How Do Annuities Work? - dummies

By Russell Wild

What’s the difference between an annuity and a bond? With an annuity, you don’t expect to ever see your principal back. In return for giving up your principal, you expect a higher rate of return.

A cross between an insurance product and an investment, annuities come in myriad shapes and sizes. The general theme is that you give your money to an institution (usually an insurance company or a charity), and that institution promises you a certain rate of return, typically for as long as you live.

Some annuities, called variable annuities, offer rates of return pegged to something like the stock market. Other annuities, called fixed annuities, offer a steady rate of return or perhaps a rate of return that adjusts for inflation. Some annuities charge a small fortune in fees. Most annuities ask for surrender charges if you try to change your mind.

Be careful out there! A majority of annuities are horrific rip-offs, with all kinds of hidden costs and high surrender charges should you attempt to escape (as many people do when they finally figure out the costs).

A typical annuity may charge you, say, 7 percent of the total amount invested if you withdraw your money within a year, 6 percent within two years, and so on, with a gradual tapering off up to seven years.

Most annuities are sold with 78-page contracts that no one, not even lawyers, can understand.

But some good annuity products are out there as well, such as fixed annuities that adjust with inflation. Among the best providers of those are several insurance companies that have contracted with Vanguard and Fidelity; go to the Vanguard or Fidelity websites and do a search for “fixed annuities” to find out more.

An intriguing form of annuity worthy of consideration is the deferred income annuity, often referred to as longevity insurance. Only a handful of insurers — including New York Life, Symetra Financial, and Northwestern Mutual — offer these policies.

Though they provide a stream of income just as other fixed annuities do, these deferred annuities don’t kick in for years to come. If you buy a policy at age 56, you may not see a payoff for another 30 years . . . and only if you’re still alive.

Because you may not live to see the eventual payoff — which, thanks to inflation, will be worth a lot less than in today’s dollars — and because the insurance company gets to play with your money for 30 years, you don’t need to kick in much cash to (potentially) get a lot at the back end.

For example, at age 56 you can buy an immediate annuity for $100,000 that pays you about $5,800 a year for the rest of your life, with payments starting right away. Or, you can buy a deferred income annuity that gives you about $68,600 a year, with payments starting on your 85th birthday — if you’re still around.

Of course, even if you are, with future possibilities of raging inflation, $68,600 a year may be just enough income to keep you stocked up in dental floss.

Longevity insurance reduces the financial risks associated with living a long life for those who have reason to believe they’ll be around a very long time. But keep in mind that you have no guarantee of throwing yourself a big birthday party in 30 years, paid for by your deferred income annuity.

Generally, annuities do not belong in tax-advantaged retirement accounts, such as IRAs. A main advantage to an annuity is the ability to defer taxes. Putting an annuity into an IRA, which is already tax-advantaged, makes about as much sense as flapping your arms as you board an airplane.

Compared to bonds: Returns on annuities grow larger the longer you hold off on buying one. (Extreme example: Any insurance company would be more than happy to take your money, stick it into an annuity, and pay you 20 percent a year — provided you are 97 years old.)

In almost all cases, if you are in your mid-60s or older, you’ll get more cash flow than you would by investing in bonds, but you give up your principal, and you may not get more than you would with bonds in the end. The taxing of annuity income can be very complicated. Talk to your tax advisor.