How to Purchase Annuities
When considering an annuity investment for a portfolio, there are some steps that should be followed to get the most out of your account. Annuity contracts have become very complex and diverse, offering a wide range of investment choices and riders to protect income, assets, and family. Annuities are offered by insurance companies, though they are only one component for financial planning. After doing some independent research, meet with a financial professional to determine how an annuity will fit into your family financial plan and portfolio.
Choosing an Insurance Company
Annuities are essentially an insurance against outliving one’s assets, which is why annuity contracts are offered by insurance companies. Annuity accounts are not covered by the FDIC (ironically, an insurance company), so the guarantee comes from the company itself. Find a long standing and reputable insurance company that has sound financial ratings and a strong claim paying ability. In addition to financial stability, an insurance company should offer the type of annuity that will suit current needs. Most of the larger companies will offer a full array of immediate and deferred annuities, as well as fixed, variable, and indexed contracts.
Companies may offer substantial deposit bonuses or teaser interest rates. Consider the value of such propositions, and discuss the importance of the risks and opportunity cost of such offers. Choosing a less financially sound company or entering a sub-par contract may not be worth the risk in exchange for a few added dollars or a percentage point.
Choosing an Annuity Type
The first question here is ‘do you need income now or later?’ Immediate annuities will require a single lump sum deposit and will begin providing an income stream right away. This choice may make sense to provide retirement income, pay for college, or even fund a life insurance or long term care policy. When income is not needed until a later date (or not at all), a deferred annuity will be appropriate. Most deferred annuities allow for deposits up front and additional deposits up until the contract is annuitized.
Though the ‘deferred’ in the title refers to deferring income, any interest or growth in value will have taxes deferred until they are withdrawn. The annuity contract is the shell or framework of terms for the account. There is a separate account that will house the investments within the contract. This distinction outlines the need for more than one decision when it comes to the type of annuity.
Determine Your Risk Level
The next choice for the annuity is the type of investment that suits the portfolio and strategy. A fixed annuity is the most conservative option and will have investments in fixed income securities like bonds and certificates. Remember, the returns on ‘fixed’ income securities are not necessarily fixed. Rates of return still carry interest rate risk and inflation risk. Variable annuities are designed to have separate accounts for holding nearly any type of investment. Choices may include mutual funds, actively managed money accounts, and other types of securities. The annuity account value, or cash value, will reflect the performance of the underlying investments in the separate account.
The portfolio of investment options within the annuity should range from conservative to aggressive investment strategies. Keep in mind that certain riders or features may place restrictions on the investment portfolio. For example, if purchasing riders that guarantee growth, the insurance company may limit the portfolio selection to moderate risk levels. Indexed annuities are a version of variable contract which offer investments into market indices such as the S & P 500. These contracts have investments that are tied to or mirror the stocks within the chosen index. This may reduce investment expenses because there is no active management of the investments. Many index annuities have guarantees and protections built in to the contracts.
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Add Riders and Protections
Riders are add-on features that can be purchased with the annuity contract. In most cases riders must be added at the onset of the contract, though some riders may be added later. These features are designed to offer protection or guarantees against other risks when choosing and annuity. Riders will be paid for by an additional quarterly fee charged as a percentage of the contract value and added to the mortality and administrative expenses.
One example of such a rider is adding ‘guaranteed growth’ to the contract. This form of protection guards against poor market performance. This rider reduces the risk of having to take a lower income stream down the road. Another feature worth considering is ‘spousal protection’. This rider will provide the surviving spouse the option to maintain the income stream rather than get a lump sum death benefit. Not only will this provide peace of mind, but it will also protect against the risk of having a large scale taxable event upon the passing of the primary annuitant.
How Much to Invest?
Careful planning can help determine the appropriate amount to deposit into an annuity contract. Except for special cases, annuities should be considered as a component of a portfolio. Because of restrictions on access and regulations most professionals agree that a maximum of 25-50% of assets should be committed to an annuity contract. Directing a portion of assets into an annuity can provide a reliable supplement to other fixed income sources for retirement.
By taking advantage of riders like the ones mentioned above, planners can calculate an exact amount to guarantee a specified income stream to begin at a set time in the future. Another scenario may include the need to add downside protection to a portion of retirement savings. By adding some guarantees and such protection on half of a family’s retirement assets, the other half could be invested with a more aggressive strategy for example.
After the Purchase
Once a family or individual has an annuity contract, annual reviews will play an important role in keeping investment strategy and income in line with life changes. The investments and riders should undergo regular evaluation as risk tolerance, account value, and family situations change over time. Though the plan is to keep an annuity for life, under some circumstances a contract can be exchanged for another type of contract without creating a taxable event. If a contract is outdated and lacks the investment options or features needed, such an exchange may be appropriate.
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