An annuity can best be described as a financial contract between you and a life insurance company. It will require that you make a lump sum payment, or series of payments, in exchange for a lifelong income. The way in which your income is paid you will very much depend on the type of annuity that you have. If you receive your income all at once this is known as an immediate annuity, whereas if the income is paid to you in the future this is referred to as a deferred annuity. There are basically two types of annuity - fixed, which will offer you an investment that is tied to fixed interest rates or indexed annuities, and the most popular type of annuity is variable which are generally tied to the various investment performances of mutual funds.
There are various pros and cons of variable annuities and these include:
The Pros - you are offered extremely flexibility for your investment choices. You will be offered various mutual funds from which you can select your investments, and it is fairly easy to change the type of investment that you have. You will also find that any investment gains that you make will have tax-deferred until you decide to withdraw the funds. Variable annuities are known to give you a guaranteed income for life. You will also find that annuities are able to protect your assets. A prime example of this is if you are subject to a lawsuit, an annuity will still protect your assets.
The vast majority of variable annuities will allow you to benefit from gains in the stock market, but will also shield you against losses. In recent years the stock market has seen some dramatic changes, however, your investment in an annuity will not be affected by the ever decreasing interest rates. You will typically find that many annuities will offer a guarantee that they will not fall below the value of the initial principal invested.
The Cons - the most obvious disadvantage of purchasing an annuity is that you may not be able to get your lump sum back, or pass the benefits onto someone else. An example of this would be that you invest a large lump sum into an annuity when you are aged 60 and the insurance company will then offer to pay you an income for life. However, the likelihood is it may take anywhere from 15 to 25 years to break even on your initial investment, should you live that long. Another disadvantage for many people is that you will not be able to touch the funds in a variable annuity until you are aged 59 1/2.
You will also find that when you do finally draw income from a variable annuity that the income you receive will be treated as ordinary income. This will mean that it will be subject to ordinary income tax rather than long-term capital rates, which is typically charged at a significantly lower rate. The most important consideration when purchasing a variable annuity is the financial health of the insurance company you choose to go with. You must realize that you have made an investment for many years into the future and therefore it is advisable that you check a company’s Comdex rankings prior to purchasing a variable annuity. This is a ranking system amongst insurance companies and will give you an idea of its strength and solvency.
You should also be aware that variable annuities will have surrender charges and fees should you wish to withdraw any money within the first 5 to 7 years. The fees will typically start at 8%, and therefore $100,000 investment will cost you $8000 in surrender fees should you wish to withdraw your money in the first year. It is also vitally important to realize that variable annuities, and annuities in general, are a commission-based products. This will mean that you will typically need to pay a commission of 5% or more to an agent who sells you the policy. Once again, if we look at $100,000 investment, this will cost you $5000 in commissions.
Annuities will also have various fees that are quite often buried into the overall cost of your annuity. These fees will include annual fees, administrative charges and mortality expenses. This may mean that within the first few years of your annuity’s performance you are likely to make very little money due to the amount of fees that are being charged.
However, with all the disadvantages that appear to come with variable annuities, you should realize that they are still able to offer fairly decent returns. Although it may be impossible to correctly predict the return you will receive in any given year, variable annuities have been known to yield up to 12% per annum. This is not inclusive of the taxes and management fees that will need to be deducted. With that said, you should also note that variable annuities have the potential to depreciate in value as well.