The Annuity Riddle Unraveled
An annuity is an investment vehicle that has very polarizing effects on people. Some people can’t say enough good things about annuities, while others are so strongly against annuities that they almost put them in the same category as door- to-door loan sharks. Before you form an opinion either way, make sure you completely understand what annuities are, the different kinds of annuities that are available, and how they can impact your future financial security.
First of all, the term annuity refers to a payment made on an annual basis. So you can notice the inclusion of the Latin root “annu,” which means “yearly.” Note that a yearly annuity payment can be broken up into twelve monthly payments, but the contract obligation is still based on a total annual amount.
The next thing you should know is that annuities are not a modern day invention by giant financial institutions out to swindle you out of your riches. If you go all the way back to the Roman Empire, you will see a primitive version of this collective savings instrument that we now call annuities. Both everyday citizens and fighting soldiers were allowed to contribute to a pool of money that was held in escrow by Caesar’s government. For its service, the government took a percentage of each contribution. Contributors would receive yearly payouts that increased the longer they lived. That system was essentially the birth of the modern day annuity. You really have to hand it to the Roman Empire for being so enterprising.
Fast-forward to today, and you have annuities being talked about in hushed tones like they are either every gazillionaire’s best kept secret or the latest version of a pyramid scheme. The fact is, annuities are neither.
In essence, an annuity is a kind of insurance policy. You pay into the policy, much like you do with a standard life insurance policy. Your contribution into the annuity might be made as one lump sum payment, or it could take the form of smaller amounts paid over time.
At an agreed upon date in the future, the payments are reversed, and the annuity starts paying you. This is why annuities are typically used as part of a retirement plan – because an annuity provides income after a certain date, usually after you retire. The financial institution that sells you the annuity takes a small percentage of your contributions (just like Caesar), in exchange for managing the investment. This sums up the basics of how an annuity works, but read on to find out how all annuities are not the same. Choosing the right one for your situation and future needs is crucial to the overall success potential of your annuity experience.
A deferred annuity is set up so you invest today for future payments tomorrow. Deferred references both your deferred payouts – which will come in the future at a date you choose – and the deferred taxes on both the payments in and the payments out.
Under the current tax law, money that you contribute to a deferred annuity is discounted from your taxable income. Whether you choose to contribute a lump sum to start your annuity or make monthly payments over a period of years, that money isn’t taxed until you start receiving the income back as annuity payouts in the future. The tax implications of your deferred annuity plan should be discussed in depth with your accountant.
When you arrange for a deferred annuity, you will receive a schedule of payments over your lifetime, according to the amount you pay into the annuity. Investors appreciate that they can budget on an exact income amount during the entirety of their life.
There are currently four basic types of deferred annuities that you and your financial planner can choose from:
- Fixed Deferred Annuity
A fixed deferred annuity is a product whereby you agree to receive a set, guaranteed rate of return on your investment not influenced by any fluctuations in the market. Fixed refers to a fixed rate of return and a fixed payment amount.
- Indexed Deferred Annuity
An indexed deferred annuity is leveraged against positive changes in the stock index. If the market improves, you get a bigger payout. If the market goes down, you get no less than a base payout sum. In other words, you rate if the the market is good, but you don’t suffer if it goes south.
- Hybrid Indexed Deferred Annuity
This is an investment product that offers the positive benefits of an indexed annuity, along with a lifetime payout rider. The rider guarantees a payout for the duration of your lifetime, even if your initial payments into the policy are exceeded.
- Variable Indexed Annuity
A variable annuity is an investment whereby your payments are invested in a selection of mutual funds. You and your financial planner can choose them together, or you can dictate where the funds are invested. Your future payouts from the variable indexed annuity are then based on how well—or how poorly—your investment performs. You can see from the explanation that a variable indexed annuity is considered a more risky option, since there is a chance that your investments could leave you financially wanting.
Immediate annuities are the second type of basic annuity. The way an immediate annuity works is this: You make either a lump sum payment into the annuity or several payments over the course of several years. You begin receiving payments immediately, which will continue for the duration of your lifetime. If you meet and early demise, you will of course not benefit from all the payments you contributed. If you live a long and fruitful life, you could make out considerably far ahead of the money you put into the vehicle.
If you want to ensure your heirs benefit from any money you invested, you have the option of having your heirs receive the balance of any money you put in over the amount you got out.
Lastly, remember that annuities are insurance investments. The safety and security of your annuity investment largely depends on the strength of the insurance company that backs the annuity. So educate yourself well about all the players before moving ahead with an annuity vehicle.
Annuities represent carefully regulated and approved investment vehicles that can play an integral part of a well-rounded financial portfolio. If you haven’t discussed your annuity options with your financial planner, you could be missing out on an opportunity that has the potential to increase your future retirement security. After you get all the facts you need from your financial expert about the risks and rewards of annuities, you might just find that an annuity is right for you.