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Annuities, what are they? You may have vaguely heard the term annuity while watching a J.G. Wentworth commercial or during a late-night infomercial. Perhaps, you may have heard about annuities during an investment sales pitch. Regardless, if you have or have not heard of annuities, allow me to explain to you how they work, the different annuity types and their ultimate purpose.

For starters, an annuity is essentially a financial product offered by insurance companies and sold by affiliated insurance brokers. Annuities function somewhat like insurance policies, in that it is a direct contract between you, the annuity owner, and the insurance company. Also similar to insurance policies, annuities allow you to leave funds directly to your heirs by allowing the annuity owner to name beneficiaries. Annuities are categorized as either immediate or deferred. If the annuity is classified as immediate, it must be funded via a lump sum and the funds are paid to the annuity owner on a predetermined basis via periodic payments. If the annuity is classified as deferred, the annuity can be funded via a lump sum or periodic payments by the annuity owner. The funds are then kept in the annuity for a predetermined period of time, then paid out via predetermined periodic payments or in a lump sum. In addition, annuities allow their owners to defer taxes on their investment gains. If the funds are withdrawn from the annuity account with a gain on the principal, the entire gain on the amount is taxed as income, much like a deferred taxed retirement account.

There are three main types of annuities:

  1. Fixed Annuities-Are just that, fixed. Meaning they provide a fixed rate return that is guaranteed for the duration of the annuity. Besides a guaranteed rate, fixed annuities provide no fluctuation to the principal. These are typically the safest annuities, but are ultimately guaranteed by the insurance company who still has risk.

  2. Index Annuities- These annuities offer stock market like return strategies within the annuity, while also providing downside protection. However, because of their downside protection, the investor is limited to only a portion of the stock market gain, because these instruments typically feature caps on their potential earnings. Therefore, these index strategies hinder the full gains that stocks could potentially provide.

  3. Variable Annuities-Annuities that allow the owner to invest directly in the stock market via mutual funds and other stock market strategies within the variable annuity.

Annuities are best suited for investors that have no trust in the stock/bond markets to provide them with the returns and income they need. They think the guaranteed rate and income provided by an insurance company, albeit a potentially smaller one compared to the market, is the best option. Another ideal annuity owner is someone who has received a large sum of money but lacks the ability to budget. Finally, an annuity may be appropriate for someone who has maxed out their retirement contributions and still seeks other forms of tax deferred growth.

As with many things in life, for every positive attribute, there are negative items with it. For annuities, the negativity is predominately focused on their high fees, lack of liquidity and selling tactics. Typically, annuities have large early surrender exit fees built into the contracts, known as surrender schedules. The annuity contracts are structured so the annuity owner has limited access to their funds for a predetermined period of time. If the investor would like their funds before this period of time is complete, they will be highly penalized via the amounts stated in the surrender schedule (Typically, 2-15%). In addition to the exit fees, index and variable annuities typically charge for additional features known as riders. Depending on the specific annuity being offered, rider fees are charged upfront when the annuity is initially funded or on an annual basis. Along with rider fees, annuities may also impose high management fees and operating expenses. Specifically, in variable annuities, the mutual funds featured within them may have higher than usual operating expenses. Most of these fees are defined in the insurance company’s contracts, however these contracts are usually very voluminous, have small print, and contain confusing industry language.

Due to the misleading sales literature and high commission bonuses provided by the insurance companies, many investors are sold annuities without realizing they had a better alternative. For every appropriate annuity owner, there are an unforeseen number of other owners who wish they had put their money somewhere else. But, when insurance companies are offering between 2-10% commission to the brokers that sell them, brokers will convince themselves (and the buyer) that annuities are suitable for many rather than a few. Annuities can be very useful money management tools. However, I would suggest any prospective annuity owner to carefully examine the annuity contract to thoroughly understand the terms and fees associated with that particular annuity. In addition, one may even consider consulting a non-biased third party. If you have any questions about annuities, feel free to contact us.

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