There’s a commercial on TV right now for a nationally-known insurance company that I think is pretty clever. It features a married couple imploring each other to sit down and talk about their retirement plan, but each of them rushes to find a much more pressing matter to tend to, such as cleaning the oven or washing the cat. It’s a comedic take on a very relatable problem. Thinking about retirement is hard.
There’s a barrage of information out there and considering all of your options can be overwhelming. This month, in particular, is Annuity Awareness Month, one of those “holidays” created by the financial services industry. It’s not something you’re going to celebrate, but perhaps maybe one day you will.
WHAT IS AN ANNUITY?
When you invest in an annuity, you are making a contract with an insurance company for a systematic withdrawal of payments over a period of time, monthly, quarterly, annually or in a lump sum like your own private pension plan. Pensions from your employer are going by the wayside, so a lot of people have to depend on 401Ks or IRAs to take care of them in retirement. Conversely, when they set up an annuity, they are repositioning their money out of the market volatility.
DIFFERENT TYPES OF ANNUITIES
There are two basic kinds of annuities, fixed and variable. The biggest difference is the fixed annuity offers guaranteed rates of interest, whereas the variable one doesn’t. Beyond that, there are some other distinctions.
1. Fixed Annuity: Income can be drawn immediately or deferred. They are usually very low cost.
2. Variable Annuity: An insurance product that contains mutual funds. You can enjoy all the growth in the market, but also suffer the losses. This type of annuity tends to have a lot of fees associated with it.
3. Immediate Annuity: You make a deposit and 30 days later, you start receiving payments.
4. Deferred Annuity: You make a deposit and allow it to accumulate before you start accepting the income stream.
5. Fixed-Indexed Annuity: This is a hybrid product of a fixed annuity that protects your principal with a guaranteed rate of interest. It also offers the potential for market gain.
HOW IT WORKS
Let’s say you invest $100,000 into a fixed-indexed annuity. That principal will never enter the market. Instead, the provider will buy a long-range bond that earns interest. If the provider can earn three percent interest, the company keeps one and a half percent and also pays the financial advisor a
commission out of it. They’ll offer you the other one and a half percent as a guaranteed rate, earning you $1500. Since that isn’t much money, you can choose to let the insurance company send that to the stock market in the form of an option purchase. If the market goes up ten percent, you’ve earned $10,000. Add that to your ever-present principal and now you have $110,000. Going forward, your principal is higher, so it will earn more interest from the original bond and the stock market, should you choose to send it there again. If the market falls, however, you won’t earn as much from your interest money, but again, your principal will still be sitting in your account.
PROS & CONS
There are a lot of misconceptions about annuities. There is no perfect investment and that’s true for stocks, bonds and mutual funds as well, but they all serve a purpose. An annuity is usually a long-term commitment. You can’t get all of your money, but you can get some of it. Most companies offer a five or ten percent free withdrawal every year. A benefit of a fixed annuity is the safety of principal. You won’t lose a penny of it. Fixed-indexed annuities are going to capture the lion’s share of the market gains, but even if it declines, you don’t give back any of the previous credits and just hold your own. Heads, you win and tails, you break even.
WHO SHOULD CONSIDER AN ANNUITY?
The best candidates for annuities are people who want to set up a lifetime guaranteed income they can never outlive. Essentially, anyone who wants to preserve and protect what they’ve spent a lifetime accumulating. What’s best for you depends on your age and your goals. You should always do your research and be aware of any fees or taxes you’ll have to pay for the guaranteed income stream.
Bill Demaree is the founder and president of Indianapolis-based Demaree Retirement Services.