Annuities are types of life insurance contracts that are issued by insurance companies to insure your income. While you might not be familiar with this type of policy, it’s used in almost every pension plan, both public and private, as well as many IRAs and other private retirement plans. Even though these contracts are commonplace, you should still understand them before using one to secure your retirement income.
Annuities are designed to exchange a lump-sum of savings for payments made over a specified period of time or for your lifetime. These contracts, sometimes called “immediate annuities,” make payments on a monthly, quarterly, or annual basis. Some annuities, called “deferred annuities,” defer this payment until a time you specify, but may defer the payment until your death.
By choosing an annuity, you are signing a legally binding contract that is irreversible. In other words, once your savings has been converted to monthly payments, you cannot get it back. If you’re comfortable with that proposition, you only have two basic choices left: a fixed annuity vs a variable annuity.
A basic fixed annuity pays a minimum guaranteed interest rate regardless of prevailing rates or market fluctuations. Some fixed annuities are a modification of the basic fixed annuity structure.
For example, some annuities offer interest crediting that is the higher of the guaranteed rate or an indexed rate tied to the upward movement of a stock market index. These annuities, called “fixed indexed annuities,” are not investments in the stock market but rather a way to potentially earn a higher rate of return than a straight fixed annuity.
Another type of fixed annuity offers a “market value adjustment.” MVA annuities give you a slightly higher interest crediting in exchange for sharing interest rate risk with the insurer. If you cancel the contract early to pursue a higher rate of return, your annuity account balance is adjusted downward if interest rates are higher than when you started your contract. If interest rates are lower, your account balance will be adjusted upward.
Variable annuities do away with the fixed rate and replace it with investment options, usually mutual funds. These funds are part of the insurer’s separate investment account. You choose the mutual funds you want to invest in and bear all the risk of loss.
Some variable annuities offer a guaranteed minimum accumulation benefit rider that modifies the basic contract, to assuage nervous investors. The GMAB rider guarantees a minimum account balance over a specified number of years if you hold the contract to maturity. For example, an insurer may guarantee an average return of 6 percent annually if you hold the contract for 10 or more years and allow the insurer to choose the investments for you.
Annuity rates are driven entirely by the cost structure of the annuity and the underlying investments in the policy. Fixed rates are driven by prevailing interest rates in the market. These rates, in turn, are driven by bond rates and the performance of other income-producing assets in the insurer’s general investment account.
Variable annuity rates are driven by the performance of the mutual funds in the separate account that you or the insurer choose. Finally, the cost structure for both annuities impacts the net return. If the insurer can earn 6 percent in its general account, but must cover costs that amount to 3 percent of the total return, you as the investor only receive 3 percent credited to your fixed annuity. Likewise, the mutual funds in a variable annuity come with costs that drag down gross returns.
How You Benefit From Annuities
Choose an annuity that fits with your financial goals. The annuity that will benefit you the most is one where you receive an acceptable rate of return, one that you fully understand, and one that allows you to achieve your long-term goals. In general, annuities are beneficial for retirees because they take away the uncertainty of providing a retirement income. Since you don’t know how long you’ll live, the conversion of a deferred annuity to an income-producing immediate annuity gives you certainty where you otherwise wouldn’t have it.
This article was composed by Ty Whitworth for the team at Lead Sure.
© 2012, Jen Carrigan. All rights reserved.