Tag Archives: annuities

Why Invest In Annuities

You have probably read articles on why you should buy or invest in annuities. These articles, of course, focus on the guarantees you get in the contracts.

You may also read articles on why you shouldn’t invest in an annuity. These latter articles are usually written by financial planners who look at these products from the strictly financial viewpoint of a wealthy person. These people need tax deferred investments with maximum flexibility during the accumulation phase of their careers. They will normally put the maximum into a 401k, possibly a profit sharing plan, and then a very flexible version of a variable annuity where the fees are lower.

Here, we are concerned with issues facing average middle class families, who have limited savings and are struggling to get by.

How Are You Saving For Retirement

You have probably been working for a number of years if you are reading this. You may have a family, a house, some kids, and little in the way of savings. You might be focusing on putting money away to pay for the kids’ college education, or you might have just finished so you have a lot of loans outstanding.

You are probably covered under some kind of retirement plan at work and may consider this as your annuity at retirement. You might also be covered under a 401k plan. If so, you most likely have not saved any amounts to supplement those plans in retirement since you have had so many other expenses.

Now, you are wondering about retirement and will your retirement plan be sufficient, even with Social Security. You are right to wonder and it is good to plan ahead.

Order of Savings

Here is a simple list showing the order of how you should save:

  • Emergency cash fund for unexpected large expenses – new roof, new refrigerator, medical, etc.
  • Savings account, CDs, College IRA’s to save for future known expenses – college, eventual new car, etc.
  • 401k, if any – put in as much as you can, but at least as much necessary to get the employer matching contributions
  • IRA’s – since you have a retirement plan or 401k, go for a Roth IRA so that it is tax free in retirement
  • Deferred Annuity – start small, but add a certain amount of dollars every month to a deferred annuity

You should never be so overloaded with house expenses that you cannot save any money in savings and retirement accounts. If you are, you might consider moving to a less expensive house since you could be in danger down the road of losing the house if you aren’t planning for the other expenses that will come.

You need to plan your financial life and this includes saving more for retirement than the amount you will get from your pension at work. Your salary should be able to cover your house expenses, a contribution to an emergency fund, contribution to an IRA, and still have some left over to put in an annuity for retirement. If you cannot meet all of these, start considering ways to reduce monthly expenses. Sounds crazy, doesn’t it? This is a real problem for the middle class family, but it can and must be done. Once you start looking at expenses, you will be surprised how many of the monthly luxuries we can cut out and not really miss them.

If you are already at bare bones expenses, then it’s time to search for ways to get additional income. This could be second job, or turning hobby into an income business.

You Need More Retirement Savings

It might be comforting to look at your retirement plan and see your benefit accumulating. The problem is most companies do not give you projections of what your benefit will look like with future inflation taken into account. Inflation is the killer to a retiree. It is for this reason that you are probably not saving enough for retirement.

An IRA is one way to help save up to $5,000 per year for retirement. However, you need still more.

Consider Opening a Deferred Annuity

A deferred annuity is simply a contract in which you will contribute a certain amount to each month after tax and then start receiving monthly benefits when you retire. These annuities are either fixed annuities in which you are credited with a fixed interest rate each month. Or, the annuities can be variable in which your money can be invested in various mutual funds. Either way, you do not have to put in large contributions.

You can begin a deferred annuity at any point in your career and put is a contribution each month. These can be started with as little as a $25 or $50 monthly contribution. The insurance company can even be given the permission to withdraw the desired amount out of your checking account so that you do not have to decide whether to write a check each month.

Plan Ahead and Pay Yourself First

Contributing to an IRA and a deferred annuity follow the general financial planning concept of paying yourself first. This means you save first, and then pay your expenses. If you do not have enough money left to cover expenses, you then go through the process of reducing expenses or increasing income as noted above.

What you do not want to do is pay all your expenses and then save whatever is left over. The reason is that you will spend all your income and never get around to saving for retirement. When you approach retirement, you will then realize you don’t have enough saved. You also won’t have enough time left to accumulate the necessary amount for a comfortable retirement.

