Annuities have a great allure, furnishing you income in retirement. But there are annuities and there are annuities. And they are dauntingly complex. One very smart advisor who can untangle them is Jeff Rose, CFP, the founder of Alliance Wealth Management in Carbondale, Ill His take: Annuities, like any other investment, make perfect sense in the right situation. In the wrong situation, they can cost you money – and even be dangerous.
Here’s what you need to know.
1. How long is the term?
The term depends on the type of annuity you choose and the payout period you require.
If you choose an immediate annuity, you fund the plan with an upfront lump sum investment and can begin receiving income payments immediately. Under a deferred annuity, you fund the plan over a number of years – typically the difference between your current age and projected retirement age – and begin taking income payments at the end of the specified term.
Beyond funding, your income payments can last as long as you choose. Three principal types of income payment plans are:
• Lifetime payments that guarantee you an income during your lifetime but provide no benefits to your survivors after your death.
• Income for a guaranteed period under which you receive payments. If you die before the end of the term, the benefit payments continue to your survivors until the end of term.
• Income for life with a guaranteed period benefit combines elements of both the above plans. You can receive an income for a specified term and payments continue to your survivors until the end of the term if you die before the term ends. If you live beyond the term, the plan pays you an income for the rest of your life.
2. What is a typical surrender charge?
Annuities typically come with surrender charges, the amount of which depends on the insurance company you buy the annuity through, as well when you begin to withdraw funds. These charges resemble redemption fees that some mutual fund companies charge.
Surrender charges can be as high as 8% to 10% of the value of the annuity. Insurers typically assess one if you begin withdrawing money from the annuity during the first few years after you establish the plan. These charges also tend to work on a sliding scale, with the highest charge occurring during the first year of redemption.
Eventually, the surrender charge either drops to a much smaller level or disappears completely. Most annuities do provide a free withdrawal: Typically you can withdraw 10% of your principal plus interest. Once again, read the fine print. Some annuities also allow a 10% free withdrawal in the first year; others make you wait at least one year.
3. Did the advisor recommending the annuity really do the homework?
Your financial advisor must know a great deal about your situation and future plans – and what aspect of those plans you hope to cover with an annuity.
The advisor needs to know (and ask):
• Are you looking primarily for income for yourself?
• Do you want to provide for survivors?
• What’s your investment risk tolerance?
• What are your other investment assets?
• What other income sources will you have?
If the advisor merely puts you in some general annuity that doesn’t end up taking all your needs into account, be suspicious. Annuities contain a host of options and variables; your advisor, if good, can construct a plan right for you. Many advisors claim independence but in fact represent – and cash commission checks from – only a few annuity providers.
4. Do you understand your annuity’s parts?
Annuities are investment contracts complete with various provisions. In addition to understanding income options and payout terms, you need to understand the good and bad of various types of annuities.
For example, with a fixed annuity the insurance company pays a fixed rate of interest for a specific time, much like a certificate of deposit. A variable annuity includes sub-accounts that function like mutual funds and often provides a higher rate of return than fixed annuities.
Still another option: indexed annuities that tie performance to an equity-based index, much the same way index mutual funds function. An indexed annuity often comes with a guaranteed minimum return to limit your risk of loss if the index does poorly. Always ask your advisor to explain any points.
5. Is your annuity guaranteed?
You risk losing some of your investment – comparable to your risk when you invest in other assets such as stocks, bonds, mutual funds and exchange-traded funds – as no federal agency comparable to the Federal Deposit Insurance Corp. (FDIC) ensures your principal.
In most states, though, guaranty associations do provide coverage of up to $100,000, similar to the Securities Investors Protection Corp. (SIPC) to protect you if the insurance company defaults. Unlike SIPC, the guaranty association is not a government-sponsored organization but an industry arrangement from various insurers operating in a given state.
Check your insurer through a third-party source such as A.M. Best, a respected rating agency in regard to insurance companies. The strength of the insurer issuing your annuity is your first, best protection.