Annuities have a reputation for being complicated financial instruments. This is not unjustified, but the features and details inside annuity contracts are there for a reason. Each one enhances a particular investment or insurance benefit. Since the annuity holder pays for those benefits, it is in his or her interest to fully understand them.
Each type of annuity contract contains unique information with which a prospective purchaser should be acquainted. That acquaintanceship is made by reading the contract. Any questions about its contents can be answered by the insurance-company representative. Doubts about whether to proceed with the purchase can be resolved with the help of a financial planner.
Fixed Annuity Contracts
By definition, a fixed annuity credits the holder’s account with interest at a rate that is fixed for a time period stipulated in the contract. It is common for this initial rate-guarantee period to last no more than one or two years. The insurance company will have the right to lower the rate each year thereafter in accordance with market conditions. Also common, however, is the bailout provision, which allows the holder to cash out the annuity without penalty if the reset rate falls below the initial guaranteed rate by more than a specified percentage (frequently 1%). Rather than simply focusing on the initial guaranteed interest rate, the prospective purchaser should become familiar with all of the foregoing details before signing the contract.
In addition to the minimum interest-rate guarantee, fixed-annuity contracts also often offer a minimum-income or return guarantee as well.
Annuities are accompanied by surrender charges, expressed as a percentage of the value withdrawn. These penalize the holder for removing money prematurely; that is, prior to the scheduled start of distributions. The duration of surrender charges varies from 4-15 years and interest penalties may approach 10% in the first year. Waiver provisions often allow suspension of surrender charges in special cases, such as disability, unemployment, death of a spouse or diagnosis of a terminal illness. These details alone would be sufficient reason to consult the contract.
Although the surrender charges severely limit it, annuities do offer a modest amount of liquidity. A common contract provision will provide for penalty-free access to 10% of principal and/or the ability to withdraw an amount equal to annual interest.
Indexed Annuity Contracts
An indexed annuity combines features of both fixed and variable annuities. As with a fixed annuity, the investment performance of the annuity holder’s contributed funds is governed by factors stated in the annuity contract. Specifically, performance is tied to an index of market performance. Moreover, various insurance-like guarantees are designed to insure a positive return and immunize the holder against loss. As with a variable annuity, the investment performance of the holder’s funds varies directly with changes in market performance.
The annuity contract states which index is used to determine the return credited to the annuity holder’s account. The most popular index is Standard & Poor’s 500 stock index. Index annuity contracts contain elements designed to buffer the effects of market variation on the annuity holder. The participation rate states the percentage change in the index that is reflected in the value of the annuity. The cap rate limits the extent to which market gains are allowed to increase the annuity’s investment value. (The contract will also put a floor under those gains, which is normally zero.) Various methods exist for calculating the value of the index itself – the point-to-point, high-water mark, annual-reset and averaging methods are some of these. The contract will state the specific one used.
Index funds are a low-cost investment vehicle, but index annuities charge administration fees for performing services such as those described above. These fees are listed in the contract. Because index funds appeal to an older clientele, they will sometimes vest holders in a schedule of increasing withdrawal benefits over time. This schedule will also appear in the contract.
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Variable Annuity Contracts
Variable annuities tie the investment performance of the annuity to the market performance of funds operated by the insurance company. These funds are the functional equivalent of mutual funds; indeed, they may even be clones of well-known, existing funds. Annuity holders get the opportunity to invest in a growth-oriented portfolio on a tax-deferred basis, without incurring the contribution limits of qualified plans such as IRAs and 401Ks. Along with these benefits come other features and costs that are included in the annuity contract.
Because variable annuities shift investment risk to the annuity holder, they are considered securities. As such, they must issue disclosure documents called prospectuses. These contain investment-related information regarding risk and return. They list the funds offered by the variable annuity and reveal each fund’s composition and investment strategy. (This is important not only for stock funds but also for bond funds, whose duration helps investors to gauge the fund’s interest-rate risk.) They also list the firm’s annual expenses. These are important because the annuity holder will pay these in addition to the expenses generated by the insurance company. All this information should be carefully considered by the prospective purchaser.
In addition to securities-related information, variable annuity contracts also contain much important insurance-related information. On top of the minimum death benefit, variable annuities often offer minimum guarantees of return, income and withdrawals. This is especially true with the introduction of Living Benefit riders in recent years, which often guaranteed returns regardless of actual market performance. Details of these guarantees and their cost to the holder are provided in the annuity contract.
Unlike other annuities, variable annuities shift the burden of investment management from the insurance company to the holder. Since optimal asset management may require changes in portfolio composition to achieve rebalancing after market fluctuations, holders should be aware that some insurance companies impose limits on the number of annual portfolio changes. Once again, these limits will be stated in the annuity contract. State governments sometimes tax variable annuity companies, which then pass along these taxes to annuity holders as “tax-reimbursement charges.” This fact will be noted in the contract.
Several provisions are common to all types of annuity contract. Each state regulatory body stipulates a time period within which the purchaser has a “free look” – the opportunity to reconsider the purchase without penalty. This time interval is stated within the contract. A death benefit is a common provision in annuity contracts and ancillary details may differ considerably depending on company policy and holder preferences. The annuity contract may allow the submission of additional payments by the holder, in exchange for additional distributions later. If so, the contract will mention it. The terms upon which the holder can surrender the annuity for cash will be stated in the contract. Sales commissions received by insurance-company employees or contractees will also be shown in the contract. In order to assess the security of investment in the annuity, the holder may want to consult the evaluation of rating agencies. The holder will need to know the company issuing the annuity and can learn it from the contract.
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