It would be easier now to just procrastinate, work and spend, and then deal with the retirement question in your late 50’s. You might also tell yourself that you will just get a part time job in retirement and everything will be fine. Maybe it will. Then again, maybe it won’t be fine.

A small contribution now to a deferred annuity contract will give you an extra monthly retirement check coming in at retirement. This payment will supplement your normal pension and Social Security checks. An annuity is the only product that can give you a guaranteed payment at retirement.

Focus on planning, cutting expenses, increasing income, opening an IRA, and buying a deferred annuity contract. You will be glad later on that you did.



An Explanation of Indexed Annuities

An Index annuity is an interesting twist in the world of annuities. It has many of the attributes of a fixed annuity and some aspect of a variable annuity. It is marketed by insurance agents as being both, depending upon the sophistication of their audience. Legally, an index annuity is a fixed annuity. However, to understand why this is true,we first need to review particular aspects of fixed and variable annuities.

Fixed and Variable Annuities

We don’t need to review items that are similar between fixed and variable annuities. These would include making contributions, withdrawal rules, taxation of withdrawals or fees ; though fees are higher under variable contracts. The area we want to focus on is the accumulation phase of the contract and how interest and investment earnings are credited to the contract.

In a fixed annuity, your contributions are credited with a fixed rate of interest. The insurance company guarantees that you will not lose any principal, nor receive less than the stated interest rate. This is one of the big selling points of a fixed annuity. You have certainty and guaranteed returns, even though you always wish the interest rate was higher. Since fixed annuities carry a fixed interest rate, they are not considered securities and do not come under the rules and oversight of the Securities and Exchange Commission.

In a variable annuity, your contributions receive investment earnings, but these are not guaranteed. You select your desired investments from a variety of mutual funds, usually high quality stock and bond funds. In this way, you have the advantage of potentially higher investment gains, and, therefore higher eventual annuity payments when you retire. Of course, you also have the potential of earning reduced investment returns due to drops in the stock market. However, over long periods, it is expected that your investment returns should outperform a fixed interest rate. Due to the exposure to the stock market, the variable annuity contract is subject to the rules and oversight of the SEC.

The Indexed Annuity

Index annuities are also known as equity indexed annuities since their investment returns are usually tied to the performance of equity or common stock investments.

An index annuity is a fixed annuity that has some relationship to a variable annuity. During the accumulation years of the contract, you receive a guaranteed interest rate which is reset periodically. On the surface, it looks just like any other fixed annuity.

However, during the accumulation phase, the interest rate to be credited is based on the investment returns of a basket of stocks or a stock index, such as the S&P 500 Index. The insurance company looks at the returns of this index and calculates an interest rate that produces a similar return. This interest rate is set and guaranteed for a certain period of time, such as 1, 3, 5, or7 years. A new rate is then calculated based on the returns of the stock index and applied for the following period.

The insurance company usually guarantees a minimum rate of interest that will be credited to the contract. This rate will be set relatively low, but it does give you the assurance that you can never lose your principal in case of a severe downturn in the stock market.

The Participation Rate

The insurance company does not provide you with the minimum guarantees and actual guaranteed rate without their getting paid for these benefits. So, you can’t simply look at the return of a stock market during a certain period and calculate your interest rate yourself. First, you won’t receive the entire return. The insurance company states a participation rate which is the percentage of stock market return that you will get. This rate might be 70%, 80% or 90%. So if the S&P 500 rises 4% in a given period, they may consider 3.2% (.80 times 4%) when calculating your interest rate at the reset date. The higher the percentage, the closer your interest rate will reflect the actual returns of the stock market investments.

Methods of Calculating Interest

There is considerable difference in how each insurance company calculates your interest rate based on stock market performance. There are 3 standard methods that may be used by the insurance companies.

