By Wes Moss. Financial Planning Expert
Wes Moss, author of the recently published guide to retirement, You Can Retire Sooner Than You Think. is the chief investment strategist at Capital Investment Advisors (CIA). CIA manages more than $1 billion in client assets and is one of Georgia’s largest private investment firms. He is also a partner at WELA Strategies, an online wealth management and financial education firm.
What Exactly Is An Annuity And How Does It Work?
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Annuities as a financial product category attempt to allow you to “invest” a certain dollar amount in exchange for a payment stream, a death benefit, and/or a tax-deferred investment vehicle – or a combination of all three.
Different Types of Annuities
If you are considering buying an annuity, there are several factors to consider. Before we get to the risks involved with annuities, let’s look at a brief overview of the different kinds of annuities that are available. The type of annuity that you decide upon will be based on several factors including, but not limited to, whether you want your stream of income now or later, or if you want a guaranteed rate of interest or one that is determined by the performance of the investments that you chose.
Immediate annuities start paying out immediately after you give the insurer a lump sum of cash. Immediate annuities are generally for people who are already of retirement age and would like to have their payments start now. Investors are generally promised to receive income payments until they die. You can also choose to defer your payments (deferred annuities ).
Fixed annuities pay set rates of interest (guaranteed by the insurance company), usually over a period of one to fifteen years. They operate much like CD s.
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This gives you a set amount of interest based on what the annuity company is able to generate from investing your money (typically in government securities and high-grade corporate bonds).
Variable annuities are contracts between you and an insurance company. Under this contract, you make a single purchase payment or a series of purchase payments, and insurer agrees to make periodic payments to you beginning either immediately or at some future date. A variable annuity operates much like a mutual fund as you can choose to invest in stocks, bonds, money market instruments, or a combination of all three. The value of your investment will vary depending on the performance of the investment options.
Indexed annuities are those annuities that you are most likely to hear advertised on the radio and television. Indexed annuities, like the other types of annuities, are purchased from an insurance company. These annuities are linked to an index, most commonly the S&P 500. The difference is that these annuities guarantee a return to your principal no matter how
the stock or bond market does. The key factor to be aware of here is that while you might have some protection on the downside, your upside is significantly limited. Insurance companies impose hefty restrictions, caps, and spread fees. For example, a spread fee is a percentage fee that may be subtracted from the gain in the index that is linked to the annuity. So, if an index gained 10% and the spread fee is 5%, your gain would only be 5%. Another fact to keep in mind is that annuities are only required by regulation to return 87.5% of your money.
What Are The Real Risks Associated With Annuities?
While we all are looking for that magical investment tool that promises us a lifetime of steady income with no risk, I do believe that old saying that there’s “no free lunch.” There are a lot of risks involved with annuities, and the below are just a few of the things that need to be considered prior to making any major investment decisions.
Surrender Charges - There is generally a penalty for making an early withdrawal above the free withdrawal amount. This penalty is often between 2-10% and can be imposed as long as 10 years after the purchase of the annuity. Surrender charges typically apply in the cases of variable and index annuities.
Restrictions - Restrictions can range from the minimum age you need to be to withdrawal money from the annuity to the amount of money per year that can be withdrawn. For example, any withdrawal made before 59 1/2 is subject to a 10% federal tax penalty.
What happens if the insurance company goes away? How is your money with that company legally protected?
High Expenses - There are high fees and commissions associated with purchasing annuities. The average annual expense is 3-3.5%. Sales commissions from the original sale of the annuity can range from 4 to 8% which is a significant incentive for those selling annuities.
If you are thinking about investing in annuities, it is always best to have a third party- someone not working on commission- give you an objective view of whether they are an appropriate investment for someone that is in your specific situation.
Have you considered annuities as a retirement planning tool? Be sure to weigh the pros and cons.
Wes Moss is the host of the Money Matters radio show on WSB Radio, host of the TV show Atlanta Tech Edge on Atlanta’s NBC affiliate, and Chief Investment Strategist at Capital Investment Advisors. In 2014, he was named one of America’s top 1,200 financial advisors by Barron’s Magazine. He is the author of several books including his most recent, You Can Retire Sooner Than You Think - The 5 Money Secrets of the Happiest Retirees , which has been one of Amazon’s best-selling retirement books in 2014.