though. The agent’s commission typically comes out of the insurance company’s pocket, not yours. In return, though, you will typically have to commit to keeping the money in place for a certain period of time. If you withdraw money from the annuity within a few years, the annuity company typically charges a “surrender charge” of a few percentage points, declining the longer you hold the annuity and going to zero usually between five and seven years.

For this reason, annuities aren’t short-term savings vehicles. Rather, they are more suited to those with longer time horizons of at least five years.

Death Benefits

One feature of annuities is this: They routinely provide a guaranteed death benefit to your heirs – if you die before you start taking income out, the insurance company will generally make up any losses in your annuity to your heirs. They will inherit what you put in, if your contract value is lower than your basis at your death, if your annuity has a guaranteed death benefit.

Annuities, then, can help absorb the shock of markets. They are a buffer of protection against market volatility. However, just like adding big shock absorbers will slow down a race car, there is a price to be paid for these protections: Your mortality and administrative charges can be significant, compared to mutual fund expense ratios.

Asset Protection

In some states, annuities also provide substantial protection against the claims of creditors. However, you should speak to your agent or an attorney licensed in your state for specifics in your jurisdiction.

About Brian Hendricks

Brian Hendricks is the President of Fidelity Insurance Group. Brian started Fidelity in 2003 with 0 clients. Today Fidelity Insurance Group is a Premier Independent Insurance Agency in Florida with over 3,000 families and businesses insured. Brian currently serves on advisory boards for 2 of the largest property insurance companies in Florida. Knowlege, Integrity, and Committment are his and his agency's guiding principles.
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