Taking the mystery out of annuities
We all know what life insurance is for. If someone has an insurance policy and dies, their beneficiaries collect the face value of the insurance policy. The whole idea behind life insurance is that it offers protection to those who depend on a wage earner if that person dies. Less known though is the concept behind annuities. Perhaps you’ve heard the word ‘annuity’ but did not have a clue what it was or how it worked. That is all about to change.
It’s not a stretch to claim that an annuity is the opposite of life insurance. If that leaves you scratching your head, let me explain. Life insurance is designed to maintain the financial health of beneficiaries if the breadwinner dies. An annuity assumes that the breadwinner lives too long. Are you following me, because if you’re not, don’t feel bad.
An annuity is the only financial instrument that can pay you a lifetime income. It can do that because it is issued by a life insurance company. A lifetime income really means that you cannot outlive the payments coming to you from the annuity. As you can tell, the annuity is for the benefit of its owner, more so than the beneficiaries. While the beneficiaries of the owner can receive funds from the annuity after the owner dies, it is not a vehicle solely created for the benefit of the beneficiaries.
So how exactly does an annuity work? Let me illustrate with an example. Joe Smith sits down with his insurance agent and works out the details for an annuity that he wants to purchase. He has the option of doing this with the agent, buying on-line, buying through a bank or even through a brokerage firm. No matter what route he takes, the annuity will be issued by an insurance company.
Joe elects his wife Ann to be his primary beneficiary. Joe writes a check for $100,000 and his check and application are processed by the insurance company. If Joe needs money right away, then he will select a type of annuity called an immediate annuity. His payments can start in thirty days, and depending on the payout option he chose, can continue for the rest of his life. There are numerous options that will cover Ann also if Joe dies before all the funds are paid out.
Let’s assume that Joe does not need the money right away. Instead, Joe wants the money to grow for several years before he begins receiving an income. In this case, Joe wants to purchase a deferred annuity. The payments will be deferred to a later date, and Joe can decide whether his funds are deposited into a fund with a fixed interest rate or into mutual funds. Either way, Joe will get statements in the meantime showing him the value of his annuity investment.
There is yet another distinction between annuities besides the immediate payment type and the kind that defers income to a later date. I mentioned that Joe had the option of buying an annuity that pays a fixed interest rate. Incredibly, this type of annuity is called a fixed annuity; what a creative name.
The other choice Joe would have had is an investment called a variable annuity. The mutual funds in the variable annuity are called sub-accounts and can be invested in stocks, bonds, real estate, international investments, the money market or a combination of investments. While the fixed annuity pays a known interest rate, the variable annuities value can change daily.
Joe decides that he wants to make sure that Ann is covered in the event that he dies before she does. He is starting his annuity payments right away and he figures he should be around for another twenty years. He has several options at this point.
Joe can choose to receive payments for his lifetime with payments continuing to Ann for her lifetime. This is called a joint and survivor annuity. He can also choose to have Ann covered for just a period of five or ten or fifteen or twenty years. This is called a period certain annuity. The period certain annuity will not pay Ann for her lifetime, but it can produce a larger income payment than the joint and survivor annuity.
What you should understand now is that an annuity is an income vehicle. It is designed for people who want a stream of income either immediately or at a later date. Unlike life insurance, it is designed to benefit the owner during their lifetime, as well as a beneficiary. The only exception is called a straight life annuity, which does not cover a beneficiary, but pays a little more to the owner during their lifetime.
Annuities, and in particular variable annuities, are frequently criticized because their expenses are high. In order to guarantee a lifetime income, the annuity has to charge something called a mortality expense. This is in addition to the expenses the funds charge for managing your money. There can also be fixed costs for administration and processing. An investor looking at annuities must always weigh the cost of these expenses against the need for an income stream.
With most types of investments there are risks. An understanding of different financial terms is a good first step to deciding what risks you are willing to take. The annuity has its place among the myriad of investment choices, but it is frequently not understood even by financial professionals. Dropping by your local library is a great way to further your understanding of annuities. And just think; you know more now than you did ten minutes ago.
Copyright 2007 K Richard Douglas
