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Annuities 101

by Craig Moser on February 8, 2019

Working with people over the past 25 years, our main objective has been to grow assets for the future. When people begin to retire, the game changes. We worked to “buy low” and “sell high” while accumulating assets.  As you near and enter retirement, the strategy changes.  This transition is foreign to many people.

Market declines during retirement can have a negative impact on your savings and investments.  You’re no longer consistently adding to your accounts during the down periods, instead taking withdrawals. Think about it, if your investments decline and you’re withdrawing from that same pool, it’s a loss. That money will not find its way back to your investments in the future, the way it did when you were saving every month.

We’ve seen the value of consistent cash flow from areas such as Social Security, pensions, interest payments, and dividends. There is a great deal of angst when we talk about Social Security, because the government can choose to manipulate the payments we get. You should get your Social Security benefits, but, if there is no cost-of-living adjustment, then the payment loses some value to rising inflation.

Pensions are valuable income streams, but many companies have eliminated them over the past 20 years.  They offer a defined contribution plan that allowed you to fund your own retirement.  With this plan, what you decide determines the lifestyle you have after you retire.

If you’re like me, then you don’t have a pension from your workplace. If you think you may live to 85 or older, there is potential to outlive your nest egg.  One method to help avoid this, is to fund an income annuity.

Types of Annuities

One type of annuity, that most people think of when they hear the word “annuity,” is an immediate annuity.  This is when you give your money to an insurance company, and in turn they provide a set payment to you. There are options available on how long the payments will last.  You can also set up a payment plan for both your life and the life of your spouse.

You can choose to define the period of time the annuity will pay, from 10 years up to your entire life.  The downside is that you lose control over the money you invested in return for the income. Some folks don’t like having an illiquid asset, which is typically what an annuity is, at least for the short term.

Other types of annuities are more established tax-deferred investments.  They just have different types of investment “engines” inside.

Fixed

A fixed annuity is similar to a CD because interest is guaranteed for a period of time. Earnings are compounded daily from interest, and this rate may be high or low, depending on what the current rates were at the time the annuity was purchased.  Obviously, it is preferable to be locked in with a higher rate. However, you aren’t invested in the “markets”.  In other words, you don’t see fluctuations to the downside in these accounts.  You also can annuitize  (“turn on” the payments)

Variable

A variable annuity is very similar to the fixed, but has a mutual fund-like investment as its “engine”.  Managing these sub-accounts are the same quality managers who run mutual funds.  Likewise, you typically pay a fee for their management of your funds, when someone is “driving the train”.

Also, insurance companies will typically charge a fee called “mortality and expense”.  This is a way for the company to create a revenue for themselves. If you add extra features, called riders to your annuity, those riders will usually have a cost associated with them.

Because variable annuities have market-based investments at their core, you’ll see the value of the contract fluctuate relative to stock markets. If you purchase an income rider, you can create a guaranteed income stream from that annuity.  You can also pass any remaining value to loved ones. Another rider can provide a death benefit for your heirs, which would not be subject to the market’s potential losses. Every rider has a cost related to the guarantees purchased.

Fixed-Index (FIA)

A fixed-index annuity (FIA), has characteristics of both the fixed and variable annuities.  FIAs are similar to fixed annuities in that you don’t experience market losses in these contracts. Your investment can “participate” in market index returns when they are positive, but not experience losses when markets are in decline. The word “participate” is important, because these contracts use interest credit to purchase an option on a market index. This means you won’t capture all market returns when it is positive.  This is a trade-off for not having the potential for loss.

An income rider provides lifetime income.  If there is money remaining in the contract, it passes to your beneficiaries.  However, an income rider allows the annuity to keep paying income, even after the paid-in amount is depleted.

As you see, not all annuities are the same, and working with an experienced professional can help determine if an annuity is right for you.  An advisor should illustrate its various benefits and options, to provide the best product for your income needs.

Annuities may help provide an income stream that you cannot outlive.  However, it’s important for one to do their research, and be aware of all costs associated with an annuity, as far as taxation, fees, and liquidity are concerned.

The bottom line is, an annuity is merely a tool that performs a specific function.  Be sure you understand how they work,  and if they best meet your needs, before purchasing one.

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