The Basics of Annuities
Before purchasing an annuity, it’s important to know the fundamentals. Here are some helpful annuity basics to cover.
What is an Annuity?
An annuity is a contract between a policyholder and an insurance company. You make premium payments. In exchange, the insurer provides certain contractual guarantees. These guarantees cover a variety of contract components, including income, interest rates, or withdrawals. Premium payments may be a one-time lump sum or a series of payments over time.
The purpose of an annuity is to provide an annuitant with a steady retirement income stream. Except for immediate annuities, most annuities allow for tax-deferred money growth until they’re withdrawn.
Immediate and Deferred Annuities
Depending on the annuity type, you start receiving income payments immediately or at some point in the future. This difference is what distinguishes the two main categories of annuities, immediate and deferred annuities:
- Immediate annuities – An immediate annuity is also known as a “single-premium immediate annuity.” With it, you make a premium payment (usually a one-time lump sum), and in exchange you begin receiving income soon thereafter. Income payments begin no later than 12 months after the initial premium payment.
- Deferred annuities – Unlike an immediate annuity, a deferred annuity starts income payments many years after the initial premium payment. A deferred annuity has two parts or periods. During the first period – the accumulation period – the money you put into the annuity, less any applicable charges, earns interest. This growth is tax deferred as long as the money is left in the annuity.
In some annuity contracts there’s a second period called the payout period. During this period, the insurance company pays income to you or to someone you choose. This is also called the distribution period, which in most cases you’re able to choose how you want to distribute your annuity money. Examples include free withdrawals, annuitization, lifetime income withdrawals, or lump sum cash surrender.
“Annuities are a conservative alternative to unstable and risking stock investments.”– The Benefits of Annuities –
Fixed and Variable Annuities
Two other annuity types are fixed annuities and variable annuities. Fixed annuities are insurance contracts which enable growth at a fixed, guaranteed interest rate. Once the initial growth period has passed (how long that first period is guaranteed for), the insurer may change the guaranteed rate depending on a number of factors.
Unlike fixed annuities, variable annuities provide an optional investment feature. Premium payments may be allocated into stocks, mutual funds, bonds, or other asset classes. If you receive interest credits, premiums and the interest credits are reallocated into this portfolio for further dollar growth potential. However, since money growth is tied to portfolio growth, your principal and interest are at risk of decline should the investments in which money is allocated have a negative performance.
What are Annuity Benefits?
Consumer benefits will vary from annuity to annuity. But in general, benefits will include:
- Conservative alternative to volatile assets like stocks
- Diverse product selection for differing needs and goals
- Can last as long as you live or for specific guaranteed period
- Backed by insurers with financial strength and claims-paying ability
- Guaranteed minimum interest rates
- Reasonable growth potential
- Guaranteed income benefits (for life or a set period)
- Only vehicle to offer guaranteed lifetime income source
- Tax-deferred money growth
- Guaranteed death benefit (subject to certain conditions – e.g., excess withdrawals can reduce death benefit)
- Options for increased interest linked to equity index gains
- Income riders can be added for further benefit
There are other advantages to annuities, but these can vary depending upon the annuity product you buy. Be sure to carefully examine all your options with a knowledgeable professional before a purchase.
Other Annuity Definition Fundamentals
Overall, there are five types of annuities: immediate annuities, fixed annuities, fixed index annuities, variable annuities, and multi-year guarantee annuities. Except for immediate annuities, most other annuities are deferred annuities. They may also differ in terms of whether they come with single or flexible premiums:
- Single premiums – You pay the insurance company only one payment for a single premium annuity, while you can make a series of payments into a flexible premium annuity.
- Flexible premiums – In a flexible premium contract, you pay as much premium as you want, whenever you want, within set limits. For a scheduled premium annuity, the contract spells out your payments and how often you must make them.
Annuity Death Benefit Basics
Annuities can be utilized as an estate planning retirement vehicle. In some annuity contracts, the company may pay a death benefit to your beneficiary if you die before the income payments start. The most common death benefit is the contract value or the premiums paid, whichever is more.
What is a Current Interest Rate?
The current rate is the rate the company decides to credit to your contract at a particular time, which the company guarantees will not change for some period. The initial rate is an interest rate the insurance company may credit for a set period of time after you first buy your annuity.
The initial rate in some contracts may be higher than it will be later. This is often called a bonus rate. The renewal rate is the rate credited by the company after the end of the set time period. The contract tells how the company will set the renewal rate, which may be tied to an external reference or index.
What is a Minimum Guaranteed Rate?
The minimum guaranteed interest rate is the lowest rate your annuity will earn. This rate is stated in the contract.
Is There Anything Else to Know about Interest Rates?
Some annuities come with fixed interest rates. Others give you the option to put your money into subaccounts which are allocated in equity markets like stocks or bonds. The way the insurance companies calculate interest varies from annuity to annuity. Be sure you know all of the details regarding interest rates in annuities you’re considering.
Some annuity contracts apply different interest rates to each premium you pay or to premiums you pay during different time periods. Other annuity contracts may have two or more accumulated values that fund different benefit options.
These accumulated values may use different interest rates. You get only one of the accumulated values depending on which benefit you choose.
Can My Annuity’s Value Be Different Depending on Choice of Benefit?
While all deferred annuities offer a choice of benefits, some use different accumulated values to pay. For example, an annuity may use one value if annuity payments are for retirement benefits and a different value if the annuity is surrendered. Or, an annuity may use one value for long-term care benefits and a different value if the annuity is surrendered. You can’t receive more than one benefit at the same time.
What Charges May Be Involved with an Annuity?
Most annuities have charges related to the cost of selling or servicing it. These charges may be subtracted directly from the contract value.
Depending on the annuity you purchase, other charges may include:
- Surrender charges (penalties for withdrawing money too early or during the surrender period)
- Withdrawal charges (annuity may have a limited free withdrawal feature, which if exceeded could mean paying withdrawal charges)
- Contract or transaction fees (a flat dollar amount charged either once or annually, or a charge per premium payment or other transaction)
- Percentage of premium charge (a charge determined from each premium paid)
- Premium tax (a tax levied on annuities by certain states, of which the cost is passed onto the consumer)
What is an Annuity “Free Look Period?”
Many states have laws which give you a set number of days to look at the annuity contract after you buy it. If you decide during that time that you don’t want the annuity, you can return the contract and get all your money back. This is often referred to as a free look or right to return period. The free look period should be prominently stated in your contract. Be sure to read your contract carefully during the free look period.
Other Annuity Definition Basics
Overall, there are thousands of annuity products available to consumers. It can make selecting the right annuity a daunting task. Remember, each annuity differs in its contract design, features, and benefits.
Should you purchase an annuity, it should be carefully tailored to your financial situation, needs, and objectives. If you believe an annuity is right for you, consulting with a GetSafe Advisor can help with your process and maximize your retirement success potential.
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