Annuities?
Few would argue that the promise of guaranteed income for life has an encouraging ring to it. Indeed, there is a product offered by insurance companies that does offer such a prospect.
The deal is straightforward. You give the insurance company your money and the company agrees to pay you a stated rate of return for a specified period of time, often as long as you live. That’s the typical model of a fixed annuity.
From a business perspective, the insurance company is betting that the return on the investment it is making with the funds you are transferring to them will exceed the regular payments it is making to you. If the specified term is however long you will live, the company ends up ahead if you die early. If you outlive the expected term, you are the winner.
With a fixed annuity, the money is gone once it’s transferred. What’s more, the rate of return specified in the agreement is usually fixed. This may or may not be reset over time. In view of the historically low interest rates that have prevailed for the past decade or so as well as the likelihood that rates are now moving higher, it would seem ill-advised to lock in at the current modest rates.
And then there are variable annuities, which share a name, but are markedly different from fixed annuities. Variables are the insurance companies’ answer to mutual funds.
One main difference is that the funds transferred to the insurance company for investment through the variable can be withdrawn. There is, of course, a caveat. That’s known as the surrender period, which is usually about seven years. If you withdraw before the expiration of the surrender period, there will be a charge. For example, if you withdraw after one year, the surrender charge would be about 6%. Surrender charges decline annually.
With rare exception, the annual fees for variable annuities are high, which is especially problematical at times such as now when interest rates are so low. What’s more, the number of investment alternatives available (a.k.a. subaccounts) tends to be limited, which is a significant negative.
Even so, there’s at least one important advantage available from variables. When the contribution limits for other tax-deferred options such as IRAs and 401K plans have been reached, a variable annuity is available for those seeking another option for tax-deferred investment. It’s important to note, too, that withdrawals from variable annuities are taxed as ordinary income, not at capital gains rates.
There may also be a death benefit, but that may be no more than the balance of whatever was transferred to the insurance company. Or it may step up over time if the value of the account increases.
Another feature could be a guaranteed minimum income benefit, when withdrawals take place. That could be even if there is not enough money in your account to support that level of payments.
A further possibility is long-term care insurance, which pays for home health care or nursing home care if you become seriously ill.
Bottom line: All annuities are not created equal. Look carefully before you leap.
N. Russell Wayne, CFP®
Any questions? Please contact me at nrwayne@soundasset.com
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