What Is An Annuity?
An annuity is a tax-deferred investment product that earns a fixed rate of return, which can then be annuitized. Annuitized means paid out as a fixed stream of payments over time, creating a separate income stream for retirees. Annuities are designed to create a steady cash flow.
With people living longer and saving less for retirement, annuities can help individuals mitigate the potential of outliving their savings. That said, annuities are not the right investment vehicle for everyone.
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Annuitization is the process of taking the funds you have put into your annuity and converting them to regular periodic payments. Annuities are classified based on the way they annuitize your funds. Immediate Annuities have a lump sum deposited and annuitized immediately, creating a stream of steady income payments from the get-go. Deferred annuities have payments start on a future date, with the investment earning tax-deferred income along the way. This period of earning interest on the investment in known as the “accumulation phase”.
The funds deposited into an annuity are put to work in an investment portfolio that can be structured as either fixed or variable.
Fixed annuities allow the principal investment into the annuity to be safeguarded, allowing the client to gain upside exposure without any risk to losing the principal investment into the annuity. That may sound too good to be true, but it is not, it is how the product is structured. In return for an investment that poses virtually no risk to the client, the rates of return are lower and come with caps on upside potential.
Investments into these fixed annuities can further be allocated to different strategies, all of which protect principal. The simplest strategy is 100% fixed, where the investment earns a standard fixed rate of return on an annual basis. It is similar to investing in the bond market.
Alternatively, money can be allocated into equity indices. These are know as “Fixed-Index Annuities". The funds allocated to the index are still safeguarded from downside, but again there are caps in place to limit upside potential. For example, the market may rise 15% in a given year, but a fixed-index annuity may only return 5% for that same year. Your principal investment was not at risk of any loss but had limited upside. In the same year the market could have lost 15% but the principal investment would have remained flat for the year (a 0% return but also no loss).
For those planning for retirement later in life or even those in the early phases of their retirement, an investment that limits risk while offering tax deferred gains can be a great addition to a retirement plan.
Variable annuities carry market risk and expose the principal investment to potential downside. That said, they can be purchased with various features and riders to help limit downside risk. Due to the riskier nature of these investments, we do not work with variable annuities at this time. We focus on transparent risk mitigation for our client base and want to make sure you and your money are secure.
When Is An Annuity The Wrong Decision?
A. When You Need A Liquid Investment
Annuity structures are inherently illiquid which means the funds deposited into an annuity are not usually readily available for withdrawal at any time without penalty. Annuities are built to provide lifetime income streams. Therefore, the complexity of the investments an annuity carrier must make for the solution to work would be hindered by early withdrawals during the accumulation phase.
Most fixed annuity products come with a fixed tenor (number of years) where the funds are mostly locked to withdrawals without penalties. These tenors can vary from 1 year to 15 or more years. Over that accumulation phase, most annuities allow you to withdraw a certain percentage of the investment each year, without penalty. These percentages are usually 5-10%. Any withdrawals beyond the stated penalty-free withdrawal amount would be subject to a surrender charge.
Surrender charges are most often on a decreasing scale over time. They start high in the early years and end up dissipating to zero by the end of the annuity’s tenor. For example, a 10-year fixed annuity may have a 5% annual penalty-free withdrawal limit, with a 10% surrender charger in the first year, falling to a 1% surrender charge in the tenth year.
Once again, annuities are designed for long term income security. This is not a product you can freely mess with.
B. When You Have A Stronger Risk Profile And Want More Market Exposure
Annuities are designed to create steady and safe streams of cash flow from a principal investment either immediately or after a given amount of time in the accumulation phase. For someone looking for a higher risk and higher reward investment, annuities are not the recommended solution.
C. When You Are Being “Sold” Into Something You Don’t Understand
Annuities can be complicated! New features such as riders and other bells and whistles are added to the product mix every year. If you do not understand the nature of the investment, or what the potential upsides and downsides are, then do not move forward. Do not feel pressured by whoever is trying to win your trust on the investment. If you want a truly unbiased assessment, come speak with us. You’ll receive the same educational approach we take with all the products we broker.
Need more info?
These are just the very basics of annuities. For more information or to schedule a conversation with one of our brokers, please call us at 848-226-6897.