In a recent post about annuities, we noted that their greatest advantage may be that they will typically last as long as you do.
Annuities usually provide payment as long as you’re alive. That means you can receive distributions without worrying about running out of money, but it also means that if you die young, you may lose out and even receive less than you invested in the annuity.
Of course, any investment carries risk and the peace of mind provided by guaranteed income for life may be worth the investment for many people.
We also noted, though, that there are two major categories of annuities. Fixed annuities provide set payments, so they do not keep pace with inflation, while variable annuities enable investors to allocate their funds to a variety of investments with a wide range of risk and potential return.
While fixed and variable annuities are the two major categories, there are many variations, including hybrids of fixed and variable annuities.
Income Can Go Up, But Not Down
Critics say that variable annuities typically have high costs and complex restrictions, and note that investors bear risk if the underlying investments in their annuities perform poorly.
However, variable annuities also typically offer a guaranteed income withdrawal rate, which is based on the highest value of the investment portfolio. This important feature means that even if the investments made by your annuity manager tank, you are still under contract to receive your guaranteed rate of income.
If, conversely, the investments perform well, your income stream will increase.
Although the primary purpose of a variable annuity is to produce retirement income, it may also serve as a form of life insurance, providing a death benefit by ensuring that your beneficiaries receive the full value of your account. A death benefit equal to the greater of premiums or cash value is usually guaranteed by the insurance company that issues the annuity.
One benefit of this feature is that if you die shortly after purchasing an annuity, your beneficiaries will be able to take full advantage of your investment in your annuity.
In addition, as with qualified retirement plans, taxes on annuities are deferred on any growth within annuity accounts, so the more your variable annuity earns, the greater your tax benefits. Earnings withdrawn are subject to taxation and, prior to age 59½, may be subject to a 10% IRS penalty.
In addition, unlike many retirement plans, there are generally no limits on the amount of money that can be invested in an annuity.
Understand Your Costs
While annuity costs vary significantly, it’s important to weigh the costs against the potential benefits. Fees for annuities, as for investments such as mutual funds and hedge funds, can be complex and expensive. What matters, of course, is what you receive in return.
Generally, variable annuity fees include:
- Investment management fees. While investment fees vary based on the investment options, these fees are similar to the management fees paid when investing in mutual funds. Like a mutual fund, the annuity will issue a prospectus that indicates the underlying investments and their fees.
- Insurance charges.Also known as mortality and expense fees and administrative fees, these charges pay for insurance guarantees that are automatically included in the annuity, as well as the selling and administrative expenses of the contract.
- The person who sells you an annuity will receive a sales commission or fee, which will vary in size depending on the product.
In addition, you may be subject to the following charges:
- Surrender charges. Insurance companies that issue annuities typically limit the amount of withdrawals that can be taken during the initial years of your contract. Surrender charges are reduced and eventually eliminated over time, but it’s wise to not invest in an annuity if you plan to withdraw significant amounts of money from it during the years in which surrender charges are high.
Most variable annuities do not charge money on the front end; however, if you withdraw more than 10% a year, you usually have to pay a back-end sales charge. The charge may, for example, start at 8% and decrease by 1% a year until it disappears.
An annuity should be a long-term investment, but even if you are saving for a date far into the future, be certain that you understand the surrender charges before signing a contract.
- Rider charges.Some annuities, like insurance products, include optional riders that, if accepted, may increase costs. For example, you may add an annual increase rider that will increase payments each year by a pre-determined percentage – usually 1% to 5% – to help keep pace with inflation.
Variable annuities are not appropriate for everyone, but, in many cases, they can play an important role in a person’s retirement plan. Be sure to shop around and to have a full understanding of your annuity before signing a contract. Seek advice from an investment professional who understands annuities and can help determine whether a variable annuity is right for you.