In order to guarantee a stream of income in retirement, many retirees are transforming a portion of their savings into an annuity. An annuity is an insurance product that transfers risk to the insurance company for a fee. According to a recent article from Bankrate, the fees are often worth it when you consider that investors are transferring longevity risk, investment risk and interest rate risk.
The most common types of annuities are deferred and immediate annuities. A deferred annuity is a product that a consumer purchases for a set period of time before withdrawals begin. An immediate annuity, on the other hand, begins paying out s soon as the investment is made. Annuities can also be fixed, which guarantees the same payment, or variable, when the payout is tied to the overall stock market or group of investments. Seems simple enough, but these financial tools can actually be quite complex. In fact, annuities are not products that you should jump on impulsively.
Here’s a look at a few questions that you should consider asking before signing on the dotted line.
Why am I buying an annuity?
Before you start shopping around for an annuity, you should have a good idea on what you hope to achieve with it. Neil Godsey, managing director at Los Angeles investment firm Miracle Mile Advisors said “One reason is for income generation and the other is for tax-deferred growth. Both play into that decision.”
Other factors, such as how much income is needed in retirement, is imperative to determine the size of the annuity and how it’s structured.
“Annuities are a great tool, but they don’t fit every situation,” said Daniel S. Miller, president of Miller Financial Group in Red Oak, Iowa. “You have to understand how they work.”
What is the payout rate?
The payout rate will depend on when you start withdrawing money, who is covered by the annuity, and the type of investments it’s tied to. Variable annuities are more risky because they are invested in the stock market, and therefore often have a higher payout or interest rate. On the other hand, fixed annuities guarantee the same payout, regardless of what the markets are doing. These products usually have a lower payout attached to them.
In order to pick the best annuity for your situation, you need to know your risk tolerance. You also need to shop around and get a variety of quotes. Payout rates will vary from one insurer to the next, and those rates change weekly.
When do you decide who gets coverage?
Annuities can cover either an individual or a couple. Usually, a couple will get less of a payout than an individual, however the timing of deciding who is covered can make a huge difference. Annuities that require you to decide upfront are fine if both spouses are healthy. But if one spouse falls ill and passes away before the withdrawal period, the surviving spouse is stuck with the lower payout over the life of the annuity.
The other option is to go with an annuity that allows you to determine who is covered at the time of withdrawal. This gives you that added layer of protection if one party has a terminal illness.
What provisions cover surrender charges?
If an annuity holder access their money before the withdrawal period begins, a penalty will be charged. Known as surrender charges, this practice is common with other tax-advantaged retirement savings plans. The penalty amount will vary based on the type of annuity contract you purchase.
“Annuities can be two years, three years and up to 14 (years),” said Joyce of ReJoyce Financial. “The longer the surrender period, the more liquidity you are giving up.”
Before you sign an annuity contract, you will want to know how long the surrender period is and what the penalty will be if you access your money early. It is recommended that you accept losing access to your income for a number of years and plan to cover any unexpected expenses, such as a medical event, with alternative funds. But again, it’s important to read the fine print here.
“Most annuities waive all surrender charges if the person is terminally ill or needs long-term care,” said Kisner. “Some of them will double the payout or increase it 1.5 times for long-term care.”
How healthy is the insurer?
The peace of mind you receive from the guaranteed lifetime income of your annuity is actually only as good as the health of the insurance provider. The insurance company is the one responsible if the underlying investments go bad, potentially setting themselves up for some significant financial mishaps. Because of this, experts say that the health of the insurer that is guaranteeing the annuity is equally as important as the payout and surrender charges.
“The carrier strength is very important,” said Godsey, who went on to add that investors should stick with an insurance company that carries a B-rating or better. It’s also important to learn how long the insurance carrier has been around, its liquidity ratio, or the difference between the current assets and current liabilities, as well as its financials and historical performance.