Have you ever heard some say they “hate annuities?” I can understand the frustration – especially if someone purchased something without doing their homework. At the same time, it can be difficult for retirees to select an appropriate annuity given the significant level of misinformation and lack of understanding in the marketplace. This often comes at the hand of biased advisors who prescribe without proper diagnosis or frankly don’t understand annuities themselves.
Are annuities for everyone? Certainly not! For retirees in the distribution phase of life, however, an annuity can be a strategic tool for protecting assets, deferring taxes, avoiding probate and leveraging mortality credits to create future guaranteed lifetime income. There are even certain annuities that pay for long-term care expenses tax-free – meaning that if the deferred gain is used for long-term care expenses, it can be withdrawn tax-free. Once again the talking heads who scream, “I hate annuities!” do a disservice to the public.
Like any misapplied tool, annuities can cause challenges if not aligned properly with your goals and objectives. What are you trying to accomplish? Are you seeking capital protection from market risk, higher returns compared to a saving account or CD rates, deferred growth or future guaranteed lifetime income options? Annuities are a tool that can meet these strategic objectives.
Remember, there is no perfect financial instrument. Each instrument (stocks, bonds, mutual funds, real estate, CDs, annuities, life insurance, etc.) has unique attributes with its own advantages and disadvantages.
With this backdrop, here are some annuity basics.
There are two types of annuities: deferred and immediate.
With a deferred annuity, money is invested for a period of time or as a lump sum until you are ready to begin taking withdrawals. Any credited interest or gain grows tax deferred. The tax treatment upon withdrawal is “last in-first out rule” meaning gains come out first and are taxed as ordinary income.
With an immediate annuity, income payments are received soon after the initial investment. Various payout options can be selected such as life only, joint life and period certain guarantee options. This process, called annuitization, can provide lifetime income like a pension. This may help those concerned about longevity risk, the risk of outliving one’s money.
Deferred annuities can be converted into immediate annuities when the owner wants to begin collecting income payments later. This can be a significant feature when a spouse passes and Social Security or pension income is lost.
Fixed, fixed indexed or variable annuities are types of deferred annuities. Within these categories, even more varieties exist which differ depending on the contract in question. This is where getting educated is critical because annuities come in all shapes and sizes! And, you don’t want to ignorantly, or regretfully utter, “I hate annuities.”
Consider these 10 frequently asked questions as you educate yourself on annuity products:
#1 – How long are annuity contracts? Generally, the shorter contract period, the better. There are many 7-year contracts that are most suitable; however, aligning the contract with your goals is the key.
#2 – What about liquidity? How much liquidity is needed? Before you do anything, it is important to have an emergency fund for unforeseen expenses. Remember, annuities generally are considered illiquid. Did you know that some annuity contracts provide an annual 10% penalty free withdrawal? This may provide enough liquidity for your situation.
#3 – Surrender charges? A surrender charge is an interest penalty assessed when withdrawing more than 10% from the contract in a given year or when fully surrendering prior to maturity. If the annuity is in an IRA, surrender charges are often a non-issue because surrendering large amounts from an IRA would all be taxable.
#4 – Are there hidden fees or charges? Unlike a brokerage account, there are no management fees or administrative charges on fixed or fixed indexed annuities – unless you add an optional policy rider. Variable annuities charge fees to manage the separate accounts in the contract and for selected riders.
#5 – Terminal illness or long-term care waivers. Some deferred annuities provide a surrender charge waiver if the owner is diagnosed with a terminal illness or requires long-term care. This feature is essential for retirees. Be sure to secure a 90-day elimination period so early long-term care expenses can be coordinated with available Medicare benefits.
#6 – Should I buy an income rider? Optional income riders on certain annuities can be complicated and are consequently often misunderstood. Seek understanding on the specific formulas and assumptions that calculate guaranteed lifetime income streams promised by these riders. Caution should be observed with respect to electing fee-based riders on both fixed and variable contracts.
#7 – Is legacy important to you? Annuity proceeds pass directly to heirs avoiding probate. However, gains are taxed as ordinary income. Funds can be passed to beneficiaries as either a lump sum, be stretched over a fixed period or annuitized thereby spreading tax exposure. Check to ensure that surrender charges are waived to beneficiaries if the owner passes during the contract period. If legacy and tax efficiency is important, a single premium whole life insurance contract may be more effective since the death benefit passes tax-free and the growing cash value can be used for income without surrender charges.
#8 – What about the insurance company you’re purchasing from? Know the credit ratings and history of the insurance carrier. Are they a stock or mutual carrier? Remember, claims are subject to the claims paying ability of the issuing company.
#9 – What are the contract provisions governing annuitization? For example, can the contract be partially or fully annuitized, and when? What are the available payout options? As the late Stephen Covey said, “Begin with the end in mind.”
#10 – What about index crediting strategies on indexed annuities? Now you are entering the world of annuity alphabet soup! What index or indexes are being followed? What are the caps, participation rates or margins governing interest crediting? Are they competitive? Caution: Check the renewal cap history of the carrier. This is sometimes called “back-casting.” This is essential to understanding how a cap may change throughout the contract period.
Being an active learner is essential to financial success – particularly when incorporating a financial instrument like an annuity in your plan. Get a professional in your corner who has the heart of a teacher.
I am just a guy who loves life, my wife, my family, my God and my country. I want to pay it forward and make a positive contribution inspiring others to make great life decisions. Growing McKell Partners, a full service wealth management and financial planning practice, is also my passion.
I love a great game of golf, tennis or chasing the sunset on my Cannondale. An evening convertible ride and a bowl of Haagen Dazs peanut butter chocolate ice cream are my go-to stress relievers.
I am just a guy who loves life, my wife, my family, my God, and my country. I want to pay it forward and make a positive contribution inspiring others to make great life decisions.