Annuities

Life Annuities

For future retirees, and those currently enjoying retirement, investment focus often turns from accumulation toward income generation. One of the largest challenges an investor will face in retirement is how to transform their investment capital into a regular income stream, replacing the once regular pay checks earned from their former employers. One popular financial instrument designed to accomplish this goal is an annuity.

An annuity describes a contract formed between an insured party and an insurance company. In return for premiums paid, the insurance company agrees to render periodic payments to the insured either immediately, or at some future date.

Basic Annuity Types

There are three common types of annuities offering customization options depending upon the insurance company issuing the contract. These common types include:

• Fixed – A fixed annuity contract guarantees to pay you nothing less than the specified interest rate, as noted at the time of issue. This interest rate applies to the funds deposited as they accumulate over time. Once the accumulated funds have been annuitized, or are in withdrawal mode, the insurance company also agrees to pay specific amounts of interest over the designated period (i.e. 10 year, 15 year, 20 year or lifetime).
• Variable – This annuity type offers the ability to build an investment portfolio from the mutual fund like investments offered by the insurance company. The rate of return generated from these underlying investments is subject to market risk, and therefore will vary over time. Investors are often attracted to variable annuities for the upside investment potential, and are generally focused on accumulation, not income generation.
• Indexed- An indexed annuity is often described as a ‘blend’ strategy. With an indexed contract, the insurance company guarantees that the contract value will not fall below a specified level, regardless of the underlying index’s performance over the period. The interest rate credited to the annuity account is derived from changes in the underlying index (i.e. S&P 500). So, an indexed annuity investor can take advantage of some market upswing, without accepting the risk of market downturns.

Common Features and Benefits

Annuities offer a variety of investor benefits, including:

• Tax Deferred Growth– One of the most attractive features of an annuity contract is the ability to defer taxes while the funds are in accumulation mode.
• Variable Payment Options– Investors can choose to deposit a lump sum or to make periodic investment payments into the contract.
• Variable Withdrawal Strategies– Investors aren’t required to annuitize their contracts; meaning, they don’t have to select a fixed payment option at a specified date. Although they can. Withdrawal strategies with most annuity contracts are designed to cater to the income needs of the insured party.

Every insurance company offers specific perks, features, guarantee benefits and options for consideration beyond these basics. As you compare offers, be sure to ask questions about what’s available, how each feature could benefit you, and the associated cost for each feature.

Policy Funding Options

Most insurance companies offer a variety of funding options, including:

• Single Premium- For investors seeking to contribute a lump sum, or non-qualified or qualified funds, single premium annuities offer the accommodations being sought after.
• Periodic Payments– For investors seeking to utilize an annuity for accumulation, periodic payments may be attractive. Periodic lump sums may be added to the annuity contract as cash becomes available, or a specified amount may be contributed on a dollar cost average basis.

When taking into consideration how much to contribute to your annuity contract, take a step back to review your entire personal financial situation (investment time frame, capital available to invest, capital accumulated for retirement, investment risk tolerance and income required).

Understanding Withdrawal Options

In addition to the basic concepts described thus far, there are a few other noteworthy points to mention about this investment vehicle.

While cash deposited into an annuity grows on a tax deferred basis, it will be taxed as ordinary income, not as capital gains, upon withdrawal. Also, as an annuity is considered to be a retirement planning vehicle, early penalties apply for withdrawals taken prior to the age of 59 ½. And finally, investments into an annuity have associated surrender fees, as assessed by the insurance company. When considering a contract, be sure to review the duration of these surrender fees and the associated penalty percentage (i.e. 7 years declining scale, 10 years, etc.).

How Much Should I Invest?

Most pre-retirees and retirees consider annuities due to their guarantees and ability to generate an income stream during retirement. When determining how much to invest into an annuity, you must first calculate what amount this income stream needs to be. Your household budget will be an important consideration in this process. If you haven’t recently evaluated your budget, now is the time.

Review your monthly spend rate, making note of the type of each expense; fixed or variable. A fixed expense is one that doesn’t change on a month-to-month basis, and which is also required (i.e. mortgage, car notes, loan payments, credit cards, grocery and utilities). Variable costs encompass everything else, and can vary on a month-to-month basis (i.e. gifts, travel, dining out, entertainment, etc.).

When building a solid investment strategy using annuities, start with your fixed costs. Ideally, you would deposit an amount into an annuity that would produce an income sufficient to cover your basic household costs, or the fixed expenses you just reviewed. The remainder of your investment portfolio should be allocated in such a manner to generate some portfolio growth, offsetting the effects of inflation on your dollar throughout your retirement.

While there are a number of strategies available for utilizing an annuity as a retirement planning vehicle, this concept is the most basic, and will ensure that your ongoing monthly needs are being met.

Now that you have developed a basic understanding of how annuities work, how they could potentially benefit your retirement vision and how to think about investing into one, spend time speaking with qualified financial professionals to determine if this option is the best for your given situation.