The Basics of Annuities
Annuities are a staple of most modern investment portfolios and are likened to a backstop that will guarantee a modest retirement income. They function like the familiar company pension plan that will pay out a fixed amount of money during the course of one’s retirement. The only difference between annuities and pension plans is that in annuities, the money you will receive will be based wholly on how much you put in to the plan.
Characteristics of Annuities
In its most bare form, an annuity is a contract made by a person with an insurance company that will grant payments on a regular basis over a designated period of time. The fixed annuity offers a set payment for the insured however long they live. The amount of the payout is computed by insurance actuaries based on their best guess of how long you will live as you attempt to buck the computation by trying to live well into your 90s.
Fixed annuities have diminished in popularity as people began to realize that a static payout does not account for inflation. This means that a comfortable $1,000 monthly payout these days will most likely be a pittance in about 10 years time. Nowadays, insurance companies are coming out with variable annuities to make this product more enticing to people. Perhaps the most popular structure on an annuity is one where the insured can realize higher payment if the performance of the securities supporting the fund is good, but is locked to a minimum amount should the investment fail.
Lump Sum Withdrawal
A popular type of annuity is one that will give the insured the option to withdraw a portion or the entire principal amount in times of dire financial need. While it would be ideal if the insured lives long, they are also prone to catastrophic diseases like Alzheimer’s or cancer. They can rely on this type of annuity to cover their high medical costs.
Another annuity model is structured so that it will continue after the original beneficiary dies. The contract contains a joint-survivor clause stipulating that should the husband die first the annuity shall continue to provide money for his wife throughout her lifetime. The beneficiary can also opt for a provision that will leave a certain amount of the remaining principal to his children and other beneficiaries.
Immediate or Deferred
These two terms often arise in annuity discussions and they have to do with how the insured will pay for his annuity. In the immediate scheme, the insured pays a lump sum and starts receiving payouts immediately. On the other hand, there are two phases namely accumulation and distribution. The insured builds up the value of the annuity over a period of time and picks a time to begin getting payouts. People moving to another company can decide to transfer their Retirement Fund into an annuity and let it accumulate there. They can also opt to add their personal funds to the annuity for a period of time. Once they have reached their financial goal for the annuity, they can name a date on when they wish to receive payments. They can also start and stop the payments anytime they want although the general idea is that they will have to wait until they retire.
How Much to Put into Your Annuities
The rule of thumb is to set up an annuity to be able to cover the basic living expenses. Experts believe that people should put only a third of their assets into annuities. Financial advisers would typically dissuade a person from placing hefty sums into annuities as they believe that the investor can get better returns from a diversified securities portfolio. The obvious benefit of investing a larger amount of assets into annuities is the guaranteed payment. Regardless of the economic situation, your annuity will pay a minimum amount of income monthly.
Downsides of Annuities
First of all annuities cost a lot. They pay out a maximum of five percent of the principal annually. You will have to put in $100,000 in order to receive a $5,000 annual payout, which is $400 dollars a month. There are also a number of fees associated with annuities. If you will opt for guaranteed features like inflation adjustment or joint survivor, you will typically pay higher costs that are embedded in the annuity. This means that these costs will not be revealed to you until they are taken out of the payouts. Distributions from annuities are taxed as ordinary income with rates that could go as high as 35 percent.