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Annuities: Income for a Lifetime

Authored by Jose Abuyuan on November 23, 2019

Annuity images. Money clock and arrow.

The sales of annuities hit record levels in 2018. These contracts remain a popular option for long-term income streams for many retirees. Risk-averse millennial investors are also drawn to the security provided by these investments.

Annuities help you hedge against your risk of outliving your savings. By transferring this risk to an insurer, you guarantee a fixed stream of lifetime income. In exchange, you pay the insurer through premiums and other fees.

Features of an Annuity

Annuities allow you to receive guaranteed payments from an insurer at a later time. These payments are usually made though fixed monthly increments. You also have the option to receive them as a lump sum payment.

You can buy them through two methods:

  • A large one-time payment (single premium)
  • Through several deposits (multiple premium)

You can either redeem immediately or after a specific period of growth. Many insurers offer a free-look period. Here, you can cancel the annuity contract without incurring any penalties.

Duration and Payouts

Lifetime annuities are the most familiar. They last throughout the lifetime of the annuitant and stop at their death. One variant lasts for the lifetime of two (usually married) annuitants.

In contrast, fixed-period annuities guarantee payments only for a specified period (e.g. ten years). The payouts would depend on the amount of money you put in.

Many insurance providers add riders, which are popular with many people. These clauses covert lifetime policies to fixed period ones. Riders are often included to hedge against your unanticipated death. This would allow your beneficiaries to inherit the annuity if you die before it is due. This option gives annuitants peace of mind that their money is not wasted.

Most annuities in the market are deferred. Their annuitants must wait for a specific period (and age) before they can receive the benefits. By choosing this type, you allow some of your money to grow over time. Immediate annuities, meanwhile, can start paying off almost immediately after you buy them. These are usually paid off once.

Many annuities are non-qualified. You buy them with after-tax dollars. Qualified annuities, meanwhile, are incorporated into another tax-advantaged retirement fund. The IRS taxes payments from qualified annuities as regular income. Non-qualified annuities, meanwhile, are only taxed on earnings.

Growth

Financial Growth
Money in annuities grows much more slowly than those in more active investments.

An annuity matures in two phases.

  • Accumulation phase: This is where you make periodic payments to your insurance company. During this time, your money grows slowly in value.
  • Payout phase: Here, your company returns the matured annuity to you as cash.

Many annuities are transferable if you die before the payout phase. Your beneficiaries become eligible to receive a part of the contract value.

Pigly's Tip!

You can make withdrawals during the so-called surrender period. These often come with a hefty tax penalty, however, along with surrender charges of up to 7 percent. The surrender period for most annuities is between six to eight years. A 10 percent tax penalty also applies when you withdraw money from it before you reach the age of 59 and a half.

Investment Control

How much control you have over your annuity varies. The most common type, fixed annuities, have limited options. They come with a guaranteed minimum interest rate and a fixed set of payments. Despite their modest growth prospects, this type is usually your best bet as a layperson. They are not complicated and have low risks.

Variable annuities offer more control and investment options. They let you allocate your payments according to your personal investing strategy. In addition, they have the option of saving part of your money to a fixed-rate fund. However, they are still complicated assets. These annuities are best left for more seasoned investors who understand their nuances. Indexed annuities function similarly but have securities and insurance attached to them. Both have much higher fees than fixed annuities.

An annuity freezes your money for an extended period. You do not have an easy way of getting these funds outside of selling it. If you have a variable annuity, meanwhile, you can have some hand in growing your funds.

Why Consider Annuities?

Annuities offer financial security for older adults. They deliver a predictable lifetime source of fixed income every month after retirement. This turns them into an alternative paycheck.

Older adults are not the only ones who can benefit from annuities. These contracts also attract risk-averse younger investors because they are not liquid assets. The money invested in a fixed annuity is secure as long as the insurers remain in business. They can be a good way to diversify and hedge portfolios in unsure economic climes.

Tax Advantages

Much like retirement funds, annuities grow tax-deferred. Non-qualified annuities have the advantage in that they have no contribution limits. This allows you to save more of your post-tax money in a tax-advantaged setting. Moreover, you only receive taxes on earnings. The post-tax principal on these annuities is non-taxable.

Qualified annuities may seem redundant, but they do have their own advantages. They often have riders, such as death benefits for your spouse. They are also paid with pre-tax income and grow deferred. This makes them an ideal option if you expect to be in a lower tax bracket during retirement.

Who Should Get an Annuity?

Couple in their prime before retirement
Annuities can help secure your financial future.

The majority of annuitants are older adults approaching retirement age. Many of them are uncertain if the amount of money they've set aside is enough to cover their needs. If you believe that you might outlive your earnings, purchasing one might be the right choice.

