Annuities are one of the most complicated financial tools around, which leads to a lot of misunderstandings about how they work. In fact, consumer research conducted by the American College of Financial Services found that only 12% of Americans knew as much about annuities as they thought they did.
The basic idea — hand over a chunk of money to an insurance company and they'll give you back a regular flow of income — is complicated by how the insurance company intends to generate enough income to fulfill that promise. By gaining a firm understanding of two primary forms of annuities — fixed and variable — you'll be properly positioned to figure out how well either might work for you.
How do annuities work?
An annuity is a promise of regular income in exchange for a sum of money that you entrust to an insurance company to manage. The moving parts of an annuity are time (how early you hand over the money), the interest rate the insurer will pay, how long you expect to be paid and how much each payment will be.
Annuities used to be weighed down by exorbitant fees, said Jared Kornfeld, who heads the insurance arm of financial services and accounting firm Kaufman Rossin, but the category has rapidly evolved. It's important to start with a fresh view of current forms of annuities rather than relying on old versions, as one might when reviewing a parent's finances, he advised.
What is a variable annuity?
A variable annuity is a way to invest in mutual funds, said Kornfeld, that has two advantages over directly investing: tax deferral and the potential for guaranteed lifetime payments.
The money in a variable annuity builds at a rate based on your selected portfolio from the basket of mutual funds offered by the insurance company. That's why it is essential to review with your financial advisor annually.
While the funds are parked in the variable annuity, increasing in sync with the invested funds, you do not have to pay income tax on those gains. Only when you start taking an income from the annuity must you pay taxes — at the ordinary income rate.
Pros
- Potential to capture market gains
- Tax deferral
- May offer protection from market drops, through riders
Cons
- Potential for high fees
- Potential for market losses
- Likely to have surrender charges that can last up to 10 years
What is a fixed annuity?
A fixed annuity spells out the interest rate it will pay when you invest your money in the annuity. Then, when you start to draw income, you know how much the account will be worth, regardless of how the market has performed in the meantime.
Pros
- Guaranteed income, even if the market declines
- Shelters potential gains from income taxes until you start taking income
Cons
- Returns will not rise with the market and may or may not keep up with inflation
- Fixed interest rate determined by prevailing rates at the time when you set up the annuity
Fixed versus variable annuity: Which should you choose?
If your goal is to keep a portion of your portfolio in the market, you might do just as well with a "plain vanilla mutual fund" portfolio instead of a variable annuity, said Kornfeld.
"Variable annuities do not protect you. There's no downside protection," he said. Especially if you are close to retirement and want to lock in market gains, a fixed annuity probably is the correct vehicle, he said. "It's a great tool for people who are market-averse," Kornfeld added.
Retirees who want to devote part of their portfolios to what he calls "mailbox money" — a regular chunk of income that covers basic living expenses — might convert a chunk of their assets to a fixed annuity and keep the rest in the market.
It's important to note, said Kornfeld, that the "variable" aspect defines how the annuity builds but does not dictate how you take income from it. When you start to take income, you establish the rate and duration of payments: Tthose are the factors that determine how much each payment is.
The lifetime income payout rate is the amount received from the annuity annually as a percentage of the premium paid. It's not to be confused with the interest rate that the annuity earns if you buy it and let it grow, at that set rate, for a few years, before starting to take payments.
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