A life annuity is a policy where the insurer makes payments (annuities), based on fixed or variable investments, to the buyer (annuitant) for a premium.
Annuities are rather complex and are full potential pitfalls. So let’s start out with some bullet-points in regard to some of the most important aspects of annuities:
- Annuities build value over an accumulation phase and then payout during a payout phase.
- Annuities aren’t life insurance, they are retirement accounts typically sold by life insurers.
- Annuities (specifically variable annuities) can carry a high risk and the fine print can result in bad investments for those who don’t understand what they are getting into. Breaking a contract could mean forfeiting your investment. A poorly assembled policy or poorly managed account can mean lots of fees to the insurer, but little payout to you.
- Common fees my include rider fees, fund fees for each fund, and contract charges like mortality and expense charges (each at or above 1% on average). “Bonus credits” can offset the fees, but the end result is an investment account with small returns compared to other investment vehicles.
- Fees are taken out regardless of losses or gains. Riders can limits gains lowering risk and reward.
- The important differences between annuities are how the money is invested (variable or fixed) and how the money is paid out (immediate or deferred). Fixed deferred annuities are probably the safest and smartest bet.
- With a fixed annuity, the money is invested in fixed-rate investments like bonds and has a guaranteed payout. In the more risky variable annuity, the money is invested in the market and is not guaranteed.
- Some tax-qualified annuities allow interest to build tax-free. Interest can be used to fund the policy, provide payouts, or fund other retirement vehicles like 401ks, IRAs, and pensions. How the funds are used and paid out depends largely upon whether the annuity is immediate (paid right away, often without tax-benefits) or deferred (payed later, for retirement, with tax benefits).
- Annuities can also provide “death benefits” helping to bridge the gap between retirement account and life insurance.
- Life annuities can make sense as a life insurance alternative for someone who is “uninsurable” since “evidence of insurability” is not required.
- If the goal of your investing is to use the annuity as a type of life insurance, consider the safer fixed annuity. If the goal is to build wealth, consider other investment options. Also consider pairing more traditional investments with a term life policy.
Fixed Annuity Vs. Variable Annuity
There is a slight, but important, difference between fixed annuities and variable annuities.
Fixed Annuity: Money is invested in fixed-rate investments like bonds. These are low-risk / low-reward. The interest rate will be low, but the insurer absorbs the risk offering a “fixed” minimum interest and payment amount.
Variable Annuity: Money is invested in variable-rate investments like stocks, mutual funds, and money markets. These are high-risk / high-reward. The interest rate varies based on performance of investments. The policy holder can even choose investments in some cases. The insured absorbs the risk and there is no fixed interest rate or payout.
The verdict: The problem most people have with annuities is that they carry a very similar risk /reward structure to other retirement vehicles but can provide more value over all due to fees, restrictions, and the ability to lose the life insurance policy (unlike with a 401k).
Immediate Annuity vs. Deferred Annuity
The other aspect of annuities in life insurance, beyond how investments are made, is how the policy pays out.
Immediate Annuity: The policy pays out right away, you’ll most likely pay taxes on the earned interest. The amount that stays in the account will continue to build value.
Deferred Annuity: The policy pays out later at a set time (upon retirement, or at the end of a set term). Since the money isn’t paid out right away interest is allowed to grow tax free.
Acceleration of Payments: In some states you can choose an acceleration of payments for immediate annuities. Essentially a sum of $5,000 or higher can be taken early for reduced future payments and market value in the case of emergency.
The verdict: If you aren’t using the account to grow interest tax free, it loses much of it’s value.
Life Annuities Versus Life Insurance
Annuities aren’t life insurance, but they are typically sold by life insurers. They are meant to provide income after retirement, and not to pay beneficiaries upon death. That being said, life annuities can include “death benefits” of sorts as well.
Death Benefits and Annuities
However, life annuities can work like traditional life insurance plans as they can provide “death benefits” (not all annuities provide death benefits). The death benefits are funded by gains from investments and are paid upon the death of the policy holder. If the policy holder dies before they begin receiving payments, the full amount at that point is paid. If the policy holder has started receiving payments, then the contract dictates the payment.
Surrender Charges and Annuities
Some annuities have surrender charges. You forfeit a percentage of value not withdrawn from the account. Some insurers will waive surrender charges on certain annuities upon death, terminal illness, or nursing home confinement.
Tax Advantages of Life Annuities
Generally anything that grows tax-free is a plus, life insurance is unique in that it can offer retirement products that allow money to grow tax free. The tax free money can be used to fund other retirement vehicles like 401ks too. The downside of this is that life annuities are regulated and managed in such a way that makes them a little less attractive than traditional 401ks or other more popular retirement plans that don’t have the life insurance aspect attached to them. Thus it’s suggested you max out other contributions before considering a life annuity.