Article By : Patrick Mansfield | U.S. Consumer Finance
There are many ways to plan for retirement, and under certain circumstances purchasing an annuity from an insurance company can be a good choice as part of a comprehensive retirement strategy.
In this article, we are going to look at the types of annuities that are available, the risks and rewards associated with purchasing annuities, and how to purchase an annuity.
What Types of Annuities Are There?
There are three basic types of annuities available, all of which include the option to purchase "options" and "riders" that spruce up the policy by adding different features.
A fixed annuity can be thought of like a bank's certificate of deposit. Usually, a person will make a lump sum deposit up front with the insurance agency, and then that sum will be allowed to grow at a pre-determined rate of interest for a set number of years before the payout period begins.
Once the payout phase initiates, the investor can either take a lump sum of their money plus accrued interest, or they can choose to have the money paid out to them over time. In the latter case, the remaining funds may continue to accrue interest while waiting to be disbursed depending on the terms of the contract.
An index annuity functions very similarly to a fixed annuity, except that the interest rate paid out each year is normally attached to some stock market index or sector (transportation, healthcare, etc.) index.
Most people will put a rider on this type of policy that prevents them from losing money if the index loses value in that year.
A variable annuity does not offer fixed interest on the deposits made by the insured. Rather, the insured is allowed to select from some different investments, usually mutual funds, and the growth of the annuity is determined by the performance of the underlying investments.
Fixed annuities and indexed annuities are overseen by the state insurance commissioner, and variable annuities are regulated by the SEC (Securities Exchange Commission) since they involve investment in securities.
Risks and Rewards of Annuities
Since annuities are allowed to grow tax-deferred, the major advantage to using an annuity is that those who are wealthier and have maxed out their retirement accounts can essentially create another "sort" of retirement account with an annuity. They can use an annuity to allow their money to continue to grow without paying taxes until a later date.
Furthermore, if they choose to take periodic payments during the payout phase, it is likely that an individual or family can keep their modified income low enough during the year not to get bumped into the next higher tax bracket.
However, annuities tend to have many risks associated with them as well. First, a person that purchases an annuity is going to pay between 1-2% to set up the annuity with the insurance company. Since other investments charge expense fees as low as .10%, it is possible that there are better investments out there that the investor could be making.
Secondly, an investor who purchases fixed annuities faces interest rate risk for if the prevailing interest rates rise too much during the life of the accumulation period. This is because they would be stuck with a lower rate of interest even though rates had risen. Also, those who purchase variable annuities face the risk of poor, or negative, investment returns.
Finally, an individual who deposits money with an insurance company is subject to stiff surrender charges if they withdraw their money early for emergency purposes. The fees charged are usually based on a six to eight-year "surrender schedule" provided by the insurance company.
How to Purchase an Annuity
Purchasing an annuity may not be the best choice for everyone, and it is always advised that you speak with your financial advisor before making any decisions that affect your finances.
However, if you are interested in purchasing an annuity, it is as simple as speaking with your local insurance agent or shopping around for the best products through your advisor or broker-dealer. They can attempt to find you an annuity product that is suitable for your situation, risk tolerance, and long-term objectives.