An annuity contract is a financial product sold by insurance companies. While these qualify as a form of insurance, such contracts are quite different from normal insurance products.
There are several different types of annuities contracts, but the basic idea is the same: You agree to pay a specific amount of money, either up front or over time, and in return the insurance company promises to make regular payments back to you. These payments can begin immediately or at some set date in the future, and continue for a specified period of time. The goal of any such contract is to provide oneself with a source of steady, long-term income.
Just as government entities sell bonds or banks sell Certificates of Deposit, promising a fixed interest payment on the money invested, insurance companies sell annuities. The insurance company then invests your money and promises to make fixed payments to you for a set period of time. Depending upon the type of annuity you choose, this fixed payment (called a distribution) can be a set amount or a pre-set percentage of the gains made on your money each year.
Benefits & Drawbacks of Annuities
There are some benefits that come with purchasing an annuity contract, but there can also be definite drawbacks. One must carefully weigh out these pros and cons in order to determine if an annuity is right for them.
The primary advantages of annuities are twofold: 1) They offer a guaranteed return on your money regardless of how the underlying investments perform and 2) They can offer various tax deferral advantages – much like a 401(k).
These sound nice but it is important to understand what one is giving up in order to receive such advantages.
It is important to have a good grasp on the fees involved with annuities. Many people are not even aware of the fact that a sales commission is paid to their broker when they buy into an annuity. What’s more, this commission is one of the highest paid out for sale of a financial product – generally averaging 5% to 6% or higher.
The insurance company that holds the contract may also charge several other types of fees, for the administration of your account. The tricky part is the way in which insurance companies spread out and disguise these fees, so that you are never really aware of them.
Often people only want to know the bottom line and don’t want to be bothered with the complexities, but the details are worth knowing. Think about it. Insurance companies don’t sell annuities for fun. They must be making a healthy profit somewhere. Maybe there’s a better option out there for you? Perhaps one in which you don’t have to split your earnings with an insurance company.
Next, there is the issue of accessibility. Almost all annuity contracts carry with them a surrender period which ranges anywhere from 3 to 15 years. This means you agree not to withdraw your money for that period of time. Some contracts will allow you to withdraw a small percentage of your money each year but will impose a surrender charge on any money withdrawn above the allowed percentage.Surrender charges can be between 7% to 30% of your total portfolio value.
Beyond the surrender period, the government imposes a 10% penalty tax on any money withdrawn before you have reached the age of 59 ½. You may also have to pay a State Premium Tax of as much as 2.5% on your initial investment, upon closure of the account.
Limiting your gains
As we have already discussed, an insurance company offering annuities will pay a commission to a broker for selling you a contract. They may also charge an annual management fee, but that’s not the only place an insurance company hopes to turn a profit on your annuity contract.
To simplify it, they plan to profit by making more off of your invested money than they have promised to pay you. Because they offer guaranteed, pre-set distributions, some individuals are ok with this, but it does mean that they receive only a portion of any gains made on their investment. Further, insurance companies generally invest these monies in mutual funds. Those mutual funds charge their own management fees, and these fees also come out of your invested money.
With the guidance of an expert financial advisor, a private individual can put their money directly into investments that are comparable or identical to those an insurance company would select. Doing so, one is able to pocket a larger percentage of any gains made and cut out fees that may be unnecessary. A competent financial advisor will also be able to consult you on alternate tax-management strategies, other than those offered with an annuity.
Are Annuities right for you?
There are instances in which purchasing an annuity contract can be the sensible thing to do, but it is important that one know all there is to know before making such a commitment.
Our top investment advisors can help you analyze your situation and determine whether investing in annuities is right for you.