Annuities

A financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. Annuities are primarily used as a means of securing a steady cash flow for an individual during their retirement years. The most attractive feature to most folks about an annuity is tax-deferred growth. And, indeed, as long as the money remains inside the annuity, the government won't tax any of the earnings. But all good things must come to an end, and sooner or later a tax-deferred annuity is going to get taxed. Let's take a look, then, at how and when that happens.

A deferred annuity has two phases, the accumulation phase and the distribution phase. During the accumulation phase, the annuity grows untaxed through the years as the investment compounds. In the distribution phase, the annuity is paid out. The payment may be made as one lump sum or as a series of scheduled payouts over a specific period or a lifetime. In insurance-speak, a series of scheduled payments is called "annuitization," and the recipient is called the "annuitant."

Types of Annuities
1) Fixed vs. variable annuities With a fixed annuity, your payment amount remains the same each month. Some think of this as creating your own "pension plan" in these days when fewer and fewer companies provide a "traditional" pension.

With a variable annuity, the amount you collect each month depends on how the stocks, bonds, or other investments in the underlying portfolio do. It can go up, but be careful: It can also go down.

2) Annuities indexed to inflation If you buy an inflation-indexed annuity, the true value of your monthly payments is less likely to shrink because of the erosion power of inflation. But this protection isn't free: your initial payments under the annuity will be lower, in anticipation of higher inflation-indexed payments years from now.

3) Annuities indexed to stock market performance Known as "equity-indexed annuities," these claim to shield you the investor from stock market losses by going up when share prices rise but not dropping when they fall.

If this sounds like a foolproof deal, many investors agree. The Wall Street Journal reports that, in 2004, sales of equity-indexed annuities rose 67%, to $23.4 billion. But to get a handle on your true yield, you must know whether the annuity calculates gains on a "point to point" basis or an "annual reset with monthly averaging" basis.

4) Immediate vs. deferred annuities An immediate annuity starts paying as soon as you buy it (or transfer funds into it.) A deferred annuity, by contrast, includes an "accumulation period" during which you pay premiums before your payments begin. Which you choose will depend on both your age and your financial health when taking out the annuity.


Which to Choose, If Any
Whether any of these products is right for you depends on several factors: your age at retirement, whether or not you'll continue to work, your other sources of income and the cost of your lifestyle. But before plunking down any hard-earned dollars, a few warnings are in order:

• Many people see annuities as solid, unchanging vehicles which deliver a certain amount of cash per month. Not always true. For example, an equity-indexed annuity might limit the amount of money you lose, but it also limits the amount of money you gain by measures such as restricting investors from participating in stock dividend payments. And watch for your company's reserving the right to change the formula for that "guaranteed return," based on variables like a longer-than-normal life expectancy.

• American consumers/investors have relied on the Securities and Exchange Commission (SEC) to protect their investments since just after the Great Depression. Many continue to believe that most investments are regulated by the federal government. Not necessarily so with annuities. For example, equity-indexed annuities are considered "insurance products" rather than securities, and regulated by each state's insurance regulator. Not exactly across-the-board protection.

• Annuities may be long-lived, but there's one things they're not: easy cash. Withdrawing from an annuity contract, should you need the money, can be painful. If you take your money out during the "accumulation period" (typically 6-10 years,) you can be charged a surrender fee (typically 7-20%.) One other caveat: tap your funds before age 59 1/2, and you'll owe the IRS a 10% penalty. So keep a couple of eggs outside this basket.

• Monthly payments for women are usually less than those for men, simply because women tend to outlive men. Keep this in mind when planning your retirement budget.

Taxes on Annuitizing
If you annuitize, part of each payment is considered as a return of previously taxed principal (i.e., your investment) and part as earnings. (Think of it as the reverse of paying a mortgage, where part is principal and part is an interest payment.) You will owe income taxes on the part of the payment that's considered earnings. The amount of each payment that won't be taxed is computed by establishing an "exclusion ratio" that's determined by dividing your investment in the contract by the total amount you expect to a receive during the payout period.

The interested reader should see IRS Publication 939, General Rule for Pensions and Annuities, for the details on how to calculate taxes due on annuity payments. As an illustration, assume you have a fixed annuity in which you've invested $100,000 that will pay you a sum of $750 per month for life starting at age 62. According to IRS life expectancy tables, you will receive those payments for 22.5 years, so your contract's value is $202,500 (12 X $750 X 22.5). Your exclusion ratio is 49.4% ($100,000/$202,500). Therefore, out of the $9,000 the annuity pays each year, you may exclude $4,446 from income. The remaining $4,554 of that payment will be subject to ordinary income taxes.



what to watch out for
Fees, Fees and More Fees
Variable annuities are notorious for the fees they charge. Indeed, the average annual expense on variable annuity subaccounts currently stands at 2.08% of assets, according to Morningstar. (This figure includes fund expenses plus insurance expenses.) The average mutual fund, on the other hand, charges just 1.38%. Unfortunately, variable annuity fees don't stop there. Many variable annuities also have loads on their subaccounts, surrender charges for selling within, say, seven years and an annual contract charge of about $37.

What Death Benefit?
The death benefit basically guarantees that your account will hold a certain value should you die before the annuity payments begin. With basic accounts, this typically means that your beneficiary will at least receive the total amount invested — even if the account has lost money. For an added fee, this figure can be periodically "stepped-up" or earn a small amount of interest. (If you opt not to annuitize, then the death benefit typically expires at a certain age, often around 75 years old.) Well, given the fact that stocks have returned an average of 12% annually (assuming dividends are reinvested) from 1926 to 2004, according to the Center for Research in Security Prices, over the long haul you need this insurance about as much as a duck needs a paddle to swim.

OK, investors who bought annuities and then died within the next two months probably got their money's worth. But currently only three out of every 1,000 variable annuities are surrendered due to death or disabilities, according to Limra International, an insurance-industry research group. And this report doesn't even measure whether those four accounts were made whole by the death benefit!

The price of this questionable feature: an annual 1.03%, according to Morningstar.

http://www.smartmoney.com/retirement/investing/index.cfm?story=wrongannuities

http://www.investopedia.com/terms/a/annuity.asp

http://www.sec.gov/answers/annuity.htm

http://www.consumeraffairs.com/news04/2006/03/annuities_fools_gold.html