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Annuities 101: The Basics

A 13.41% first year yield! That is what one indexed annuity is currently guaranteeing. Although this is one of the better annuities available, there are multiple types of annuities and you need to know some basics before investing in them. There are four types of annuities: immediate, variable, fixed and indexed. Here is an explanation of some of the basic features along with some of the pitfalls that you need to watch out for.

Immediate Annuities

The least common variety is the immediate annuity. This type of annuity allows you to purchase an income stream that you can never outlive, very similar to a pension plan. The amount of income that is received depends on the age of the person whose life will be used to calculate the income. The older someone is, the shorter their life expectancy and therefore the more income they will get.

Typically, when the individual dies, the income stops and the remaining principal, if any, is kept by the insurance company. However, there are several options available that protect the principal or income for the heirs and is often well worth the time to look into.

However, the purchase of an immediate annuity is irrevocable so once the first payment has been received, the purchaser no longer has access to their principal. Because of this inflexibility, less than 3% of all annuities sold are of this variety.

Variable Annuities

The variable annuity allows someone to invest directly in the market through sub-accounts that are very similar to mutual funds. As a result, variable annuities can go up or down in value depending on the performance of the underlying investments.

The primary advantage is that most variable annuities have a death benefit that is built in, although sometimes at an additional cost. This benefit guarantees that the beneficiary will at least get the initial investment assuming the investment has dropped in value. Therefore, if the initial investment was $100,000 and the current value is only $75,000, the beneficiary will get the $100,000 upon the death of the individual whose life the annuity was based on.

Another benefit of variable annuities is that some of them offer a guaranteed percentage of growth each year for future income, regardless of market performance. However, this benefit also comes at a cost and has caused much confusion among consumers since it is often sold in an unclear manner. For example, if the annuity guarantees a 6% interest rate, you are most likely required to take an income for life or a specified period of time (usually a minimum of 10 years) in order to take advantage of this benefit. If you don’t want the income but would rather take the cash, then this benefit is worthless and you will effectively be entitled to the current value of the annuity, even if it has fallen to much less than the initial purchase amount.

The primary disadvantages of variable annuities are that they are very expensive, often costing you 2% to 4% per year, and you lose the capital gains tax advantages that you may have with mutual funds. Because of this, there are often better investment options to accomplish your growth and/or income goals than a variable annuity.

Fixed Annuities

The fixed annuity can best be compared to a CD in that it often pays a return based on the current interest rate. Unlike the variable annuity, this type of annuity protects your principal and is insured by a state guarantee fund.

It is the steady rate of return and tax deferral that makes the fixed annuity attractive to some investors. Additionally, because insurance companies invest and manage their funds in a manner different than the banks, fixed annuities often times pay a higher interest rate than their CD counterparts in addition to being tax-deferred.

Indexed Annuities

The indexed annuity has become very popular in the last decade, and rightfully so, since the interest earnings’ potential is tied to the stock market, but without the risk. It can be viewed as a hybrid between a fixed and a variable annuity. It offers the protection of principal that is inherent in a fixed annuity combined with the above-average growth potential offered by a variable annuity, but without the fees. While CDs have returned extremely low rates in the last few years, many indexed annuities have produced double digit returns for their owners.

Like variable annuities, indexed annuities also offer the ability to earn a guaranteed interest rate, often up to 8% per year compounded annually, for future income. This essentially allows the investor to participate in the growth of the market without potential for loss while guaranteeing a minimum amount of growth for a guaranteed income stream in later years, all without giving up control of your principal as required by an immediate annuity.

The indexed annuity will appeal to individuals who want to protect their principal while still having potential for above average growth and a guaranteed rate of return for future income.

 

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