If you want a steady stream of income in retirement – and who doesn’t? – you may decide to invest in an annuity, a financial contract between you and an insurance company that’s designed to grow the money you invest. How do you choose the right one? That’s where an annuity provider comes in – to dispense information, provide advice and help you select the best annuity for your specific needs.
Choosing the right provider calls for advance homework on your part about what annuities are, who issues them, how much they cost (fees) and a number of other factors. Here’s a guide to get you started.
How Annuities Work
These investments, which are issued only by insurance companies, have three phases: accumulation, annuitization and payout. Here is more on each one.
1. Accumulation phase Through the annuity contract, you invest funds – all at once or over time. The period from the start of your regular investments (or lump sum deposit) until you begin withdrawing funds is the accumulation phase, the period during which your investment grows.
2. Annuitization phase This is the point at which the insurance company must begin making payments to you. It coincides with the distribution or payout of your accumulated invested funds and earnings.
3. Payout phase The length of time for this phase can vary, depending on a number of factors.
It’s important to note that your annuity will continue to grow even after the annuitization phase kicks in.
Pluses and Minuses
Like any investment, annuities come with advantages and disadvantages. The degree to which these factors weigh on your personal financial situation should determine whether or not you choose to purchase one. (Of course, the role of an annuity provider includes helping you understand and maximize the benefits while minimizing the effects of the disadvantages.)
Advantages
• Investments grow tax deferred until they are withdrawn
• There’s no annual contribution limit
• A guaranteed lifetime payout option is available
• They’re exempt from probate and usually exempt from creditors
Disadvantages
• High fees
• They’re illiquid
• Complexity
• Withdrawals are taxed as ordinary income
For more on the pluses and minuses surrounding annuities see Introduction to Annuities: Advantages and Disadvantages
Types of Annuities
There are two basic types of annuities, immediate and deferred. An immediate annuity is purchased with a single lump sum payment and begins the payout phase almost immediately.
The more common annuity, especially for those saving for retirement, is paid for either over time or with a lump sum, with payout deferred until later – usually retirement age.
Although there are many variations available when it comes to payout, within the two main categories, annuities are classified as fixed or variable. With a fixed payout, you get a certain amount of income for a specified period of time – usually life. A variable payout can fluctuate with market conditions and the performance of your annuity investment.
For more on types of annuities see Introduction to Annuities: Basics of Annuities.
While hundreds of insurance companies issue annuities, the top 25 issue the lion’s share – about 90%. These companies include Jackson National Life, AIG and Lincoln Financial Group.
Annuity Providers
These are the entities that sell annuities (as opposed to those that issue the contracts). There are several types of annuity providers available to you as an investor.
Insurance companies While they normally issue annuity contracts, insurers can also be annuity providers. Some insurance companies sell annuities direct to consumers without an intermediary or agent. More often, however, insurance companies sell through their own network of licensed agents or through other providers.
It pays to check on the stability of the insurance company, even if it is not the provider. After all, if the insurer behind the annuity fails, no matter who the provider is, you could be out of luck when it comes time for the payout. (See Issuer Stability, below.)
Broker-dealers Large brokerage firms, also known as wire houses, such as Merrill Lynch and Morgan Stanley, are one class of annuity providers. Independent broker-dealers like Raymond James and LPL also sell annuities.
Banks While big banks like Bank of America and Wachovia sell annuities, a growing trend has been for local banks – not just the largest ones – to offer annuities along with a variety of other insurance products. Keep in mind that an annuity purchased through a bank, unlike CDs and other types of bank deposits, is not insured by the Federal Deposit Insurance Corporation (FDIC).
Mutual fund companies Vanguard, T. Rowe Price and other mutual fund companies have a variety of annuity product options. They may offer direct-sold annuities that do not charge a sales commission or surrender charge, which sometimes makes these annuity providers attractive.
Annuity brokers These brokers are independent financial advisors who sell annuities. They do not work for an insurance company. In theory, at least, the advice you receive from an independent annuity broker should be unbiased.
Choosing a Provider
Answers to questions about the following topics can help you evaluate and choose a provider for your annuity contract:
Payout This is your ultimate goal – a monthly, quarterly or annual income stream. Find out what this amount is, based on the various payout options available to you. For more see Selecting the Payout on Your Annuity.
Fees and penalties Fees represent the cost of managing your investment and receiving those payouts. Penalties represent the cost of deviating from the strict terms of your annuity contract. Fees and penalties are not always clearly spelled out, but a competent provider will apprise you of possible fees and penalties and how they might affect your investment.
Ask about the following fees: the commission (paid to the agent who sells you the annuity), underwriting fees paid to whoever calculates actuarial risk on the benefits of the annuity, management fees for managing your investments (including mutual fund fees if your annuity invests in mutual funds and even margin fees that are taken out of earnings by the insurance company).
Penalties include surrender fees if you exit from your annuity before a certain time. In addition, if you withdraw funds early (before age 59½), you may be subject to a 10% income tax penalty.
Altogether, according to Barron’s, investors can expect to pay around 3.5% in management and investment fees and as much as 7% in surrender fees if they back out of a contract early.
Benefits These include a guaranteed lifetime withdrawal benefit (GLWB), which promises an income stream for the rest of your life; death benefit, which guarantees your beneficiary (or heirs) a specified amount upon your death; and access to funds, which allows you to withdraw money without penalty in the event, for example, of a terminal illness. Learn which of these benefits are available to you and, more important, how much each costs.
If you are relatively young when you purchase your annuity, you may also want to check on the cost of inflation protection. It could be worth it if there are many years before you annuitize.
Issuer Stability While considering the choice of a provider, don’t forget the issuer (insurance company). Check the insurer’s COMDEX score, which reflects the compilation of various ratings, providing a comprehensive evaluation of the company (see Choosing the Best Life Insurance Company for You). The closer to 100 the COMDEX score is, the safer the insurer. Other places to check include individual ratings companies like A.M. Best or Moody’s.
State Guarantee Fund
States (not the federal government) regulate annuities, and each state has a guarantee fund that protects policy holders should an insurer default on payments or go under. You can find out the dollar amount of that guarantee for your state at www.nolhga.com. One tactic some investors use is to stay within their state’s guarantee but buy multiple annuities from different carriers.
When (and Whether) to Buy
Traditionally, annuities have been considered more appropriate for wealthy individuals who want to shelter large sums of money and who have a variety of other investments.
This doesn’t mean younger people should never buy an annuity, but if you are young, have short-term financial goals and not a lot of liquidity, an annuity probably doesn’t make much sense.
In addition, most experts recommend that you maximize contributions to 401(k) accounts and IRAs before considering an annuity.
The Bottom Line
Choosing an annuity provider also involves evaluating the annuity issuer, or insurance company. This is an important point and something to take into account even if the provider is not also an issuer.
Beyond that, providers should be able to answer your questions about payouts, fees, benefits and other factors. Once you have those answers, comparing providers should be an easy task.
