Income Through Annuities
Annuities are versatile investment vehicles with income-producing potential. There are three types of annuities, all of which have similar features but are much different investments. Additionally, there are four general methods for accessing the funds within an annuity. In any case, annuities are designed to provide income later in life or even for an entire life.
To begin, the three types of annuities should be examined and explained because the options for income are not the same with each. The annuity types are fixed, variable, and index. Each type of annuity exists to provide a different investment choice. As a result of the investments within each type, there are differences in the potential for providing income of the three.
Fixed annuities are the conservative choice of the three, holding investment options that offer fixed interest. Such an annuity will invest the funds into bonds, money markets, certificates, and possibly other securities that are not tied to the equity markets.
Though the fixed annuity investor is not exposed to market risk, there are other risks associated with ‘fixed rate’ investments. First, fixed annuities are like cash savings and CD’s in that they have interest rate risk. As interest rates change, the crediting rate for such accounts may change. The other clear risk is ‘inflation risk’ or the risk that money will not grow enough to keep up with rising costs. If long term inflation is 3.5% and you earn the same rate over time, your money is NOT really growing.
There are multiple choices for getting income (all are explained in detail later in this article) from a fixed annuity. Lump sum withdrawals can be taken, which in turn may fund a cash savings to finance the expenses for some period of time. The fixed annuity owner can also choose to have interest payments sent to them, leaving the principal investment untouched. The third choice for income is to annuitize the contract, providing regular income for a period of time or even over a lifetime.
Index annuities are a hybrid design of investment, many offering the better of a fixed rate offering or a percentage of the market gains during a year. Many investors like the balance of guaranteed growth and potential for bigger gains. The downsides to such an annuity are longer surrender periods and the limitation of partial participation in market gains. Index annuities mirror market indices, and the upside participation rate may be limited to 80% or less.
The choices for income from an indexed annuity are similar to those of a fixed annuity. Lump sum withdrawals are an option, though attention must be paid to surrender charges during the initial years. Additionally, the interest credited to the account can be withdrawn. Remember, this is not going to be a fixed income as it will most assuredly change from one year to the next. The contract can also be annuitized to provide regular income.
Variable annuities are contracts that allow for ultimate flexibility with investment choices. The owner can choose from nearly unlimited investment options; conservative portfolios, mutual funds, managed money, or even aggressive equity portfolios. The key differences when compared to index annuities are the full participation in the market and that the downside protection is not built into the contract (though such protection may be available through the purchase of riders).
Variable annuities do subject the owner to direct market risk. Another component that some consider a downside is the mortality and administrative expenses, which are higher when compared to direct funds or other similar investments outside annuity contracts. Keep in mind that the fees and expenses are charged in exchange for the option of annuitization, which insures income for life and is a risk for the insurance company offering the contract.
There are additional methods for producing income from a variable annuity contract. In addition to the lump sum withdrawals, interest-only payments, and annuitization – the added choice is lifetime payments without annuitizing. With lifetime income riders and limiting annual income to a percentage of the contract value, it is possible to get income for single or joint life without forfeiting the principal to annuitization.
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Lump Sum Withdrawals
This method of accessing the funds of an annuity contract is simply withdrawing a portion of the funds and moving them to a bank account for expenses. Withdrawals will likely include any interest earned since the previous withdrawal, meaning that the deferred taxes will also be recognized immediately.
There are two concerns with this type of income from the annuity. First, this is not steady income and doesn’t maximize the earning potential and deferral of the annuity contract. Second, this activity will diminish the account principal and can potentially exhaust the account before the end of life.
Interest Only Payments
This type of income stream has the insurance company sending the annuity owner checks for only the interest earned in the account. This works with fixed accounts, not variable accounts, although the checks may vary in amount over time. Remember, once the fixed rate period is over the crediting rate for the annuity can change.
Risks with this type of payments are that income may change when interest rates fluctuate or due to other circumstances. Another less obvious risk is the inflation risk. For example, $2000 per month might get you by now but what about ten years down the road… twenty years down the road?
Payments Through Annuitization
This method of generating income requires the surrender of the principal account value in exchange for payments over a period of time or life. There are payouts that include payments to beneficiaries or preserve a legacy. The lifetime payments available through annuitization can be compared to pensions or social security – savings accumulate to a point in time where a lifetime income stream is triggered.
Though lifetime income protects against certain risks, there are other risks associated with annuitizing an annuity contract. The most prevalent is again the inflation risk, meaning that the income stream may not provide enough money in the future because costs will rise. Another risk is mortality risk, which is evident in the case where the annuitant perishes before the breakeven point where payouts equal deposits.
Hybrid Payouts with Variable Contracts
There is a relatively new choice for lifetime income without annuitizing. Some variable contracts offer a rider or feature that will pay income as a percentage of the account value. By purchasing other riders it is even possible to get downside protection, meaning the income stream can go up but not down. This is an excellent option to consider because it has the potential to create a rising income stream and to protect against the surrender of principal.
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