Buying an Annuity: Five Points to Consider
While an annuity can be one of the most advantageous financial products an investor can choose to provide guaranteed income in retirement, he or she would be wise to consider five key points before committing to an annuity. Because an annuity represents a contract between the investor and the insurance company, it is most often irrevocable and non-negotiable once it is in force. If an investor is unsure about making such a large and permanent financial commitment, he or she can always purchase an annuity from a company that offers a “free look” period. The free look period may last between 15 and 60 days. During this time, the investor can truly get a sense of what he or she has given up in exchange for guaranteed payouts. Because an annuity may represent one of the largest purchases an investor will make in his or her lifetime, the following five points should be reviewed carefully.
1) Consider the Financial Stability of the Insurance Company
AM Best, Moody’s Investors Services, and Standard and Poor’s each rate insurance companies on financial strength, stability and the ability to meet future financial obligations. The ratings issued by these companies should be reviewed carefully by an investor considering buying an annuity, as the insurance company is in effect taking on a financial obligation to the annuitant that can last 10, 20, 30 years or more.
The highest ratings issued by each of the three ratings agencies are as follows:
- AM Best - “A++ - Superior.”
- Moody’s Investors Services - “Aaa – Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.”
- Standard and Poor’s - “AAA. Extremely strong capacity to meet financial commitments.”
Purchasing an annuity from an insurance company with the highest possible rating should put an investor’s mind at ease that even during a financial crisis, the company will be able to meet the obligations it has. Insurance companies have financial obligations not only to those who have purchased annuities, but also to those who have purchased true insurance products such as term life or permanent life policies.
2) Buying an Annuity for Tax Deferred Retirement Savings
A deferred annuity is a solid way of building retirement savings. There are two phases to a deferred annuity: The accumulation phase and the distribution phase. During the accumulation phase, the investor makes regular contributions that increase the value of the annuity. This is different than the funding of an immediate annuity, which does not have an accumulation phase as it is purchased with a single premium. During the distribution phase, the insurance company makes regular payments to the annuitant based on the specifics of the contract.
For those investors who need to maximize retirement savings, but who have already contributed the maximum amount of pre-tax dollars, a deferred annuity can provide an additional level of tax-deferred savings. While the money contributed to the annuity will most likely be post-tax dollars, the earnings and interest will grow tax-deferred until the annuitant chooses to begin taking distributions after age 591/2. Investors are reminded, however, that distributions taken prior to age 591/2 are subject to a 10% penalty and are taxed at ordinary income rates.
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3) Choosing an Annuity for Lifetime Income
For investors who do not have an employer sponsored defined benefit or pension plan, an immediate annuity that provides guaranteed lifetime income may be a good option. Most lifetime income annuities are immediate annuities. That means they are most often funded with one large single premium and payouts from the insurance company begin immediately.
An investor with few assets, or one who may not be as disciplined, as he or she needs to be when it comes to withdrawing savings, may benefit from an immediate annuity. And, for those older investors who risk outliving their assets, an immediate annuity that will continue to payout even after the entire premium amount has been paid out, can provide a level of financial security not available with other investment options.
4) Choosing an Annuity Based on Risk Tolerance
Annuities are available in three standard investment options: Fixed, variable and indexed. A fixed annuity pays a guaranteed amount each month (or each year) regardless of stock, bond, or credit market performance. This is usually the best choice for an investor who prefers not to take risks with his or her money. The downside is that the longer the annuity exists, the greater the danger of a loss of purchasing power due to inflation.
The premium paid for a variable annuity is invested in stock funds, bond funds, money market funds or a combination of the three as directed by the annuity owner. The advantage is that the owner will take part in market gains. The disadvantage is that the payout can vary each month, and principle can be reduced.
The returns of an indexed annuity are tied to the performance of a market index, most often the Standard and Poor’s 500. The advantages and disadvantages are the same as those with a variable annuity.
5) Buying an Annuity for Estate Planning
While each investor’s circumstance is unique, annuities are generally not recommended as a tool for college saving or estate planning. A good financial planner will recommend alternate investment options for these goals, such as a whole life insurance policy.
If, however, part of the goal of the annuity is to ensure that a spouse has guaranteed income upon the death of the original annuity owner, the annuity can be purchased jointly or with a “period certain” option. As one would expect, both the joint and the period certain options will result in a smaller monthly payout. But, it will ensure that a spouse receives payments until his or her death, or for the predetermined number of years as determined for the period certain.
Purchasing an annuity is a complicated process with far-reaching consequences. As always, investors are advised to discuss the options available to them with a qualified financial planner and tax professional.
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