Frequently Asked Questions
Variable annuity contracts are sold by insurance companies. Purchasers pay a premium of, for example, $10,000 for a single payment variable annuity or $50 a month for a periodic payment variable annuity. The insurance company deposits these premiums in an account that is invested in a portfolio of securities. The value of the portfolio goes up or down as the prices of its securities rise or fall.
After a specified period of time, which often coincides with the year the purchaser turns age 65, the assets are converted into annuity payments. Although the insurance company guarantees a minimum payment, these payments are variable, since they depend on the periodic performance of the underlying securities.
Almost all variable annuity contracts carry sales charges, administrative charges, and asset charges. The amounts differ from one contract to another and from one insurance company to another.
Fixed annuity contracts are not considered securities and are not regulated by the SEC (Securities and Exchange Commission).
Should I invest in annuities?
There are two reasons to use an annuity as an investment vehicle:
You want to save money for a long-range goal, and/or
You want a guaranteed stream of income for a certain period of time.
Annuities lend themselves well to funding retirement, and, in certain cases, education costs.
One negative aspect of an annuity is that you cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10 percent premature withdrawal penalty on money taken out of a tax-deferred annuity before age 59-1/2, and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers’ penalties are termed “surrender charges,” and they usually apply for the first seven years of the annuity contract.
These penalties lead to a de facto restriction on the use of annuities as an investment. It really only makes sense to put your money in an annuity if you can leave it there for at least ten years, and only when the withdrawals are scheduled to occur after age 59-1/2. This is why annuities work well mostly for retirement needs, or for education funding in cases where the depositor will be at least 59-1/2 when withdrawals begin.
Annuities can also be effective in funding education costs where the annuity is held in the child’s name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax on the earnings when the time came for withdrawals. A major drawback to this planning technique is that the child is free to use the money for any purpose, not just education costs.
If an investment adviser recommends a tax-deferred variable annuity, should you invest it? Or would a regular taxable investment be better?
Generally, you should be aware that tax-deferred annuities very often yield less than regular investments. They have higher expenses than regular investments, and these expenses eat into your returns. On the plus side, the annuity provides a death benefit. You should also be aware that there may be a commission on the product an investment adviser may be entitled to a commission on the product he or she is recommending.
Should a retiree purchase an immediate annuity?
At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly, quarterly or yearly payments, representing a portion of principal plus interest, and guaranteed to last for life. The portion of the periodic payout that is a return of principal is excluded from taxable income.
However, there are risks. For one thing, when you lock yourself into a lifetime of level payments, you aren’t guarding against inflation. You are also gambling that you will live long enough to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to keep the rest. Unlike other investments, the balance doesn’t go to your heirs. Furthermore, since the interest rate is fixed by the insurer when you buy it, you are locking into today’s low rates.
You can hedge your bets by opting for what’s called a “certain period,” which, in the event of your death, guarantees payment for some years to your beneficiaries. There are also “joint-and-survivor” options, which pay your spouse for the remainder of his or her life after you die, or a “refund” feature, in which a portion of the remaining principal is resumed to your beneficiaries.
Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of 10 percent at three-year intervals for the first 15 years. Payments are then subject to an annual cost-of-living adjustment, with a 3 percent maximum. However, for these enhancements to apply, you will have to settle for much lower monthly payments than the simple version.
A few companies have introduced immediate annuities that offer potentially higher returns in return for some market risk. These “variable, immediate annuities” convert an initial premium into a lifetime income; however, they tie the monthly payments to the returns on a basket of mutual funds.
If you want a comfortable retirement income, your best bet is a balanced portfolio of mutual funds. If you want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time horizon.
How do life annuities differ from life insurance?
While traditional life insurance guards against “dying too soon,” an annuity, in essence, can be used as insurance against “living too long.” With an annuity, you will receive in return a series of periodic payments that are guaranteed as to amount and payment period. Thus, if you choose to take the annuity payments over your lifetime (there are many other options), you will have a guaranteed source of “income” until your death.
If you “die too soon” (that is, you don’t outlive your life expectancy), you will get back from the insurer far less than you paid in. On the other hand, if you “live too long” and outlive your life expectancy you may get back far more than the cost of your annuity–along with the resultant earnings. By comparison, if you put your funds into a traditional investment, you may run out of funds before your death.
What’s the down side to buying an annuity?
You cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10 percent premature-withdrawal penalty on money taken out of a tax-deferred annuity before age 59-1/2 and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers’ penalties are termed “surrender charges,” and they usually apply for the first seven years of the annuity contract.
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