Understanding How Annuities Work
Defining an Annuity
The key to understanding how annuities work is to first define what an annuity is. An annuity is a lump sum payment paid regularly to an annuitant called an insured. There are two phases of annuities: the accumulation phase and the payout phase.
In the accumulation phase you can make regular payments into the annuity or pay it all at once. If you pay a lump-sum into an annuity, and you receive the benefits at once, it is an immediate annuity. Deferred annuities are when you make payments towards the annuity over time and once the contributions end, you start receiving payments.
When you start receiving payments it is known as the payout phase. Annuities usually pay monthly or yearly but an annuitant can request payments as needed. It can pay out over a set number of years or last a lifetime. Taxes are due once you start receiving the payments. They were designed to protect the annuitant from outliving their income.
Another important factor in understanding how annuities work is understanding the types of annuities as categorized below.
Understanding How Annuities Work is Knowing the 3 Basic Types.
Fixed Annuities:
Offers a specific interest rate. This lets you know ahead of time how much your annuity will increase in value. It is best to look for annuities that offer at least the inflation rate so that your investment doesn’t lose its buying power over the years.
Indexed Annuities
An indexed annuity is an annuity tied to an index. What is an index? An index is an investment vehicle tied to a group of stocks or bonds. The most well-known of indices is the Standard and Poor’s (S&P 500) or Dow Jones Industrial Average.
Variable Annuities
Have a range of investment options from mutual funds that invest in stocks and bonds, money markets or a combination of those investments. The value of your annuity will have vary depending on how the investments perform. If they perform well, you can increase your investment quite handsomely. They are also a higher risk because they are tied to the market, and you could lose money.
What You Need to Know About Annuities
Know the fees associated with annuities. Fees listed do not apply to indexed annuities only. These fees also apply to variable annuities. Surrender fees apply to all annuities unless you pay for the annuity in one lump sum.
Below are ways the insurance industry decides your rate of return:
Asset fee/margin/spread:
These are fees associated with indexed annuities. The fees will be subtracted from the gains the indexed annuity earns. For example, if an index gained 10% and the asset fee (spread or margin fee) was 2%, then the annuity would only be credited 8%.
Bonus:
This is the percentage of the first-year premiums the insurance company received and is added to the value of the contract. It is decided through a vesting schedule which decides when a benefit is earned. It may be something like 15% or 20% over 5 years.
Then there is the surrender charge period. Suppose you decide to cancel your annuity that has a ten-year surrender charge. it would look something like this:
7% charge if you cancel your annuity in the first 1-3 years.
5% charge if you cancel your annuity within 4 to 5 years
1% charge if you cancel in year 6 – 10.
After 10 years there are no surrender charges.
Cap:
Most insurance companies have a cap on indexed annuities. Suppose the index your annuity is tied to earns 10%, but the cap on the indexed annuity is 5%. You will only earn 5% regardless of how high the index earns. The index can earn 20% and you will still only get 5%.
Participation Rate:
This is the percentage of the index’s return an insurance company credits to the annuity. An example of this would be if the annuity’s participation rate is 75% and the market went up 10%, then there would be a 7.5% return credited on the annuity. However, most indexed annuities have a participation rate cap, which would limit the credited return to 5% instead of 7.5%.
Riders:
Are extra features or benefits that can be bought in addition to the annuity depending on the needs of the annuitant.
As with all insurance products an annuity is only as good as the insurance company behind it. Whenever considering buying insurance do your research their ratings. There is a reason for cheap insurance. They may not pay their claims promptly or may find a way not to pay. Remember the saying “you get what you pay for.” Cheapest products generally aren’t the best products. To rate an insurance company, you can use:
- Standard and Poor’s
- Moddy’s
- AM Best
- Fitch
Don’t overlook rider’s to insurance products. They are there to make sure all your needs and wants are addressed.
When looking at annuities, look at the fees associated with them. After fees are subtracted from your rate of return, is it above or below the inflation rate? The inflation rate is between 2%-4% a year with exceptions during peaks and downturns in the economy, when it can be lower or higher.
For myself I do not like anything below 4% after fees are taken into consideration. However, with that said, you will be hard pressed to find annuities that offer more than 6%.
Once fees are taken into consideration, you returns will probably be between 1%-4%. This is one of the reasons knowing algebra is helpful. Insurance and investment companies are aware that we do not understand the math. We are being sold products that are paying us much less than we think they are.
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