Annuity For Dummies

Last Updated on April 7, 2023 by George

Bonds and Treasury bills are popular because retirement investors are frequently interested in finding secure, blue-chip investments that provide guaranteed returns. On the other hand, Annuities are a less well-known class of fixed-income instruments that can give even better returns with similarly little risk.

Investing in annuities has grown in popularity over the past few years among risk-averse individuals. These assets are written contracts that ensure the delivery of fixed payments over a lengthy period, not securities. These payments often continue until the annuitant’s demise.

A lifelong stream of guaranteed income is undoubtedly intriguing. However, before investing in this asset class, you should know the dangers and drawbacks of annuities. We’ve gathered all the required knowledge if you’re considering investing with annuities but have no prior experience in this “annuities for dummies” guide.

An annuity is a contract in financial investing between an insurance company (or reseller) and an investor (the “annuitant”) that ensures the payment of a specific amount of money at predetermined intervals for a specific or arbitrary amount of time. Because they entail a lump-sum payment to an insurance firm in exchange for fixed payments, typically until the annuitant’s death, annuities might be regarded as “reverse life insurance policies.”

For people without fixed pensions, annuities can help with retirement expenses and offer vital financial security. For many seniors, the concern of outliving their retirement resources is well-founded. This is why annuities are advantageous since they give people who are concerned about their financial security in later life comfort.

Due to their set, low-risk structure, annuities are becoming a more well-liked financial product. Global sales of delayed annuities exceeded $58.1 billion in the first quarter of 2021, 28% more than the year before. Nevertheless, because annuities are frequently eclipsed by more well-known fixed-income assets, like bonds, many retirement investors need to be made aware of the investment possibilities of annuities.

Variable vs. Fixed Annuities

Basic annuities come in two primary categories: fixed and variable. Variable annuities fluctuate following the performance of an underlying mutual fund, index fund, or investment portfolio, unlike fixed annuities, which provide guaranteed payments that never change.

The following table outlines some critical distinctions between variable and fixed annuities.

In general, variable annuities should be considered by those ready to assume a little bit more risk. This is due to the possibility that the underlying assets perform well and they could produce higher returns. However, fixed annuities provide more security and guarantee that the annuity bearer will receive payments regularly.

Benefits of Annuity Investing

Annuity investments include a wide range of advantages. No matter where you are in your investing career, we’ve outlined some of the critical benefits of annuity investing for your portfolio below.
Financial security: is the main advantage of annuities since it assures you that your payments will be consistent and guaranteed. For people without pensions or other sources of retirement income, annuities offer vital economic security.

  • Tax advantages: Tax-deferred contributions can be made to annuities; you will only have to pay taxes on your investment once you begin getting payments. The annuity may increase in value before you begin receiving payments without triggering a tax event.
  • Guaranteed Returns: Unlike most other investment forms, annuity investing offers guaranteed rates of return, which can give investors with extremely volatile portfolios much-needed security.
  • Death Benefits: The insurance company frequently includes a guaranteed death benefit payable to a beneficiary in the event of your early death when you invest in variable annuities. By doing this, you can invest with confidence, knowing that your loved ones will have financial security in the event of your death.
  • No Contribution Restrictions: Unlike IRAs and 401(k) accounts, annuities do not have contribution restrictions, allowing you to keep growing your annuity indefinitely.
  • No Required Withdrawals: Are you considering a delayed retirement? Not to worry. Unlike an IRA or a 401(k), annuities do not mandate that you begin taking minimum withdrawals at 72.

Although they have many similarities, the advantages and disadvantages of annuities for fixed and variable assets differ. The table in the section above shows a list of the main distinctions between these two annuity types.

What are The Risks of Annuity Investing?

A fixed annuity is not an actual “investment” in the same sense as a security, bond, cryptocurrency, or tangible good. This is due to the annuity’s lack of (or, at the very least, minimal) payout variability over time. In other words, there is no risk to your money.

Annuitants are fully aware of the amount and schedule of their payments under the contract. As a result, there is no real doubt about how the contract will be fulfilled. The annuitant’s expected life expectancy is the only unknown. The annuitant who purchases at age 50 and lives to be 100 will receive a more significant “return” than those who purchase at age 50 and live to be 80.

The risk of passing away too soon is a myth, as some people think that passing away before recovering the value of their lump sum investment constitutes “losing” the agreement. Nevertheless, one shouldn’t obsess over how their portfolio does after passing away.

The annuitant still “wins” their side of the bargain, even in the event of an early demise, as they continue to enjoy the lifelong financial security they sought. Because it paid less than it received from the annuitant, the insurance company is the only other party who benefits.

Retirement Plans and Counterparty Risk

The only real risk that annuities take on is counterparty risk. Annuities, like almost all paper-based financial instruments, are dependent on the counterparty (such as the insurance company) keeping up their half of the bargain. The annuitant’s payments may be stopped if the annuity vendor declares bankruptcy for whatever reason and is unable to keep their promise under the

Investors can reduce their counterparty risk by selecting a reliable annuity provider with a solid track record. In addition, you should have an annuity contract reviewed by a knowledgeable financial expert or attorney to ensure a state regulator supports the counterparty.

