Today, Certificates of Deposits are at an all time low causing people to take a closer look at annuities. To help you understand them better we have put together some brief questions and answers.
Q. Why would someone want an annuity?
A. The main reason is to obtain guarantees. Annuities provide:
- Guaranteed Interest rates- no matter what happens to the stock market. The insurance company assumes the risk in a bad economy, not you. At certain times, annuity interest rates are higher than Certificates of Deposits (CD’s)
- Guaranteed payments- collect as long as you live. If you live longer than your normal life expectancy the insurance company must continue to pay.
Q. I’m confused. I hear a lot about annuities but I’m not sure I fully understand exactly how they are supposed to work.
A. A simple way to understand is to compare an annuity to a life insurance policy. With a life insurance policy you pay a relatively small amount of money (the premium) to an insurance company. When you die they pay your beneficiary the full amount of insurance you purchased. The annuity works in the exact opposite way. With an annuity you pay a relatively large amount of money to an insurance company which then pays you a smaller monthly amount for as long as you live. Think of an annuity as something that keeps on paying and doesn’t stop until you die. That kind of annuity is called an Immediate Annuity.
Q. But I see advertisements saying people can “invest” in annuities, could you explain that?
A. Similar to CD’s, you can purchase an annuity with a guaranteed interest for a period of time. The term could be for 3, 5, and 7 years or longer. Instead of collecting monthly payments right away (which is called annuitizing) you can defer receiving payments. That is called a Deferred Annuity. You simply let the money grow and accumulate before you take it out.
Q. When can I take money out?
A. At the end of the term, you can withdraw the money without any penalty or charge, keeping all the interest earned. You may take money out sooner but there will be a stiff penalty. Some annuities allow you to take out the interest earned free of charges each year while others allow up to 10% to be taken out each year without penalty.
Q. At what rate can the money grow?
A. That depends on the type of Deferred Annuity you purchase. There are three main types:
- Fixed annuities – They pay a guaranteed rate of interest. The insurance company determines what interest rate they will offer and guarantees the payment (for example 3 1/2% for a 5 year period). The principal and the interest are both guaranteed. This is the safest type of annuity.
- Variable annuities – The rate of return varies depending on the investment performance of the underlying investment. For example, you may have a choice of mutual funds to invest in. If they perform well you may earn more income. On the other hand, if the mutual funds do poorly you could lose money.
- Equity Indexed annuities – The rate of return is tied to how well an index performs (i.e. the S & P 500). These annuities combine aspects of the first two annuities. They typically guarantee a minimum rate of return (for example 1 to 2%) yet offer the potential to earn more than the minimum rate should the investment results do well.
Q. What is the downside to annuities?
A. Typically there are surrender charges if you decide to cash in an annuity before the term of the contract expires. For example, if you purchased a 5 year annuity and you cashed it in before the 5 years were up- you will be charged a penalty. Penalties range from 10% to 1% depending on how long you have kept the annuity. Unlike bank CD’s which are backed by an agency of the U.S. government; annuities are backed by the full faith and credit of the insurance company.
Q. Are there other things I should know?
A. Everyone’s circumstances are different. Before you make a decision seek out a trusted advisor for guidance.