Annuities are a financial product that people seem to love or hate. Most people I talk to have a pre-conceived bias about these products. The truth is that annuities are neither good nor bad. They are a tool. When used in the right situation they can be a good choice. When used inappropriately, they can be a poor fit for your financial situation.
Here, I will not discuss whether they are good or bad because that is unique to your situation. That requires a much more involved conversation. But, I will explore some of the basics of annuities so you can be better informed about them.
This is not intended to be an all inclusive guide to annuities and should not be used as a source for deciding if an annuity is right for you. I will not be including information about important considerations, such as taxes, because that is too involved for this brief introduction.
Annuities come in many varieties. There are fixed annuities, fixed indexed annuities (FIAs), variable annuities (VAs) and a newer product category are registered indexed linked annuities (RILAs).
Annuities can be immediate annuities or deferred annuities.
Annuities can include optional features, called riders.
Annuities are either in the accumulation phase or the annuitization phase.
Annuities can be held in retirement accounts or non-retirement accounts (referred to as non-qualified accounts).
Let's look at some of the basics of all these different types of annuities.
Fixed annuities – these annuities are designed to pay a guaranteed rate of interest for a set period of time. In my opinion, these are the most basic form of annuities. These annuities typically consist of a current interest rate that is guaranteed for anywhere between 1 year to 20 years and will also have a minimum guaranteed interest rate. For example, a 5 year annuity may guarantee to pay an interest rate of 4% for 5 years, but if you hold the annuity beyond the 5 year period they guarantee to pay at least 1% per year at a minimum. In this example, in years 6+ they could pay higher than 1%, but the annuity company cannot pay you less than 1%.
Fixed indexed annuities – these annuities incorporate an interest rate tied to a market index. The most common index used is the S&P 500, but there are many different indices than can be used depending on the insurance carrier. These annuities will have a guarantee that the value cannot go down, but the rate of interest you earn is tied, to a degree, that the index goes up. They can have a cap rate (the maximum amount you can earn) and/or a participation rate (what percentage of the index's upward move you capture).
For these examples, we will assume the annuity used the S&P 500 as the index, it has a cap rate of 7% and a participation rate of 100%.
- If over the next year the S&P 500 is up 5%, then your interest rate would be 5%. You captured 100% of the S&P 500's upward move and the move did not hit the cap.
- If over the next year the S&P 500 is up 20%, then your interest rate would be 7%. You captured 100% of the upward move up to the point it reached the cap rate of 7%.
- If over the next year the S&P 500 is down 15%, then your interest rate would be 0%. You don't earn any interest, but you also did not suffer the downside of the index.
Variable annuities – these annuities include an investment component to them. These are invested in something similar to a mutual fund, called subaccounts. These subaccounts can range from very conservative to very aggressive. Some variable annuities may offer a subaccount with a guaranteed rate of return, but for the most part with variable annuities the investment is not protected from losing money in the same way the annuities above are. The performance of these annuities is tied to the performance of the subaccounts. For example, if the variable annuity is invested in an aggressive growth subaccount and the subaccount is up 25% for the year, you will gain 25%. On the flip side, if the subaccount is down 25% for the year, you will be down 25%.
Registered indexed linked annuity – these annuities are a blend between a fixed indexed annuity and a variable annuity. Like a fixed indexed annuity, they are tied to the performance of a particular index and will often include a cap rate. Like a variable annuity, they are not protected from a loss. These annuities offer something called a buffer where the insurance company absorbs a portion of a loss in the event the underlying index is down. The investor absorbs any loss greater than the buffer protects.
For these examples, we will assume the annuity used the S&P 500 as index, it has a cap rate of 10% and a buffer of 10%.
- If over the next year the S&P 500 is up 5%, then your gain would be 5%. You captured the full upward move of the S&P 500 and the move did not hit the cap.
- If over the next year the S&P 500 is up 20%, then your gain would be 10%. You captured the upward move of the S&P 500 up to the cap rate of 10%.
- If over the next year the S&P 500 is down 25%, then your loss would be 15%. The annuity contract's buffer protects you from the 1st 10% of the downside. However, since the market was down more than 10% (the buffer) you absorb the remaining loss.
Whether or not any of these types of annuities is right for you involves consideration of many factors. If you want to learn more about if any of these annuities are right for you OR if you currently own an annuity and want to get a better understanding of your annuities features please reach out to us.
Part 2 will cover additional basics such as immediate vs deferred annuities, some common types of riders, accumulation vs annuitization stage and common annuity fees.
If you have questions or would like to discuss your personal situation please contact me at 740-264-4466 or zrinyie@ceteranetworks.com
Gene Zrinyi, MBA
Financial Advisor
Tri-State Financial Services
The guarantee of an annuity is backed by the claims paying ability of the issuing insurance company, not an outside entity.
Although it is possible to have guaranteed income for life with a fixed annuity, there is no assurance that this income will keep up with inflation. There is a surrender charge imposed generally during the first 5 to 7 years or during the rate guarantee period.
Index annuities are insurance contracts that, depending on the contract, may offer a guaranteed annual interest rate and some participation growth, if any, of a stock market index. Such contracts have substantial variation in terms, costs of guarantees and features and may cap participation or returns in significant ways. Investors are cautioned to carefully review an index annuity for its features, costs, risks and how the variables are calculated.
Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
There is a surrender charge imposed generally during the first 5 to 7 years that you own a variable annuity contract. Withdrawals prior to age 59½ may result in a 10% IRS tax penalty, in addition to any ordinary income tax. Investment sub-account values will fluctuate with changes in market conditions. An investment in a variable annuity involves investment risk, including possible loss of principal. Variable annuities are designed for long-term investing. The contract, when redeemed, may be worth more or less than the total amount invested. Variable annuities are subject to insurance-related charges including mortality and expense charges, administrative fees, and the expenses associated with the underlying sub-accounts. Investors should consider the investment objectives, risks and charges and expenses of the variable annuity carefully before investing. The prospectus contains this and other information about the variable annuity. Contact your financial professional to obtain a prospectus, which should be read carefully before investing or sending money.