Do Annuities Make Sense For Anyone?

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There is a lot of confusion about whether annuities are good or bad. Some of this stems from viewing the product as complex and too time-consuming to study and understand. But I don’t think annuities are any more complicated than other financial products. For example, one type of annuity is just like a pension, and there’s almost no one who thinks a pension is bad.

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An annuity is a type of insurance product. By purchasing one, you are transferring risk to the insurance company just as you would with home, auto or life insurance coverage. With annuity products, the insurer is assuming some, if not all, of the longevity or market risk and is charging a fee for doing so. Risk mitigation is common to all types of annuity products, yet they differ markedly in other ways.

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variable annuities

When people talk about contract complexity and high fees, they are usually referring to variable annuities. I think these products are best explained as mutual funds wrapped in an insurance contract.

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For example, I can buy an annuity with the following features. If I put $1,000,000 in a variable annuity and its value drops to $800,000 when I die, the insurance company will still pay my beneficiary $1,000,000. If I’m earning 5% of that million dollars each year, and the annuity value declines, the insurer will continue to pay me 5% of the principal amount, even if the account value drops to zero, if I Appropriate rider on the policy purchased. In both these cases the insurance company has taken the market risk.

Of course, all this comes at a cost. I will pay the charges for the insurer’s estimation of risk and charges levied by the sub accounts (mutual funds). The combination of fees is typically between 2 and 4% per year.

Variable annuities don’t look attractive right now because the fees are relatively high compared to guaranteed low interest rates. When interest rates rise and companies can offer higher minimum guaranteed interest rates (think of the early 2000s), it can be an entirely different ballgame.

immediate annuities

Immediate annuity enables a person to deposit a lump sum amount with the insurance company and get an income immediately. This is the annuity I mentioned earlier, it is like a pension. The product typically offers multiple payment options, including a guaranteed lifetime income benefit, where the insurer assumes all longevity risk and market risk. What if you die soon after making a purchase? Well, some payment options allow you to designate a beneficiary who will receive a stream of payments.

Immediate annuities that provide regular, guaranteed income can be a good alternative to traditional pension plans that are no longer widely available. They can fill a huge gap in retirement income plans.

fixed annuities

A fixed annuity is not a CD, but it certainly looks like one. For example, let’s say a fixed annuity and a CD pay an interest of 3% for 3 years. If you stay invested for a period of 3 years, there is no risk to your principal. If you withdraw your money before the expiry of the 3 year period, you will have to pay a penalty.

CDs are, of course, insured by the FDIC or NCUA. Guarantees of an annuity are backed by the insurance company that issues them. Purchasing products from insurers that receive high marks for financial strength and stability from major third-party credit rating agencies is critical.

Annuities typically pay higher interest rates than CDs because of the difference in their underlying investments. For example, annuity rates are based on long-term, illiquid investments — bonds, mortgages, private equity, personal loans and real estate. The premium from liquidity is the high rate of return without the high risk.

fixed index annuities

Fixed index annuity is a form of fixed annuity that does not guarantee an interest rate, but lets you participate in an index such as the S&P 500. Most contracts are designed to guarantee any loss while participating in some upside profit. For example, a contract may protect against losses in a year when the index declines and credit 50% of any increase in years when the index rises. These annuity products have the potential to grow assets, yet they are protected against downside losses. They are not securities, which creates some confusion because many people who are “anti-annuities” analyze them as if they are securities.

Annuities can shine in volatile markets

Volatile and unpredictable market environment like ours today spurs people’s interest in the principal guarantee and downside protection of fixed or fixed index annuities. You may gravitate to bonds as an alternative to annuities, yet bonds are poised to decline in value as interest rates rise.

If you have recently retired, you may be especially sensitive to broad market volatility. Some advisors attempt to reduce market risk, specifically sequence return risk, by allocating 35% of a portfolio to an annuity with principal guarantees and the other 65% to equities. This strategy provides flexibility in choosing the source of income. Income can be taken from the equity component of the portfolio when the market is rising. When the market is falling, fixed annuities can provide income while equities have time to recover.

More and more 401(k) plans are making annuities available, giving participants a way to get a guaranteed income for life without taking their money out of the plan. Participants who no longer need income can use an annuity as a type of fixed value account. This can allow them to lock in profits from the bull market and move the money off the table, knowing that the interest rate and their principal are guaranteed.

Don’t approach annuities with a closed mind. Keep your eyes open to see how effective they can be in protecting assets, providing guaranteed lifetime income, and building a secure financial future.

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