5 Most Important Points About Understanding Annuities
Once I heard from an advisor, we use to have a saying that said, “If you are a hammer, then everything looks like a nail”.
If you only market annuities, fee-based managed money is not good. If you are into fee-based managed money, then annuities are bad. That is like saying that table saws are never good, only portable circular saws or vice-versa.
The best way to look at this is that annuities are just another financial tool that has its place in a well-planned wealth creation plan.
So to help you understand annuities, in general, I will give you the 5 most important points.
1. Guaranteed income
The first issue to understand is that annuities are created to guarantee a steady stream of income for your retirement years. This is not to say it is enough or not enough income, it is to say it will guarantee the income stream for life or a period certain of your survivors.
This is based on the claims-paying ability of the issuing insurance company. Now before you go and discredit that statement let’s put it another way.
Insurance companies are required by law to carry a much higher reserve requirement than do banks in our fractional reserve banking system.
That is partly why banks are backed by the FDIC, a congressionally authorized insurance company.
2. Principal protection
Unlike other investments whose amount invested could be lost or seriously eroded, annuities are designed to protect the principal amount invested into the product.
What this means is that you or your beneficiaries are guaranteed at a minimum to have your principal returned to you during distribution.
This is based on the guarantee that this principle is returned over time through income distribution. In some cases, this principle can be returned in a lump sum. However, this is not the normal way of accessing your cash. Income distribution is what they are designed to do.
3. Underlying investment
Of course, just getting your principal back creates peace of mind, but is not a reason to put your money into annuities. The reason is a loss of purchasing power if all you received was your principal back.
Consequently, there are basically three ways annuities grow your amount invested. These three are fixed interest, variable or fix-indexed.
- Fixed Interest. In the fixed interest model, your principal earns interest based on a guaranteed rate during a pre-determined time. This could be two years to five years on average. Once the term time is finished the rate will renew for another block of time.
- Variable. In a variable annuity, your principal is invested into sub-accounts that act like mutual funds. You can create a diversified portfolio and trust the markets to grow the principal. This may not always be successful, which is why most annuity companies allow a lock-in of the growth after two to five years. A great feature.
- Fixed Indexed. In fixed indexed annuities, part of the investment is invested in a fixed interest rate bucket and part of it is targeted to mirror the returns of an index, such as the S&P 500. Again, there is a lock-in of the growth at predetermined time periods.
4. Guaranteed death benefit
One of the other features that make annuities attractive is the death benefit. It is typically the initial principle less any withdrawals.
It also can capture the growth of the underlying investments added back in and lock into the higher amount.
The main point to remember here is that the death benefit can also increase and be locked in. This means it can go higher, but never lower, with the exception of withdrawals back to the policy owner.
5. Tax deferral
The other feature about annuities is that your money grows on a tax-deferral basis. This means that you do not pay taxes on the growth until you make a withdrawal.
This is important to understand because it allows you to build upon the investment on top of the growth that you already achieved.
It is very similar to a snowball rolling down a hill full of snow. It will just keep getting bigger. You do not have to stop it as it is going down the hill to take some away and give to the government in the form of taxes.
Once the snowball gets to the bottom of the hill, that is the distribution phase and that is when you take some away for yourself and pay the ordinary income on the distribution.
In short, the more you have to compound, the bigger the assets become. That is the beauty of tax deferral.
Of course, this is just the beginning of understanding annuities. The other issues are such things as surrender charge, 10% free withdrawal rate, annuitized versus withdrawing your income and other issues.
I strongly encourage you to contact a well-qualified financial insurance advisor who can explain this concept to you in more detail.