Millions of Americans have watched their retirement savings invested in 401Ks, and IRAs take massive percentage loses during this global financial crisis. Equity investors’ appetite for risk has evaporated. Safety of their principle is now the primary investment concern. And it is likely to stay this way for years.
Annuities have re-emerged as a potentially safer way to accumulate and manage distributions of retirement funds. There are many common misconceptions about annuities and their uses. We attempt here to provide some basic information about annuities and to help investors decide if annuities are a suitable investment vehicle for investing their hard earned money or planning for their retirements.
An annuity is a contract between typically an insurance company and one or more persons whereby that person or persons receive periodic payments for life, or for a specified number of years. There are two major types of annuities, immediate and deferred annuities. Normally immediate annuities are purchased with a single payment (aka. SPIAs) and income payments begin within one year from date of purchase. The more common type of annuity is the deferred annuity where monies are contributed for an extended period of time to accumulate value and the payments do not begin until some defined future date.
The primary objective of an annuity contract is to pay financial benefits to the person(s) who receive the annuity payments during their lifetimes. Annuities are unlike a life insurance contract, whose primary objective is to pay a death benefit. No medical underwriting is required to enter into an annuity contract. However, certain annuity contracts may offer optional death benefits and other living benefits found in insurance contracts. The annuity products environment is very dynamic and new products with useful riders and flexible benefits are continually being designed and approved for sale in the marketplace.
The insurance company who issues the contract assumes a number of financial obligations to the owner, the annuitant, and the beneficiaries. The insurance company promises to invest the owner’s premium payments responsibly, or according to the owner’s instructions as in variable annuities, and to credit the interest earned or capital gains to the appropriate funds within the annuity.
The owner is the person or legal entity who enters into the contract with the insurance company to purchase the annuity. The owner is the pays the premiums, chooses which options and riders are to be included in the contract, and has the right to withdraw or surrender the contract.
The annuitant is the person whose life is the measuring life for the annuity contract. It cannot be a legal entity or corporation. The annuitant has no legal rights to the contract. The annuitant cannot alter the contract, withdraw funds, or change beneficiaries.
The beneficiary is the person or legal entity who normally inherits the annuity proceeds at the death of the annuitant. The annuitant and the beneficiary should not be the same person because the beneficiary is to receive the funds at the annuitant’s death. The beneficiary has no legal rights to the contract before the annuitantýs death. When the annuitant dies, the beneficiary does have legal rights to the death proceeds. However, the owner may change the beneficiary at any time right up to the annuitantýs death bed.
The most common reason people purchase annuity contracts is to accumulate funds for retirement and to manage those funds once in retirement. Deferred annuities are tax-deferred investments. They compete for investment dollars that would otherwise go into taxable investments like money market funds, CDs, bonds, and savings accounts. Fixed deferred annuities guarantee the principle and some level of interest earnings, currently about 3%, or less. Variable deferred annuities compete for investment dollars that would otherwise go into taxable mutual funds or stock equities.
Qualified annuity contracts are funded with pre-tax dollars. Nonqualified annuity contracts are funded with after-tax dollars. There are many IRS rules governing the additions, transfers, and roll-over of funds between qualified and nonqualified accounts to annuity contracts. The tax deferral feature that is a part of all annuity contracts is redundant when dealing with qualified accounts that already enjoy the advantage of tax-deferral. Consult your tax advisor before making any purchasing or transfer decisions of money in or out of an annuity contract.
Annuities may be classified into several different categories:
Deferred annuities are classified by the method the insurance company uses to determine how interest is credited to the annuity contract.
Fixed-interest annuities are the simplest and safest type of deferred annuity. The principle is guaranteed by the financial strength and required reserves of the insurance company. They offer the annuity owner a guaranteed interest rate for a specific period of time, usually 1, 5, or 10 years. Once the initial interest rate guarantee period is over the companies set renewal interest rates according to the interest rate environment at the time of renewal. Lately, renewal interest rates have been resetting lower because of the declining interest rate environment.
Indexed annuities tie the interest earnings of the annuity contract to an outside index of securities, in most domestic cases, to the S & P 500 index. This type of annuity offers its owners the same guarantee of principle as the fixed annuity. But the built-in S & P indexing strategy allows the owner to participate in potential market growth without the down-side market risks of a variable annuity. Indexed annuities allow the owner to select one of usually several indexing strategies and to periodically reselect different ones based upon the movement in the tracking index. Indexed annuities are becoming more popular since the financial crisis and the equity markets collapse.
Variable deferred annuities are the most complex type of annuity. Variable annuities enable the owner to invest their contributions in a series of sub-accounts tied to various financial markets, usually mutal funds of stocks and bonds. The owner takes on all the market risks in these sub-accounts and may in fact lose portions of their investment principle.
Which annuities are the right retirement planning tool for you? It depends. Our recommendation is that you should only invest in annuities if you plan to leave the funds in the annuity for the entire term. There are substantial surrender charges and early withdrawal penalties associated with most annuities. But wouldn’t it make sense to take just a portion of your retirement savings and purchase an annuity with sufficient lifetime income guarantees to cover your basic living expenses? This is a decision you should only make after consulting with your financial advisor.