Annuities Simplified

What are Annuities and What Gives Them a Bad Rap?

I went to get a membership at the gym the other day.  New Year’s resolutions right!  Anyway, my options were $50 a month for six months at a time, $35 a month for a year at a time or $500 lump sum for 3 years than $10 month for as long as I want.  Which would you take?  For most, probably the first or second option would make more since just so you can test your motivation.  Myself, feeling very motivated, paid the $500.  I felt there was more value in $14 a month, now whether I last for three years or not is undetermined!

Annuities work very similar to my gym payment, where an individual gives a lump sum to an insurance company for some guarantee in return for a particular time.  What the guarantees are depends on the annuity type and the offering insurance company.  Before we get into that let me give a brief history of annuities that most people are not familiar with.

The first recorded annuity payment dates back to the Roman Empire.  An “annua”, Latin for an annual contract, was primarily used to pay soldiers for their time served.   Annuities were also used to fund heavy expenses such of wars and other conflicts.  This is how the war during the depression was funded.  The government sold bonds that were bought up through the insurance industry to finance the construction of military equipment.  In short, the insurance company gave a lump sum to the government for a guaranteed value paid back at a set time in the future.

Now that the “ahh haa” is over with, let’s dig in.  There are generally three types of annuity that include variable annuity, immediate annuity and fixed annuity.  Now, if you are slightly familiar with annuities, you probably have heard different names in addition to the previously listed.  Names such as CD Annuity, Fixed Index or Equity Index annuity and Income annuity all are sub categories to the Fixed and Immediate annuities.

Let’s start with a variable annuity.  This annuity is just as the name suggests, the value follows the underlying mutual fund investments that of course has market variations.  This annuity tends to have rather impressive gains but also not so impressive losses.  The fees associated with this type of annuity are typically higher than the average simply due to the many different hands needed to direct the investment.  The insurance company that offers the contract, the brokerage company with its advisors that markets the annuities and finally the mangers of the underlying mutual funds.  With the way a variable annuity is structured, a lump sum at the end of a term is not likely to be very impressive.  An investor is more likely to take advantage of a certain payout for a certain number of years.  The younger generation of 30 – 40 has a stronger chance of coming ahead with this type of annuity because they have a greater time horizon.

Next, an immediate annuity also referred to as an income annuity is just that.  This annuity is the most simple of all types.  An individual gives the insurance company a lump sum in return for a predetermined rate of return that is going to produce immediate income checks for a certain amount of time.  The time frames can range anywhere from five years to a lifetime.  The most familiar immediate annuity is the state lottery.  If you are in need of guaranteed income immediately, this is the tool to use!

Fixed annuities, also commonly known as CD Annuity is just that, a certificate of deposit through an 

insurance company rather than a bank.  They are also known as Multiyear Guaranteed Annuity (MYGA).  The insurance company provides predetermined annual yield based on the 10 year treasury and is usually set slightly higher.  These annuities are used as a “safe vehicle”, just as the CD’s of a bank except that the rate of return is significantly higher.  They are offered anywhere from 1 to 10 years.

Last and certainly not least, the Fixed Index or Equity Index Annuity is a hybrid of the variable, income and fixed annuities.  This unique annuity allows the investor to participate in market gains based on a market index, most common is the S&P 500, and have no losses as the market index declines.  Sounds good, right?  Well the catch is that the gains are limited to a cap or ceiling; however the losses do not exist.  Another aspect that does not exist up to this point is a “FEE”.  That’s right, contrary to popular belief; there is no cost to this annuity as well as the other fixed annuities.  With that being said, the investor has the option to add additional benefits, much like life insurance riders, for a set price.  For instance, an income rider that provides a regular pay check at some time in the future for the life of the investor.  This expense usually ranges from .5% - 1% per year.  These annuities are used from the ages of 40 – 65 to provide security in a portfolio that is probable to beat inflation and to create the ever so desired “pension” that has almost become extinct.

To wrap this up, annuities have been misrepresented by their marketers.  Brokerage firms, investment advisors, Financial Planners and Insurance agents have been known for utilizing the wrong annuity for the wrong reason.  This can be blamed on many variables such as; brokerage firms being limited to their representation, advisors cannot go outside their parent company and the most popular is the incentives offered from the insurance company. There are many different types of annuities that offer an array of benefits and all need to be matched to the investor.  If your neighbor has one, this does not mean that the annuity will meet your needs. 

Annuities are the best “Safe Money” vehicle offered in the investment world and have a place in everyone’s portfolio no matter how affluent or not an individual may be.  Take the time to find an advisor that is not tied down by his or her parent company and make sure that their aspirations for your portfolio is based on your goals, not their own.  If you are fortunate enough to accomplish this, I assure you that your financial future will be bright and successful.