  • Annual Reset or Rachet Method – This method is a calculation of stock market performance between the beginning of the year and the end of the year, and it locks in the increases. Possible decreases in market performance the following year will not affect interest you have already received. So, this method of calculating your rate may produce greater interest when the market index is moves up and down a lot during the reset period. On the other hand, to reflect this potential for greater interest, you may receive a lower participation rate under this method. Also, many companies using this method impose an interest rate cap.
  • The High Water Mark Method – This calculation will look at the highest level of the stock index during the year, and compare his point to the start of the next year. Interest may be higher with this method if the index is high at the beginning of the year and falls later in the year. However, interest does not get credited until the end of the reset period. So, if you terminate the contract prior to the end of the term, you will not get the higher interest for that period. Use of this method may also reduce the participation rate and impose an interest rate cap.
  • The Point-to-Point Method – This method calculates the change in the stock index between values at the beginning and end of the year.But interest is not credited until the end of the reset period.You will probably get a higher percentage rate under this approach, which could be several years.

Administrative Expenses

You may get hit with a host of fees and expenses. Some companies will impose management fees which are calculated as a percentage of your account value. These fees will be taken your of your earnings. Others will advertise that they have no administrative fees, but they impose higher investment management fees.
The areas of expenses, management fees and other negatives to your account must be reviewed, understood and compared to ensure you get the best deal.

Advantages of an Indexed Annuity

These annuities are designed for conservative investors who want exposure to stock market investments, but cannot afford a large drop in their assets. Older investors nearing their retirement age may consider his type of annuity to get the stock market participation without fearing loss of principal. The indexed annuity may also be appropriate for high income investors who are over the maximum limits in their other retirement plans.

Understand and Compare the Contracts

The contract provision above can be found in all index annuity contracts.  However, the provisions come under different names, and the will be slightly different among the insurance companies. You need to understand each provision and compare among the various contracts. You are investing for your retirement and you need to ensure you know what you are getting for your long term commitment.


Should I Invest in Annuities

Annuities are designed to meet the needs of a number of financial situations. You can select annuities that have flexibility in how and when you put money in, the methods for taking money out, and how you contributions are invested during the term of the contract.

Contributing to an Annuity Contract

There are two methods of putting money into an annuity contract. The method used depends upon how much money you have to invest now.

The first method is putting one large sum at one time. This is called a single premium or lump sum annuity. You may use this approach if you come into a large amount of money such as an inheritance, and you are buying the annuity primarily for tax deferral purposes.

The second method is periodic contributions. You would put in a certain amount each month and then start receiving your payments out when you retire. You would use this method when putting a portion of your salary aside each month to save for retirement

Type of Annuity Contract

There are basically two forms of annuity contracts. These are the fixed annuity contract and variable annuity contract.

With a fixed annuity contract, your contract earns a specific interest rate for a specific period of time such as 3 years or 5 years. After that time, the interest rate is set for the next period. Your principal and interest are always guaranteed against loss by the insurance company. So, a fixed annuity is similar to a bank CD. However, the guarantees are made only by the insurance company and you are not covered under any type of government insurance such as the FDIC. If the insurance company should become insolvent, your annuity is as risk.

Under a variable annuity contract, you can make the same types of contributions as under a fixed annuity. The insurance company guarantees that it will make periodic payments to you later on. The difference is can be found in how money accumulates in the contract. Your contribution does not go into the general account of the insurance company. Your money is invested in in one or more mutual funds that you select as your investments. You may have a choice among a number of mutual funds to match your investing style and goals. These will include both stock and bond funds. The amount of your eventual payout will depend upon the investment performance of the funds you selected.

Advantages of Annuity Contracts

The main advantage of all annuity contracts is that all taxes on your earnings are deferred until you withdraw money from the contract. This is a huge advantage over putting your money directly into mutual funds, where you would be taxed each year on earnings, assuming the money is not covered under an IRA, 401k, or other retirement plan.

