If you are not familiar with Fixed Annuities and Variable Annuities but are considering investing in annuities to accumulate wealth for retirement, we’ve got you covered.

An annuity is an agreement (contract) between an individual and an insurance company. The individual promises to pay the insurer a specified amount of money, either in a lump sum or over time. The money is invested by the insurance company in various places so that when the individual decides to retire, he or she will start receiving regular payments from the insurance company. These payments will continue for the rest of the individual’s life.

Simply put, this is how annuities work. For most consumers, annuities have a history of being complicated and difficult financial tools. As the preceding description indicates, annuities are structured on standard, fundamental principles. Certainly, it is not mandatory to be a financial professional in order to understand these principles. You simply need to be informed.

What is a Fixed Annuity?

People who own fixed-annuity contracts consent to make scheduled payments to the insurance company for a specified period. The insurance company will accumulate the payments, which is the reason this period of time is known as the accumulation period of the contract. The insurance company then credits the holder with interest, at a predetermined rate specified in the annuity contract. This is what the “fixed” component of “fixed annuity” relates to.

The company must calculate the benefits it will have to pay the annuitant in the future and the funds it has available to invest in order to fund those payments. Taking withdrawals of funds will worsen the accuracy and reliability of its estimates, so the insurer needs to charge penalties for the annuity holder to withdraw their money early. These penalties are known as surrender charges.

The insurer will penalize a withdrawal by charging the account holder a percentage of the money taken. The term of the surrender charges varies by insurance company and by each contract, ranging typically from 4-15 years. The percentage of the penalty may be close to 10 percent in the first year, and then decrease significantly in the following years.

Exceptions to the Penalty Rules – The annuity holder nevertheless has an opportunity for taking funds out of the account without a penalty. Annuity contracts permit as much as 10% of the principal value of the account to be removed penalty-free, and in some cases, the annual interest that has been credited to the account can be withdrawn without being subject to a penalty as well.

What Annuities are Used For

The basic strategy behind annuities is to schedule the accumulation period to conclude around the time your retirement will begin. At this stage, when earned employment income stops coming in, it is time to discontinue saving and accumulating funds and to begin disbursing the funds that you’ve accumulated. Needless to say, this is called the distribution phase.

The conventional plan is to dispense it in the form of regular, payments that will last for the remainder of your life. The account holder can also schedule to have the distributions paid to a surviving spouse for the rest of their life. Annuities that have an accumulation period and a distribution period are called deferred annuities because the compensation stream is deferred until the sum of money that is necessary to maintain it has been accumulated.

Who Should Consider Fixed Annuities?

Fixed annuities are considered conservative investments, similar to government bonds. They are appropriate for older individuals who are near or recently reached retirement.  They are not considered appropriate for young individuals because the surrender charges render them relatively illiquid, and the conservative rate of return renders them unsuitable for a growth-focused retirement portfolio.

What is a Variable Annuity?

Variable annuities broaden on the concept of the variability of investment return. The account holder assumes complete responsibility for guiding the performance of the annuity’s accumulation account. The insurer provides the account holder with a selection of investment solutions that range from money market funds to bond funds to funds that are basically the same thing as mutual funds but are referred to as “sub-accounts.”

The reason for giving the account holder more responsibility and more options is to allow them to have the ability to earn even higher investment returns than returns associated with fixed and indexed annuities.

This will make it feasible to experience higher annuity payments in their retirement. Investments in bond funds and stock mutual funds typically fluctuate in value, and therefore so will the accumulation account of the variable annuity. Variable annuity holders are provided the chance to earn a bigger return but in return must tolerate more risk.

Who Should Consider a Variable Annuity?

Variable annuities can accumulate on a tax-deferred basis because they are considered life insurance products. In fact, one of the features of a variable annuity is the choice to identify a beneficiary for the death benefit that would equal the value of contributions made to the annuity account minus withdrawals taken before the account holder’s death.

On the flip side of this variable annuities come with the same management-related expenses as mutual funds, plus there are insurance-related expenses. These rather high expenses indicate that other options to get tax deferral, such as contributions to qualified plans, ought to be used up before choosing a variable annuity. These high expenses, plus the increasing level of risk and the lack of liquidity due to surrender charges, make variable annuities inappropriate for elderly investors.

The Bottom Line

Annuity contracts can be confusing because each type is built for a different purpose. Suffice it to say; annuities are complicated. Because of this, consumers who are looking for an appropriate investment solution should consider where they are in life according to their age, their individual risk tolerance, and the specific goals they wish to achieve before committing to a long-term investment.

The annuity experts at Structured Wealth Strategies are available to answer questions and address any concerns you may have. You can call us at 800-595-1130 or book a phone appointment to discuss your circumstances and budget.

Frequently Asked Questions

Can I lose money in a fixed or variable annuity?

It depends on the type of annuity. With a fixed annuity, your principal is generally protected and you will not lose money as long as you hold the annuity until the end of the term. With a variable annuity, however, you can lose money if the underlying investments perform poorly. It is important to understand the risks involved with any investment and consult with a financial advisor before investing in an annuity.

Are there any tax advantages to investing in an annuity?

Yes, there are several tax advantages to investing in an annuity. The earnings on an annuity are tax-deferred until you withdraw the money, which can help you save money on taxes over time. Additionally, some annuities offer tax-free withdrawals for certain expenses, such as long-term care expenses.

How do fixed and variable annuities differ in terms of risk?

Fixed annuities are generally considered to be less risky than variable annuities because the rate of return is guaranteed. With a variable annuity, the returns can fluctuate depending on market conditions, which can result in higher risk.

What is a deferred annuity?

A deferred annuity is a type of annuity that allows you to save money for retirement and receive a stream of income at a later date. With a deferred annuity, you make payments to the annuity over a period of time and the money grows tax-deferred until you start receiving payments. The income payments typically begin at a predetermined date in the future, such as when you reach retirement age. This type of annuity can be either fixed or variable, and may offer different features and benefits depending on the insurance company and the specific annuity product.

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Curt Gibbs