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Over the last few years Annuity ownership within retirement plans has become more commonplace. But, annuities can be very confusing and misunderstood.
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Just look at the following quotes to get some understanding of the varied opinions on annuity ownership:
“You could also do annuities. There are fixed annuities and variable annuities. I would not do fixed annuities because they are a bad savings account with an insurance company.” -Dave Ramsey
“People who buy annuities, it turns out, live longer than people who don’t, and not because the people who buy annuities are healthier to start with. The evidence suggests that an annuity’s steady payout provides a little extra incentive to keep chugging along.” – Steven Levitt
“The peace of mind is born from the sales pitch, not the contract. Only the contract is truth.” Annuity contracts are almost impossible to understand and the average person doesn’t read them. – Jim Cramer
“You don’t date an annuity, you marry it. An annuity isn’t a mutual fund that you buy today and sell tomorrow. Nor is it a certificate of deposit, ready for any new use at maturity. When you buy an annuity, you are making (or ought to be making) a 15- or 20-year commitment, at least.” – Jane Bryant Quinn
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It quickly becomes obvious that they are great differences of opinion regarding annuity types, validity, and ownership.
These are my thoughts on annuities: Through an annuity, money is irrevocably transferred to an insurance company. The insurance company takes the money and it’s invested for long periods. The insurance company returns your money in small increments and charges an annual fee for the privilege of returning your money to you. With the termination of most contracts (normally at the annuitant’s death), the insurance company keeps the remainder of the money. That sounds like a great deal, right?
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What Exactly is an Annuity?
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According to Investor.gov: An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments.
The largest single benefit of annuity ownership is SECURITY. Annuities provide a guaranteed income stream for a defined period (or lifetime) of an individual or a couple. The security of guaranteed income for life is very alluring.
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Who Benefits Most From an Annuity?
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People approaching retirement can be segmented according to their level of retirement funding. Underfunded people usually can’t afford to forego significant amounts of limited retirement funds to purchase an annuity. People adequately funded for retirement have the hardest annuity decision because they have adequate funds to purchase an annuity, but usually have a hard time deciding to purchase an annuity. People who are overfunded may purchase an annuity for added security but are usually in a position where they can self-insure lifestyle expenses with retirement income from investments.
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The Five Types of Annuities for Retirement
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Immediate Annuity– with an immediate annuity, a certain amount of money is placed in an annuity contract. In return for giving up your money, an annuity owner receives a certain amount of income. The length, size, and frequency of annuity payments are determined by policy provisions. The big advantages of immediate annuities are an ongoing income stream and protection against outliving your savings.
Fixed Annuity– fixed annuities have a set interest rate that is determined by the insurance company. The fixed-rate ensures that money will grow steadily over time, and rates are determined by the length of the Annuity’s term (longer contracts equal higher interest rates.) when the contract expires the money can either be withdrawn or reinvested.
Variable Annuity– Variable annuities invest in multiple investments such as stocks, bonds, and mutual funds. Because income is tied to investment returns, income can increase or decrease. Income is not guaranteed and will depend on the embedded investment’s performance.
Fixed-Indexed Annuity– These annuities combined the benefits of both a fixed annuity and a variable annuity. Investors benefit from the growth of funds that are invested in indices such as the S&P 500, but at the same time are protected from losses that are due to market downturns.
Long-Term Care Annuity– Long-term care annuities combine annuity and long-term care insurance features to provide money for long-term care services. Using a long-term care annuity may double or triple the amount of money available for qualified, long-term care expenses, and any remaining unused annuity value can be passed on to beneficiaries.
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Pros and Cons of Annuities
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Pros:
- Guaranteed income– annuities provide the stability of a guaranteed stream of income for a specified period, or the lifetime of the policyholders.
- Tax deferral– money generated from annuity investments can grow tax-deferred, allowing for potential higher returns, and is taxed when distributed.
- Rollover potential– certain classes of annuities are renewable and earnings are rolled over into a new annuity without tax implications.
- Planning– annuities have the potential to be a valuable and comprehensive part of a diversified retirement portfolio. Annuities can provide beneficiary designations that facilitate the transfer of residual value in the annuity in a tax-efficient manner. Annuities with guaranteed death benefits create wealth transfer vehicles that benefit beneficiaries. In some situations, annuities may also be protected from creditors.
- Medicaid and long-term care planning– strategic use of annuities can be useful in Medicaid planning by protecting assets, and helping in qualifying for long-term care benefits by sheltering assets inside annuity contracts. Annuities can also be structured to fund long-term care expenses.
- Risk management– Annuities can help decrease overall risk through the diversification of investment portfolios.
- Predictable and risk-free returns– fixed annuities offer a guaranteed rate of return while fixed indexed annuities protect the principal from losses incurred with market declines.
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Cons:
- Penalties and surrender charges– most annuities levy penalties, and may have surrender charges early in the contract. In many cases, penalties and surrender charges decrease or disappear over time.
- Inflation risk– very few annuities provide true inflation risk mediation. This means that most annuities are vulnerable to the ravages of inflation, and the income they provide is subject to loss of buying power in high inflation periods.
- High fees– high commissions, management fees, and surrender charges all harm overall income potential and investment returns.
- Contract complexity– One of the biggest complaints with annuities is that contracts are very complex and, in many cases, almost impossible to understand.
- Liquidity– As stated above, most annuity contracts make it difficult, if not impossible, to access funds early in the contract. Annuity contracts may also impose large surrender charges early in the contract.
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The main benefits of annuities appear to be secure and guaranteed income that can occur over a fixed period, or for the remainder of a person’s life. However, it should also be noted that these benefits come with a higher cost in terms of fees, lack of liquidity, lack of flexibility, and loss of principal in most cases at the contract’s end.
I have over 45 years of interactions with insurance companies concerning the determination of dental insurance benefits. I realized early in my career that insurance benefits, though a necessary evil, are always tilted towards the benefit of the insurance company. Annuity contracts follow the same principle. Actuaries determine the insurance company’s exposure and insurance companies base their contracts, interest rates, and fees on actuarial information with a healthy profit built into every contract. Most insurance companies make it easy to put money into an insurance contract and much harder to get it out.
As a form of disclaimer, I must state that I do own annuity contracts. In my investment portfolio, I created an annuity ladder using Multi-Year Guaranteed Annuities (MYGAs).
Annuities, through their use of secure income and with their potential for portfolio diversification, can provide added benefits to a comprehensive retirement plan.
Most annuities are very complex, and in almost every case professional help is indicated and beneficial. There are multiple annuity companies and independent annuity brokers that can provide needed assistance. Independent brokers have access to different annuity products and are not tied to one annuity company. It’s my opinion that independent brokers will give the most unbiased opinion about the best annuity product in any given situation. It’s important to remember that even independent annuity agents receive commissions and incentives to recommend certain annuity products. However, this is one area of retirement planning where I would not recommend that you go it alone! Mistakes made in purchasing annuities can be disastrous, costly, and almost impossible to reverse!
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Final Thoughts
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- Annuities are a very complex and confusing area of retirement planning.
- An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments.
- Annuities come in many forms. Contracts may be fixed or variable, immediate or deferred, and may or may not provide protection from inflation.
- Annuities have many positive aspects such as guaranteed fixed income, the potential for inflation mediation, retirement and estate planning benefits, portfolio, diversification, and risk management potential.
- Annuities also have several negative aspects such as high fees, severe surrender charges, complex contract verbiage, and lack of liquidity.
- Because annuities provide secure income and a potential for portfolio diversification they can provide additional benefits to retirement plans.
- When purchasing an annuity, professional help is beneficial and advisable.
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