Insurance company guarantees are the next advantage of an annuity. Under a fixed annuity, your money is guaranteed against loss at all times. You are also guaranteed to receive a set benefit for life in retirement. Also, you are usually guaranteed a death benefit to your beneficiary.  Under a variable annuity, the insurance company guarantees to make payments though the amount varies with the underlying investments you chose. You can also add contract riders to provide any additional guarantees you might desire. One of these riders is a minimum return guarantee on your investments. Of course, adding in these riders come at a cost. Variable contracts also provide for death benefits most of the time.

Disadvantages of Annuities

Insurance guarantees come with a cost, both in dollars and flexibility of what you can do. Rather than just list the disadvantages, let’s compare investing in an annuity with putting our money in a mutual fund, outside of your 401k or IRA.

Annuities give you a choice of a guaranteed income for life under various options. You receive a small payment per month compared to your overall account balance.  This scenario turns off many people who hesitate to commit such a large amount of money. It really comes down to your having to decide how long you expect to live. Then again, that is the purpose of an annuity; to ensure you do not outlive your money.

You are making a long term commitment with your money. In order for the insurance company to make guarantees, they need to control the assets. Therefore, you have very little flexibility after you make the commitment. You also cannot undo the commitment should your situation change later on.

In fixed policies you get a guaranteed interest rate. In saving for the long term, such a fixed interest rate may not allow you to earn enough to outpace inflation and give you a comfortable retirement. With a variable annuity, you do have the ability to participate in the performance of stock and bond mutual funds. However, you also have the ability to choose the wrong funds, and change funds at exactly the wrong time in a given economic environment. However, you have the same investment responsibility under a regular mutual fund. You are the one that must make the investment choices.

Fees, commissions and cost of guarantees are the factors that turn off most financial planners. These factors can be high in fixed annuity contracts and very high in variable annuity contracts. The expense factors must be carefully weighed when shopping for an annuity. Much less fee levels exist under mutual funds, which is why financial planners favor these types of investments. However, your financial planner is not the one who will have to deal with the insecurity of not having a guaranteed annuity at retirement. Having an annuity will give you a much more secure feeling when you know your payments will be coming in for life.


In an annuity, your investment earnings, either fixed or variable, will be taxed as ordinary income when you withdraw money. When you withdraw money from a mutual fund, your earnings are taxed as capital gains. Ordinary income is taxed at a higher rate than capital gains on your tax return.

If you should die, your annuity earnings are taxed to your beneficiary when he or she starts taking withdrawals. The IRS views your earnings as being passed to your beneficiaries and so they must pay tax on these earning when they receive withdrawals. Under a mutual fund, your beneficiary inherits your money at current value tax free. Your assets receive what the IRS calls a Step-Up in cost basis as though your beneficiaries had bought these assets at the value when you died.

Withdrawals from an annuity are taxed as though you are taking out earnings first. In other words, you will be fully taxed on all withdrawals until your balance gets down to the amount of contributions you put in. Then further withdrawals will be tax free. Withdrawals from a mutual fund will be taxed as though you took out your own contribution first, and then your earnings. So, you won’t start to be taxed until you take out all of your contributions.

Your Own Financial Situation

Taxes upon withdrawal may or may not be a big consideration for you depending upon your situation. Are you concern with the effect of withdrawals for you beneficiaries? Do you plan to make withdrawals in a lump sum? Do you want or need the tax deferral advantages of an annuity? All of these factors go into your decision.

No two financial situations are alike. Your situation and priorities will be much different than your neighbor’s. You need to look at how much you have in various retirement accounts and compare that to your expected expenses when you retire.

If you are covered under a defined benefit pension plan you will be receiving a portion of your overall retirement payments in the form of an annuity. In this situation, I would suggest you look to maxing out your IRA and 401k, and then putting further contributions into assets outside of an annuity.

If you are not covered under a defined benefit pension plan, you are going to experience certainlevel of insecurity in retirement regardless of how much money you have. This is because you will have no guaranteed payments coming in. Ask any retiree and he will tell you his number one fear is outliving his money. An annuity can alleviate some of this fear.