What are Secondary Market Annuities?

In structured settlements known as secondary market annuities (SMAs), the annuitant sells their collecting rights to a second buyer. Put another way. It is similar to a standard annuity contract but with a middleman.

The annuity is lawfully transferred from the original owner to the annuity buyer by factoring companies. After that, no further payments will be made to the original annuitant or settlement claimant; all payments will be made to the investor.

Secondary market annuities aren’t annuities, technically speaking. Instead, they are invariably repackaged tort settlements (i.e., lawsuit settlements) or lottery winners offered for sale in a lump sum or a structured manner according to a state court’s legally correct decision.

Secondary market annuities are frequently paid to the annuity buyer in a lump amount at a discount. In essence, SMAs buy a guaranteed long-term payment structure and sell it for a smaller lump sum. SMAs are aftermarket financial products rather than investments or annuities. Thus correctly speaking, they are neither.

Read our comprehensive guide on secondary market annuities for more details on buying or investing in SMAs.

What are Equity Indexed Annuities?

The performance of an equity index, such as the Dow Jones Industrial Average (DJIA) or the S&P 500, is tied to some forms of fixed annuities. Equity-indexed annuities are frequently chosen by investors who are willing to assume some risk in their annuity investment plan since they have the potential to produce higher returns.

Let’s use the example of an annuity invested in the S&P 500 to demonstrate how an indexed annuity might function. During FY2020, the S&P 500 returned a total of 18.4%. So, a portion of those gains would be realized by the annuitant. However, a factor known as the participation rate determines how much the annuitant will receive in benefits.

Explaining Indexed Annuity Participation Rates

The percentage by which the insurance will increase the underlying index’s gains, which are later applied to the annuity, is the participation rate.

Consequently, a typical 80% participation percentage for an index annuity would credit 14.72% (18.4*.8) to the annuitant’s contract. This is based on the baseline 2020 S&P 500 return of 18.4%. The indexed annuity in this scenario would produce an excellent yield (14.72%), but it also carried the risk of equally significant losses in the event of a bad year.

Equity Indexed Annuities’ Drawbacks

Equity-indexed annuities have a clear disadvantage over traditional fixed annuities in that the former can experience losses. Your annuity payments will be less than their base amount if the underlying index (such as the DJIA, Nasdaq Composite, or S&P 500) loses value.

In essence, indexed annuities include higher levels of risk than other annuity options. Investors that seek fixed annuities rather than variable or indexed annuities as a “safe” asset with a guaranteed return would be wise to do so.

  • Before beginning to invest in indexed annuities, potential investors should be informed of several other significant drawbacks, such as:Capped Earnings: Since the contract’s terms may limit upside gains, they may not accurately reflect the index’s performance.
  • Surrender Fees: Premature withdrawals of annuity payments are subject to additional fees.
  • Cost opacity: Some insurers have a cost structure that is not disclosed, and they have the authority to add extra, unforeseen fees to every payment.
  • Sales Commissions: Buyers of indexed annuities frequently pay the seller high commissions in the region of 5–8%.

When considered collectively, these disadvantages of investing in indexed annuities should allow everyone to do so. Purchasing indexed annuities still offers significant advantages, and they stand out from other annuities by having the potential for significant value growth.

Examples of Top Annuity Investments

You can invest in annuity products with the assistance of several reliable annuity businesses. There are specialized insurance providers that you can deal with directly, but your typical brokerage accounts provider, like Fidelity or Vanguard, could manage annuity transactions as well.

Below, we’ve listed some of the most reputable and well-known annuity suppliers in the US.

  • Specializes in annuities for 401(k), 403(b), and 457 Plans, AIG Annuities.
  • Variable annuities are the focus of John Hancock Annuities.
  • Specializes in fee-based variable retirement annuities, Jackson Annuities.
  • Specializes in commission-free “safe growth” annuities under the name DCF Annuities.

Annuity investors can choose from various subaccount options from the companies on the above list. For its variable annuity programs, Jackson National Life Insurance, for instance, now offers 110 managed investment options. As a result, investors are free to select the funds that will support their variable annuity.

Should You Hold Annuities Within an IRA?

Investors and advisors are frequently still deciding about retaining annuities separately or within a tax-advantaged retirement account.

Adding an annuity to your self-directed IRA or employer-sponsored 401(k) could be tempting so that you can benefit from tax-free or tax-deferred growth. However, there are situations when we do not advise using an IRA to purchase annuities.

This is because all annuities grow tax-deferred, negating the need to use up valuable contribution space on annuity assets that are already tax-sheltered. That is if you are mainly investing in annuities for tax benefits. There are, however, several additional significant advantages of annuity investing, as we have already covered.

