Annuity
What is an annuity?
An annuity is a product that can provide you with a lifetime income, typically on retirement. Annuities are viewed as a way to hedge against longevity risk, or the potential for one to outlive one’s invested assets.
Social Security and/or defined pension benefits are prominent examples of annuities.
Annuities can be structured with a variety of different specifications. Given its traditional purpose of providing perpetual cash flow to the beneficiary (also known as the annuitant), it is commonly structured as open for the duration of the annuitant’s life or his or her survivorship beneficiary.
They can also be constructed as providing benefits over a set period of time, such as 25 years. Annuity payouts can also begin at the outset of a lump sum deposit, or can take place at a certain specified point in the future, such as ten years from initial deposit or when the annuitant comes of retirement age.
The payment sum, typically monthly, can also be set up as a fixed or variable structure.
A fixed rate provides the safety of a knowable monthly number. But it also sets up risk in the form of higher inflation reducing its real value or leaving cash on the table in the event the investments perform better than expected.
A variable structure allows for payments to ebb and flow based on returns and can also provide less risk for the issuer (usually a life insurance company) of the product by avoiding getting locked into a fixed payout scheme.
The accumulation phase
The accumulation phase is when an annuitant is making periodic deposits into the annuity contract.
Just like any other investment account, the money deposited will grow based on the performance of the underlying investments.
The distribution phase (or the annuitization phase)
The distribution phase begins when the annuitant starts to receive payments from the annuity.
The frequency and amount of payments are determined by the terms of the contract.
Who are annuities good for?
Invested cash in annuities is illiquid and subject to withdrawal, so they are not generally good for those with regular or uncertain liquidity needs.
They are good for retirees who want reassurance that they’ll continue to receive a stream of income for the duration of its life to ensure that they don’t outlive their assets.
Types of annuities
There are two types of annuities:
- immediate, and
- deferred
Immediate annuities
Immediate annuities begin paying out immediately after the initial deposit is made, while deferred annuities allow for a period of accumulation before payouts begin.
With an immediate annuity, you make a lump sum payment and then start receiving payments immediately. This is ideal for someone who wants to start making an income immediately from the investment to live off of or put into other investments.
Deferred annuities
With a deferred annuity, you make periodic payments into the account and then start taking distributions at a later date, such as retirement. This is ideal for someone who wants to save for retirement while also insuring against longevity risk.
There are two types of deferred annuities: fixed and variable.
Fixed deferred annuity
A fixed deferred annuity pays a guaranteed rate of interest on your deposits.
The payments you receive in retirement will be based on the interest rate at the time you annuitize (start taking distributions).
Variable deferred annuity
A variable deferred annuity does not offer a guaranteed rate of interest.
However, the payments you receive in retirement will be based on the performance of the underlying investments.
Features of annuities
Annuities come with a variety of features that can be tailored to your specific needs.
Some common features include:
–Guaranteed income for life: This feature guarantees that you will receive income payments for as long as you live, even if your account value runs out.
–Period certain: This feature guarantees that you will receive income payments for a set period of time, even if you die before the end of the period.
–Inflation protection: This feature adjusts your payments to keep up with inflation.
–Death benefit: This feature pays out a death benefit to your beneficiaries if you die before the end of the term.
What are some of the downsides to annuities?
The biggest downside to annuities is that they are not liquid. If you need access to your cash, you will likely incur surrender charges from your provider.
Additionally, if you pass away before the full value of your annuity has been paid out, your beneficiaries will only receive what is left in the account – they will not receive the full face value of the annuity.
This can be mitigated by choosing a joint-life annuity, which pays out as long as either member of the couple is alive, but this option typically comes with a lower monthly payout.
Another potential downside is that annuities are subject to market risk, depending on the nature of the annuity. This means that if the market falls a lot, your annuity value can go down.
However, if you have a fixed annuity, your monthly payments will not be affected by market fluctuations.
And finally, annuities have fees, which can include surrender charges, mortality and expense risk charges, administrative fees, and rider fees.
These fees can eat into your investment returns, so it’s important to understand all the fees associated with an annuity before investing.
Annuities are also complex instruments, so many employers don’t offer them as part of their 401(k) retirement plans.
Nonetheless, in December 2019, US President Donald Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act into law.
This bill loosened the rules as it pertains to how employers can select annuity providers and includes annuities within their 401(k) or 403(b) investment plans.
Annuities vs. Life Insurance
Annuities and life insurance are both financial products that can be used to help you reach your long-term financial goals.
Here’s a quick overview of the key differences between annuities and life insurance:
Annuities are designed to provide income in retirement, while life insurance is designed to provide financial protection for your loved ones in the event of your death.
