What is an annuity?
An annuity is a financial plan/product that pays fixed streams of income to an individual. The plans are commonly used for retirement plans for retirees. Annuities come from financial institutions that accept investment funds from individuals. After annuitization, the institution issues streams of income at a later point in time.
Why do people buy annuities?
People buy annuities to help them have income streams upon retirement. Annuities provide three things:
- Periodic payments for a specified duration. Payments are made to you, your spouse, or named beneficiaries.
- Death benefits. When you die before receiving the payments, they will be received by your beneficiary
- Tax-deferred growth. No tax on income and investment gains from your annuity until you withdraw money.
What kinds of annuities are there?
There are 3 types of annuities: fixed, variable, and indexed. They work as follows:
- Fixed annuity– The insurance company promises to pay fixed periodic payments using a minimum rate of interest. Fixed annuities are under the regulation of State Insurance Commissioners. The state insurance commission talks about the risks and benefits of fixed annuities and confirms whether the insurance broker is registered.
- Variable annuity– The insurance company allows you to put your annuities in different investment options through mutual funds. The payout varies depending on the interest rates and how much you put in investments and expenses. Variable annuities are regulated by the SEC.
- Indexed annuity– the annuity combines features of insurance products and securities. The insurance firm credits you with a return based on a stock market index such as Standard & Poor’s 500 Index. All are regulated by State Insurance Commissioners.
When an annuity is a good investment
An annuity is an insurance product since you buy it to reduce risk. Variable annuities have a selection of stock and bond portfolios as investment choices in the contract. Other annuities are actual insurance without an investment option.
An annuity provides a hedge against longevity risk (the risk of outliving your assets after retirement). An annuity is a good investment for this reason.
If you know your retirement goals, an annuity can help you accomplish them. You need to understand all the fees and restrictions on the annuity product you are considering. You must know how annuity income is taxed when payouts begin, viable investment options, and how the annuity complements your other investments.
When an annuity is not a suitable investment
When buying an annuity for your retirement, ensure the person selling it to you looks and understands your financial plan. Some policy sellers may not have a full understanding of the annuity they are offering you. There are different types of annuities, and you need to find one that suits your financial needs.
All annuities are not alike
There are different types of annuities, and each has its pros and cons. After understanding the annuity plan, you are in the position to ask specific questions about that annuity before choosing it.
Compare broker-sold annuities to no-load annuities before purchasing. Broker-sold annuities are sold by salespersons with an insurance license and a securities license. No-load annuities are purchase directly, and they have lower fees. Some fee-only financial advisors will help you select an appropriate no-load annuity if it fits your plan.
If the advisor does not take time to explain how they are compensated for the product, do not buy.
An annuity based on a well-structured investment will guarantee retirement income. Ensure you understand it before buying.
A variable annuity has investment risk
All annuities do not guarantee a fixed rate of return. In a variable annuity, the premiums are invested in sub-accounts similar to mutual funds. Each sub-account has set objectives, and a management fee is charged in addition to the insurance company’s fees.
An annuity rate of return is based on the performance of sub-accounts. The annuitants bear all risks of investment, and no guaranteed rate of return is assured.
A variable annuity is like a 401(k) plan. Since you choose your investments in sub-accounts, you have an opportunity to get higher returns than a fixed annuity but very risky.