The word annuity conjures up multiple thoughts and reactions from multiple sources. Some advisors would say that an annuity is a “one size fits all” solution to every financial problem. Others would tell you that purchasing an annuity is equivalent to committing financial suicide. Frankly, both of these opinions are wrong. We will be covering annuities in detail throughout this site. For purposes of this discussion, I would like to discuss some frequently asked questions regarding annuities.
1. What is the definition of an annuity? An annuity is a systematic payout of a sum of money. When annuitized (not to be confused with systematic distributions) every payout is part principal and part interest. Depending upon the payout chosen, a consumer can never outlive any annuity. Annuities are only issued by insurance companies who provide the contractual guarantees.
2. What is the difference between annuitizing and taking a systematic distribution? As said above, each annuitized payment is part interest and part principle. A consumer exchanges the use of the lump sum for the contractual guarantee that the payments will be made for life. A systematic distribution keeps the principle intact (based upon the terms of the policy) by paying out only “interest”, or a set percentage during each payment.
3. What happens to the principal upon the death of the contract owner?Based upon options chosen, if a contract is annuitized, payments may continue to the beneficiary upon the death of the contract owner. For example, under a ten year certain payment option, should the annuitant die within the first ten years, payments would continue to the beneficiary for the balance of the ten year period. If the annuitant dies after the ten years has expired, payments would cease upon death. If the consumer had chosen only to take “systematic distributions,” then the remaining principle would be payable upon death to the named beneficiary. Contractual provisions would determine if the principle would be payable in a lump sum or over a reasonable (5 years) period of time. These disclosures should be discussed at the time of inception with the insurance representative.
4. How can annuities be used? Annuities provide a guaranteed stream of income and they are beneficial when used as a hedge, or to provide additional guarantees of principal. If a consumer has moderate risk tolerance, I believe the use of annuities for 20-35% of a portfolio would not be considered excessive. The consumer must have reasonable liquidity to provide for emergencies, as most annuities allow for only a certain percentage (5-15%) to be removed annually without any penalty. It is imperative that the consumer have additional streams of income and sources for emergency cash so the annuity is not his only investment.
5. Why do annuities receive such a “bad rap?” There are horror stories of some insurance companies which charge excessive fees, as well as brokers (the omission of the word “advisor” is purely intentional) who are not opposed to taking all of their clients’ money and placing it into annuities so they can receive generous commissions. These stories receive much more publicity than those of the people who use annuities as intended: to provide for additional guarantees. Recently the Wall Street Journal published an article which explained how well annuities did during the market debacle of 2008 and early 2009.
We will explore other areas of annuities to try and clear up what is obviously a confusing subject. If annuities are used as a minority position in a portfolio with adequate consideration given to overall liquidity, they can represent a valuable position in a person’s financial plan.
Disclosure:
The guarantees of an annuity contract are contingent on the claims-paying ability of the issuing insurance company.
There may be additional costs associated with options or features of an annuity.
With either systematic withdrawals or free withdrawals you will still be subject to regular income taxes, as well as the 10% tax penalty on early withdrawals prior to age 59 ½. You may also incur surrender charges on amounts withdrawn in the early years of the contract.