With an annuity, you make regular payments into the account, and then receive payments back from the account at a later date. With life insurance, you make a one-time payment for coverage, and if you die during the policy term, your beneficiaries receive a death benefit.
Annuities can be either fixed or variable, while life insurance is always fixed.
Annuities are not tax-deferred, while life insurance is.
So, which one is right for you? It depends on your individual financial situation and goals.
If you’re looking for income in retirement, an annuity may be a good option. If you’re looking for financial protection for your loved ones, life insurance may be a better choice.
An annuity is an insurance contract that guarantees income payments for a set period of time, even if you die before the end of the period.
The biggest downside associated with annuities is that they are not liquid. If you need access to your cash, you will likely incur substantial penalties.
Another downside is that annuities are complex products, and it can be difficult to understand all the fees and charges associated with them. It’s important to work with a financial advisor to make sure you understand the product before you invest.
An example of an immediate annuity is when an individual would pay a single premium – e.g., $100,000 – to an insurance company and receives monthly payments – e.g., $1,000 – for a fixed period of time afterward.
The amount that’s paid out for immediate annuities depends on market conditions and interest rates.
IRA vs. Annuity – What’s the difference?
An IRA is an individual retirement account that allows you to save for retirement and receive tax benefits. An annuity is an insurance contract that provides income payments for a set period of time, even if you die before the end of the period.
The key difference between an IRA and an annuity is that IRAs are tax-deferred, while annuities are not.
This means that with an IRA, you don’t have to pay taxes on the money you contribute until you withdraw it in retirement. With an annuity, you pay taxes on the money you contribute as you go along.
Another key difference is that IRAs offer more flexibility than annuities.
With an IRA, you can choose how your money is invested. And once you reach age 59½, you can withdraw funds from your Traditional IRA without restrictions or penalties.
With an annuity, you cannot withdraw your money without incurring penalties, and you have less control over how your money is invested.
Which one is best for you?
If you’re looking for tax-deferred growth and flexibility, an IRA may be a good choice. If you’re looking for guaranteed income payments in retirement, an annuity may be a better choice.
Annuities in Day Trading
Annuities can be a great option for those who want to hedge the risks involved with potentially outliving their saved assets.
Day trading is an active form of asset management where traders are generally looking to take advantage of short-term movements in the market.
Even so, it can be beneficial for those with more active, higher-volume trading styles to set aside a portion of their income each month as savings in a longer-term portfolio, potentially in the form of annuity.
Developing a nest egg or rainy day account as a complement to your active trading strategy can work to hedge risks and better secure your financial future.
Annuities – FAQs
Who buys annuities?
Anyone who wants to ensure they have a steady income stream in retirement can buy an annuity.
Annuities are also popular with people who want to leave an inheritance to their family.
How do I know if an annuity is a good investment for me?
That depends on your individual financial situation and goals.
If you’re looking for income in retirement, an annuity may be a good option. If you’re looking for financial protection for your family, life insurance may be a better choice.
Is an annuity a good investment if I’m already retired?
Yes, annuities can be a good investment for those who are already retired and looking for income.
What are the different types of annuities?
There are two main types of annuities: immediate annuities and deferred annuities.
Immediate annuities start paying out income right away, while deferred annuities allow you to grow your money over time before taking income payments.
How does an annuity work?
An annuity is an insurance contract that guarantees income payments for a set period of time, even if you die before the end of the period.
With an annuity, you make regular payments into the account, and then receive payments back from the account at a later date.
What are the benefits of an annuity?
Some of the benefits of an annuity include:
- Guaranteed income payments for life
- Principal protection
- Tax-deferred growth
- Death benefit protection
What are the drawbacks of an annuity?
The biggest downside associated with annuities is that they are not liquid. If you need access to your cash, you will likely incur substantial penalties.
Another downside is that annuities are complex products, and it can be difficult to understand all the fees and charges associated with them. It’s important to work with a financial advisor to make sure you understand the product before you invest.
How much does an annuity cost?
The cost of an annuity depends on the type of annuity, the features you choose, and the company you buy it from.
To get an idea of how much an annuity might cost, contact a financial advisor or insurance company.
When can I start taking money out of my annuity?
The date when you can start taking money out of your annuity depends on the type of annuity you have.
With a deferred annuity, you typically cannot start taking money out until you reach retirement age.
With an immediate annuity, you can start taking income payments right away.
What are some things to consider before buying an annuity?
Some things to consider before buying an annuity include:
- Your age and health
- Your investment goals
- Your financial situation
- The type of annuity you want
- The company you want to buy the annuity from
It’s also important to understand all the fees and charges associated with annuities before you purchase one.
What are some red flags to watch out for when buying an annuity?
