Retirees are worried that they are running out of money, which is one of the reasons annuities continue to grow in popularity among older investors. The right type of annuity can help ease that concern by providing a dependable income stream when retirees are stop receiving a paycheck.
A recent study conducted by Michael Finke and Wade Pfau, researchers with The American College of Financial Services, found that adding an income annuity can boost the chances of a retiree’s portfolio lasting until they reach the age of 95. The Principal-funded study concluded that using annuities as well as investments can enhance the legacy value of assets over the long term.
There are different types of annuities, and they can come with complicated rules, restrictions, riders and fees. An income annuity allows investors put money into an insurance contract that guarantees how and when they’ll get their money back. But that’s where the simplicity ends. And any guarantee on the contract is only as good as the claims-paying ability of the insurance company.
A little healthy skepticism is a good thing when you’re looking at any investment. Annuities aren’t a fit for every retirement plan. But they can be a good choice for some.
For those interested, here are a few annuity basics:
The Five Main Types of Annuities
Variable annuities: A variable annuity’s returns are tied to the stock market or other investments the owner chooses, and gains and losses are based on the performance of those underlying subaccounts. If the fund performs well, the value of the annuity will grow, and the owner may receive a larger total payout. But even if the fund’s performance declines, the contract’s guaranteed rate may provide a reliable long-term income.
Terms to Know
Cap: A cap is the maximum an investor can earn in a given year. There are usually different cap choices available on each contract.
Spread: The spread is the amount the insurance company deducts before crediting an annuity with any gains. For example, if the S&P 500 goes up 6% and the investor has a 2% spread, the investor would be credited with a 4% gain.
Participation rate: This is the percentage of index gains the investor is credited with. If the investor has a 50% participation rate and the S&P 500 goes up 10%, the investor is credited with a 5% gain (50% of 10%).
Surrender charges: If the investor takes out more than the predetermined free withdrawal amount, he or she will be charged an early withdrawal penalty. Surrender charges typically apply for the first five to 10 years of the contract. This allows the insurance company to give more guarantees on its product because it knows investors won’t be taking out a lot of money early on.
Income rider: Some annuities have an income rider that will use a second, separate account value to determine a future income stream. It has no lump-sum value and can’t be passed on to a non-spouse beneficiary. Most income riders will grow at a fixed rate every year and aren’t subject to market gains or losses. Some income riders have a fee, but most companies offer fee-free income riders.
Other riders: Some annuities have riders such as long-term care or terminal illness waivers, which allow access to the invested money if it’s needed to cover qualifying expenses. These riders are sometimes added at no cost, but they can be structured in various ways, so be sure you know what you’re getting.
Possible Fees
It’s also important to be aware of any fees that could add to the cost of an annuity (and, therefore, take away from your nest egg).
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Variable annuities usually have the highest fees. These can include mortality and expense charges, policy administration fees, subaccount fees and rider charges.
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A fixed rate annuity typically doesn’t have any fees.
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A fixed indexed annuity can have a fee for an income rider, but investors can choose whether they want the rider included or not. Most fixed indexed annuities without an income rider have no fees.
An annuity can be a great tool if used properly, but it probably isn’t the best DIY buy. Working with a financial professional — preferably a fiduciary, who is bound to do what’s in the client’s best interest — who can discuss the pros and cons of various investment options, including annuities, can help you make the right decisions based on your objectives and risk tolerance.