When to Buy Annuities Inside of an IRA

However, there are circumstances where investing in annuities through an IRA may be advantageous. For instance, those near to retiring (within 5 years) may profit from having their annuity contract’s “guaranteed living benefit” protected within an IRA.

Most contemporary annuities have a guaranteed living benefit rider that ensures a return-of-premium can be used while the annuity owner is still alive. These horsemen carry out two tasks. First, they make sure that the annuitant has access to income security while they are still alive. Second, they don’t call for initial annuitizing.

These annuities revolutionized investing when they first appeared in the late 1990s and early 2000s, and
early 2000s. Previously only investors searching for tax deferral advantages would purchase annuities, but today they are frequently employed as a retirement income security.

With the introduction of guaranteed living benefits, purchasing annuities through an IRA quickly gained popularity. You must invest IRA funds in an annuity if you want guaranteed income. Since non-IRA annuities do not provide the same income security, investing IRA funds in an annuity provides assured lifetime income security on a tax-deferred basis.

Myth: “Don’t Purchase an Annuity in an IRA”

If someone advises you that you should never invest in an annuity through an IRA, they are giving you out-of-date advice. This was typically true before the 1990s in that most annuity contracts did not yet include guaranteed living benefits. However, these days, IRAs fund almost 60% of annuities.

The chart below (Fig. 1) shows how much funding is from IRAs for both fixed-rate and variable annuities. By 2012, IRAs supported the bulk of indexed and variable annuities and accounted for 39% of fixed-rate retail annuity sales.

The era of annuities without IRA funding is passed. Annuities are becoming increasingly popular among investors who prefer income security benefits over tax benefits.

It is still reasonable and proper to invest in annuities through an IRA if you want to take advantage of the guaranteed living benefit—which is what most annuity investors are—even though the tax benefits of IRAs and annuities are redundant.

What is An Annuity Exclusion Ratio?

The percentage of an annuity payment excluded from one’s taxable income is known as an exclusion ratio in the context of annuity investing. In other words, it shows the portion of your annuity subject to taxation.

One’s premium is divided by their predicted return to determine the exclusion ratio.

Let’s use an example where someone buys a $200,000 annuity before retiring. The insurance company determines you have 25 years to live and agrees to a $775 monthly payout. Additionally, they predict that it will take that long for your $200k investment to increase to $275k.

In this scenario, your $200K principal would be paid over 25 years at a rate of $667 per month. Thanks to your annuity, you are entitled to $775 a month. Because the first $667 of your annuity payment is merely a return of your initial principle, the IRS does not see it as taxable income, and only the $107 left over is taxed.

By dividing one’s principal by the predicted return (for example, $200K divided by $775*300 months), we would get an exclusion ratio of roughly 86% in the example above. In other words, taxes are not applied to 86% of annuity payments.

Investors should be aware that exclusion ratios do not apply to annuities funded by IRAs, 401(k)s, or any other type of retirement plan. Instead, these payments are entirely taxable.

Don’t Outlive Your Money: 1 Rule for Lifelong Financial Security

It’s crucial to consider your motivations before making an annuity investment. If you’re like most investors, your motivation is undoubtedly the security that comes with knowing that you’ll get a fixed income throughout retirement. However, if you take better care of your retirement assets, you can eliminate the need to invest in annuities.

Many investors are concerned about outliving their retirement funds. For example, if someone only saved for a 30-year retirement and lived another 10 years beyond that, it would be very stressful and challenging for them in their final ten years.

Fortunately, there is a straightforward spending guideline called the “4% Rule” that you can adhere to prevent overspending during retirement.

The Secret to a Secure Retirement: The 4% Rule

The 4% rule (sometimes known as the “four percent rule”) is a guideline for retirement spending developed using the findings of the Trinity Study, a significant study published in 1998.

In other words, the study demonstrated that an investor could remove 4% of their well-diversified retirement account each year, or 4% of the portfolio’s initial value, without ever running out of money.

Some investors question whether the conclusions of the Trinity Study still hold, given that it was published more than 20 years ago. Fortunately, RBC Royal Bank conducted a follow-up investigation to determine whether the study’s findings apply today.

According to the study, the 4% rule was adequate for a 40-year retirement in a 75% stock portfolio 92% of the time.

Check out our comprehensive guide to the 4% rule of retirement withdrawals for additional details on this crucial spending guideline.

Final Thought- Annuity For Dummies

The first question that is frequently asked when the subject of investing in annuities comes up is, “Are annuities safe? ” In a nutshell, the answer is “yes.” Annuity investing is a risk-free method of ensuring a steady income after retirement.

Annuities, however, are not all made equal. For instance, variable and equity-indexed annuities are intrinsically riskier compared to fixed-income annuities. If the underlying funds perform well, the possibility for more significant gains will offset the risk.

Fixed-income annuities may be a good option for risk-averse investors, while variable or indexed annuities may be a better choice for riskier investors. Individuals ready to take on more risk may be rewarded with more significant profits, but they forfeit the fixed annuity contracts’ guaranteed income security.

Scroll to Top