What are Annuities?￼
Guaranteed income streams are becoming more attractive as crushed dreams and investments become the retirement nightmare for most people. With some annuities, you can get this guarantee. Annuities come in different types. You need to be educated before you commit your money. So here is a guide. Annuity can be defined as a contract between an insurance company and a consumer (you) to cover certain goals. The goals could be long-term care expenses, legacy planning, lifetime income, or principal protection.
An annuity is not an investment, even though some insurers market it as such. It is a contract. Breaking the contract is almost impossible. Why an Annuity? Many people buy annuities to get a guaranteed source of income. That is why they are popular in retirement planning. There is no contribution limit and you can save as much as you want.
In simple terms, an annuity transfers risk to the insurer from the owner (annuitant). You then pay the company premiums. These premiums can either be paid in a series of installments or a single lump sum. The payments are not indefinite. After some time, you stop paying and get paid instead. All annuities are not the same.
Some pay you for as long as you live, and when you die at a defined time frame, your beneficiary will be paid the remainder. Annuities are divided into two categories: immediate and deferred. With an immediate annuity, the income begins almost immediately. It, however, will not come right away. After you pay the lump sum, you start receiving income after one annuity period. It could be a year or one month. A deferred annuity offers a lifetime income and tax-advantaged saving.
The payments begin years later. The series of payments and minimum rate of return are fixed with this type of annuity, but under predetermined conditions. If you choose to withdraw your funds before the specified time, you may incur surrender charges. The charges usually reduce with time. The insurer invests your money in different sub accounts if you choose a variable annuity. The rate of return will depend on how these subaccounts perform. Just as with an IRA or 401(k), you pay taxes when you withdraw the money.
The tax depends on whether you funded the annuity with after-tax or pre-tax dollars. Variable annuities have annual fees, but most other types do not. All of them, however, have commissions. Contrary to how they are marketed, fixed indexed annuities are complicated, and they have limited protection and potential. Riders can enhance the long-term care provisions, legacy, or income—but at a cost.
They can either be living riders or death benefit riders. If you die earlier than expected, the insurance company will not keep your premiums. Annuity payments are guaranteed by the insurance company, not the government. So, the insurer’s financial strength matters. Annuities present an opportunity cost risk. That is why you need to annuitize gradually instead of paying your premium as a lump sum. People who do not expect to reach their life expectancy or run out of income do not require an annuity. Also investigate bonds.
Tracking bonds is not the most fun thing to do. It is about as interesting as watching a pot boil or paint dry. It is not as exciting as watching stocks—you have probably seen how investors get. But the lack of hype should not mislead you. Bonds and stocks both have their advantages and disadvantages. Bonds may be less exciting than stocks, but they would be great in your portfolio. Bonds, unlike stocks, are less risky and less volatile.
If you hold them to maturity, you may get consistent and stable returns. Bonds interest rates are higher than money market accounts, certificate of deposits, and bank savings interest rates. When stocks are falling, bonds tend to perform better. The key difference between bonds and stocks can be fitted into three words: debt versus equity. Bonds are a debt while stocks are equity ownership. Investing in debt is always safer compared to investing in equity. If the business is declared bankrupt, debtholders (creditors) are paid before shareholders.
Creditors are more likely to get their money while the shareholders may lose theirs altogether. Treasury Bonds (U.S Government bonds) are risk-free, whereas there is no such thing as a risk-free stock. Bonds may not yield high returns (just about 3% annual interest rate) but they are the best for capital preservation. It is important to note that bonds may be safer, but they are not 100% safe. Also, other bond types, such as junk bonds, are very risky. In the long run, stocks tend to outperform bonds, if history is anything to go by.
But at certain points, bonds perform better. Stocks can lose 10% or even more in a single year. If this happens, you will be lucky to have bonds in your portfolio to ease the blow. Another thing, people will need predictability and security sometimes. Think of retirees, for example. They may depend on the predictability of bond income. With only stocks in your portfolio, retiring into a bear market will be disappointing, to say the least. Better Than Saving with the Bank? Bonds typically have higher interest rates than a CD or savings account.
If you have some money that you will not use for a while (like a year), it is better to invest in bonds. Having money in the bank is not bad. But you will not get any returns. How Much Should You Invest in Bonds? You will not get a direct answer. However, there is an old rule that some investors use. Your allocation among cash, bonds and stocks should depend on your age. According to this rule, you should subtract your age from 100. The number you get is the percentage of your assets that should go into stocks, then spread the rest between cash and bonds. If you are 50, 50% should go to stocks and 50% to cash and bonds.