Annuities are useful when you have maxed out your contributions to retirement plans. They provide a tax-advantaged, low-risk place to save your extra money. These can also serve as an alternative or supplement to life insurance coverage. This makes sense if you have become the legal guardian for your grandchildren.

Of course, there are times when this option might not be right for you. You would not need an annuity if you have a lot of money saved in retirement funds and social security. You also wouldn't need to invest in one if you don't expect to live for very long after retirement.

Liquidation

With annuities, there is no way to access your investments until the payout date. Withdrawing before the surrender period ends also incurs tax penalties. You also do not always have the option of receiving it all as a lump sum.

By itself, this is not disadvantageous. Annuities in normal circumstances are meant to provide future income. Yet there are circumstances when you might find it necessary to cash in your annuity early.

You can give up a part of your future earnings for a large sum of cash right away. The losses may be a fair price to pay to cover the costs of a dire emergency or major life milestone.

Liquidation Factors

You have three options when liquidating an annuity: in part, as a whole, or a lump sum. Selling the entire annuity gives you a sum smaller than the value of your contract. You do get a large influx of cash at once. Meanwhile, you can sell annuity payments for a specified number of years for a smaller lump sum. The annuity payments revert back to you after the years have passed. Lump sum sales split the difference. You receive the exact amount of money you need while keeping the rest of your annuity. The option you choose will depend on how much money you need.

Annuities are sold to factoring companies. These companies would receive all later payments from the annuity. To profit, they buy annuities for a sum that is less than its total value. To maximize your gains, select a factoring company that offers the best deals at the lowest costs.

The discount rate is the difference between the amount you receive and the value of your annuity. On average, the rate is 12 percent. Many things can influence how much money you can receive from liquidating an annuity:

  • The value of the contract
  • The number of the remaining payments
  • Economic conditions
  • Prevailing interest rates as set by the Federal Reserve.

You may also expect a few fees and charges. When selling, you can expect to recover between 50 to 80 percent of the value of your annuity.

Stay well informed of the specifics of liquidating an annuity. Before making the decision to sell, consult a financial professional or a lawyer. This could help you avoid scams and save thousands of dollars in fees.

Investment Drawbacks

Drawbacks
Illiquid investments like annuities lose out on opportunity costs.

Annuities are not an attractive option for investors unwilling to play the long game. They give the biggest returns after they've matured over several years. Investors may also not appreciate locking their money for years at a time. Liquidating annuities early always incurs losses.

They also do not outperform the market. You may find that your money might not grow in an annuity than if you invested it elsewhere. This opportunity cost can be a hefty price to pay for relative stability.

The returns from annuities are not hedged against inflation. The incremental payments you receive will neither increase nor decrease. You have no safeguard for changes in the economy and the dollar's buying power.

Annuities can be expensive to maintain. You may expect to pay the following fees:

  • Risk charges
  • Administrative fees
  • Commissions
  • Fees for other contract features

Moreover, annuities are dependent on the stability of the insurer backing them. You have few hedges against the company going under before you can redeem anything.

Risk Management

Annuities are a large investment. Smart investing decisions can help you optimize your returns and cut expenses. Do your research and consult experts to ensure that you buy one with terms that suit your needs. Read the contracts with care and ask questions when you find anything hard to understand.

Invest Little by Little

Annuities in general don't offer that many growth opportunities for your money. You can often grow your earnings faster with stocks when times are bullish. Variable and indexed annuities offer some advantage of growing along with the market. These are often too complex for the lay investor to manage.

Annuities often grow based on ten-year treasury interest rates. Some people try to have it both ways by following rates before investing in an annuity or in stocks. This is not an easy strategy as you cannot always predict when a good rate may come your way.

Pigly's Tip!

As an alternative, you can still invest in both stocks and annuities by taking the slow route. Take advantage of the option to pay for annuities in increments. By annuitizing your savings over time, you free some of your extra cash to invest elsewhere. You also give yourself time to reconsider your annuity coverage. Your coverage needs may turn out smaller than you expected.

Hedge Your Bets

Diversifying isn't the only way to counteract the risks involved. You may also need to buy contracts across several reputable companies. Keep the amounts you save in each of these to below your state's coverage limit. This way, you hedge against any unforeseen events that affect any one company.

This method does make each annuity you get smaller. The losses you avoid might be worth the smaller guaranteed payments.

About The Author

Joey Abuyuan is a web content writer, fictionist, and digital artist hailing from Las Piñas City. He is a graduate of Communication and Media Studies at San Beda College Alabang, who took his internship in the weekly news magazine the Philippines Graphic. He has over a decade of professional writing experience behind him.

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