For many years, annuities were simply a method of receiving a stream of payments in exchange for a large chuck of money up front. During the latter part of the 20th century, annuities were modernized by the insurance industry so that they fit just about all financial situations.
Annuities offer flexibility in many of their provisions. You have flexibility of how and when money goes in to an annuity, how and when it comes out, and the investments that will be used by your money is in the contract.
If you are lucky enough to have a defined benefit pension plan, you actually already have an annuity. Once you retire you will begin to receive payments for the rest of your life under some type of payout option. In this situation, you may wish to buy an annuity to supplement that pension income. However you will probably want to put any additional assets into investments which allow for greater capital gain during your retirement years. This might include various types of mutual funds, or a combination of stocks and bonds.
As you can imagine, each person’s financial situation is different and, therefore, the reasons for buying an annuity differ also. Let’s look at some of the more common reasons.
Guaranteed Lifetime Income
Having a guarantee that you will receive payments for the remainder of your life is probably the primary reason people buy annuities. An annuity can be bought at any time. You can start an annuity program in your 20s and contribute a small amount each month into the contract. In this case you would have a deferred annuity since payouts will not start for a number of years in the future.
You can put your money into a contract all at once, such as just before you retire. In this case you would have an immediate annuity since you begin to receive payments shortly after you pay the entire premium. This latter method also gives you complete flexibility during your working career to invest your money in any type of investment program you desire. However, when you retire, you may desire more security in receiving monthly payments, and that is the point at which you would buy the annuity.
There are a couple of considerations you will have when deciding to buy an annuity. Your first concern should be the safety of the insurance company. Since you are making a very long term commitment with your assets, you want to be sure that the insurance company is going to be in existence for a very long period of time. However, insurance companies do become insolvent periodically. For this reason it is imperative that you select an insurance company that is well-known, healthy, and is highly rated by the rating agencies. The primary rating agency that you should review is A. M. Best.
Another consideration is being locked in long term to a single interest rate. The advantage of having a fixed payment each month for your entire life, also becomes a disadvantage. Inflation is the number one problem that a retiree faces over a long period of time. Living on a fixed income each month may be nice at first. However inflation will erode your purchasing power steadily during your retirement years. A new car which costs $20,000 today may cost $40,000 a number of years into retirement. A can of soda which today costs one dollar, may cost you $2 dollars in the not too distant future. Your fixed annuity will not keep pace with inflation.
It is the inflation problem that prompts many financial planners to suggest that you do not place or your assets in a fixed annuity. You need some of your assets placed in investments which will outpace inflation. So if you are considering a fixed annuity at retirement, you may place half your assets in an annuity contract, and invest the other half in a portfolio of high-quality stocks and bonds or mutual funds.
Annuities are used in various situations in which periodic payments are required. An annuity does not always have to be paid for life. Also an annuity does not have to be bought from an insurance company. Any form of periodic payments is technically deemed an annuity. Insurance companies are needed if you wish to receive additional guarantees of payments for life.
One such situation involving periodic payments might be a corporate buyout situation, in which a company pays a business partner for a specific period of time. Or, the company could be a partnership in which one of the partners wants to leave. Here, the partnership would pay the departing partner over a number of years.
Even your state lottery uses annuities for periodic payments. Most people think when they win the lottery that they will get a lump sum. However many of the states have lottery rules where the amount of winnings will be paid over a certain period of time, such as 20 years. You may still be able to select a lump sum, however you will receive much less than you think. For instance, as a general rule from, if you win $1 million, you can expect 50% of that to pay for federal and state taxes. If your state has a rule that the winning amount will be paid over 20 years, and you want a lump sum, you can expect another 25% reduction in the overall amount. So the amount you actually receive in this example will be roughly 25% of the overall lottery winnings. This is not widely known and is a shock to state lottery winners.
Annuities can be used during the asset accumulation phase of your career. The annuity product was originally constructed so that you put in monthly amounts and when you finally retire you would begin to receive payments. The interest credited to your account is guaranteed at all times and you are guaranteed against loss of principle.
In order to stay competitive with the mutual fund industry, insurance companies developed the variable annuity. This type of annuity contract allows you to invest your account value in various mutual fund investments. The purpose is to allow greater growth potential by having your assets invested in stocks and bonds type funds. Of course, such investments carry additional risk. So the insurance company is not providing guarantees of interest and principal during the accumulation phase of the contract.
The variable annuity contract is also fairly expensive when compared to ordinary mutual fund investments. For this reason, many financial planners suggest that you place your assets in various high-quality usual funds during your working career and then by a single premium immediate annuity at retirement.
Contributions to annuity contracts are made with after-tax dollars. You get no tax deduction on your contributions. However, while your money is in an annuity contract, you are not taxed on any earnings are capital gains. You are only taxed when you make withdrawals.
High earning workers will usually make the maximum contributions to their 401(k) plan and, if eligible, to some type of IRA plan. If they are still looking for additional tax deferred investments after that, they might consider an annuity. Tax deferrals under annuities can be delayed all the way up to age 70 1/2. At this age, the tax law forces you to start taking withdrawals.
For those who buy the annuity to receive lifetime income, the tax on any earnings is spread out over the life of the recipient. Your beneficiaries also have tax advantaged options in when and how they wish to receive payments after your death.
Relative to the guaranteed income stream that you receive during retirement, the greatest advantage of an annuity is the feeling of security you receive when you retire. You can go to bed at night with the assurance that you will receive payments each and every month while you live.
Financial planners do not emphasize this point enough. Even if you have a large portfolio of stocks and bonds, you may still have the nagging feeling in retirement that you could outlive your assets. With an annuity, this feeling goes away. You might wish that your payments for higher each month, however, the feeling of certainty is a very real advantage of an annuity. You may not know this feeling until you retire. So, ask a retiree who does not have an annuity, and he will tell you that his number one fear is outliving his assets. With an annuity, you will not have this fear.
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