Some red flags to watch out for when buying an annuity include:
- High fees and charges
- Complex product features
- Pushy salespeople
It’s important to work with a financial advisor you trust to make sure you understand the product and aren’t being taken advantage of.
What are some of the risks and criticisms of annuities?
Deposits into annuities entail a lockup period, where funds generally can’t be withdrawn before a specified period.
If funds of a certain amount are drawn before the stated period, the annuitant would face a penalty.
Lockup periods can be 10 years, or sometimes even longer similar to other illiquid investments such as hedge funds, private equity, and venture capital. The sooner the funds are drawn, the greater the penalty tends to be.
This is instituted by issuers to better ensure that they’ll make a return on investment on these products (otherwise there is no point in them offering the service).
Similarly, insurers will add costs to a product that demands earlier payment withdrawals, longer payout durations, accelerated payouts upon the triggering of some clause, risk hedging (e.g., inflation linkage, etc.), survivorship benefits, and other potential features that could conceivably increase the product’s present value of cash flows.
What is a non-qualified annuity?
A non-qualified annuity is an annuity that is not held in a qualified retirement plan, such as an IRA or 401(k).
Non-qualified annuities typically have fewer restrictions than qualified annuities, but they also may be subject to taxes.
It’s important to talk to a tax advisor to see if a non-qualified annuity is right for you.
What is a qualified annuity?
A qualified annuity is an annuity that is held in a qualified retirement plan, such as an IRA or 401(k).
Qualified annuities typically have more restrictions than non-qualified annuities, but they may also offer tax benefits.
It’s important to talk to a tax advisor to see if a qualified annuity is right for you.
What is a single premium annuity?
A single premium annuity is an annuity where you make one lump sum payment into the account.
Single premium annuities typically have higher income payments than other types of annuities.
What is a variable annuity?
A variable annuity is an annuity that allows you to invest your money in a variety of different investments, including stocks and bonds.
The value of your investment will fluctuate based on the performance of the underlying investments.
Variable annuities also typically have higher fees than other types of annuities.
What is an index annuity?
An index annuity is an annuity that is linked to a stock market index, such as the S&P 500.
The value of your investment will fluctuate based on the performance of the underlying index.
Index annuities typically have lower fees than other types of annuities.
What is a fixed annuity?
A fixed annuity is an annuity that pays a fixed rate of interest.
The value of your investment will not fluctuate based on the performance of the underlying investments.
Fixed annuities typically have lower fees than other types of annuities.
What is an immediate annuity?
An immediate annuity is an annuity that allows you to start receiving income payments right away.
Immediate annuities typically have higher income payments than other types of annuities.
What is a deferred annuity?
A deferred annuity is an annuity where you make regular payments into the account over time.
The money in the account grows tax-deferred and can be used for retirement income or other purposes at a later date.
Deferred annuities typically have lower fees than other types of annuities.
What is an annuity fund?
An annuity fund is the investment fund in which the annuity holder’s funds are invested.
An annuity fund is structured similar to a pension fund, where returns are matched against corresponding liabilities (i.e., the payouts that have to be paid to annuity holders).
What is the best age to buy an annuity?
There is no single answer to this question as it depends on your personal circumstances.
It’s important to talk to a financial advisor to see if an annuity is right for you and, if so, what the best age to buy an annuity would be.
Typically, annuities are purchased by those who are near or in retirement.
What is the surrender period?
The surrender period is the length of time that you are required to keep your money in the annuity before you are able to withdraw it without incurring a penalty.
Surrender periods typically range from 5 to 10 years.
Summary – Annuities
Annuities are a type of investment that can be used to generate income in retirement.
They are contracts between an investor and an insurance company, under which the investor makes periodic payments into the account.
In return, the insurance company agrees to make income payments to the investor for a set period of time, or for the rest of their life.
Annuities are illiquid. Deposits into annuity contracts are usually locked up for a period of time, which is known as the surrender period.
In these cases, the annuitant would incur a penalty if all or part of that money were taken.
Annuities are also subject to market risk. This means that if the market falls a lot, your annuity value can go down. However, if you have a fixed annuity, your monthly payments will not be affected by market fluctuations, though you’ll still be subject to the credit risk associated with the company paying you the annuity.
And finally, annuities have fees which can include surrender charges, mortality and expense risk charges, administrative fees, and rider fees. These fees can reduce investment returns, so it is important to understand all the fees associated with an annuity before investing.
An annuity can be a great option for those who want to hedge the risks involved with potentially outliving their saved assets.
Even so, it can be beneficial for those with more active trading styles to set aside a portion of their income each month as savings in a longer-term, well-balanced portfolio, potentially in the form of an annuity.
Developing a nest egg or rainy day account that serves as an additional source of reliable income as a complement to a more active trading strategy or separate investment plan can work to hedge risks and better secure your financial future.