As mentioned in Part One of this article, while annuities have been around for over a century, there is nevertheless a ton of misinformation about them.
In Part One, we explained Annuity Misconceptions #1 – #5. In Part Two, we will explain Misconceptions #6 – #10.
Misconception #6: The different types of annuities are confusing.
Don’t let all the different types of annuities confuse you. They basically come in four flavors:
Fixed Interest Rate Annuity is a contract whereby you give your money to an insurance company and are guaranteed a fixed, set rate of interest for one or more years. What they pay you is generally based on the return of the insurance company’s investment portfolio, but you get the guaranteed rate regardless of their profitability or loss. Does this sound similar to the say a bank CD works?
Variable Annuity. Insurance company invests the money you give them into mutual funds or some other type of security. While you have unlimited upside potential and can make a lot of money in a variable annuity, you also have unlimited downside and can lose a lot of money. In fact, over the past several years, you might have experienced or seen market losses. That’s the main reason the variable annuity tends to charge higher fees—it is the only way to protect the insurance company from potential losses the market might suffer (remember, the insurance company has a contractual obligation to not only protect other people’s money, but also turn a profit).
Fixed Indexed Annuity. Key point to remember about fixed index annuities is that when the stock market goes up, you generally get some of the gains. But when the market tanks, you lose nothing and the gains you made the prior year are not lost! It is a really good deal when you think about it, especially if you’re a risk-adverse saver who doesn’t like losing money. This comparison of the variable annuity and the fixed indexed annuity is like the tale of the tortoise and the hare—fast starts and abrupt stops may not be as good as always moving forward at a steady pace.
Immediate Annuity. The ultimate form of mailbox money, you invest your money (technically a premium) with an insurance company in exchange for a lifetime income for a set number of years (called a period certain), for the rest of your life only (called a “life only option) or for your life and the life of a named beneficiary (referred to as joint and survivor option). While the concept of guaranteed mailbox money for the rest of a set term or one’s life sounds good, there is one drawback: once you tell the insurance company to send you income, you cannot change the election. So before ever establishing an immediate income, be certain you are okay with the option elected, because you cannot change it down the road.
Misconception #7: Annuities are bad for older folks.
Most older folks planning for retirement are looking for two things: 1) safety of their money, and 2) not running out of it!
This misconception makes no sense unless the older person IS NOT looking for safety and security, and assuming the older person is looking at a fixed annuity (as opposed to a variable annuity, which contains more risk and higher fees).
Again, without beating a dead cow, the majority of annuities (mainly the fixed variety) are very well suited to the older retiree. That’s because the annuity not only guarantees the return of the money, but also guarantees a certain amount of mailbox money. What’s not for older folks to like about that?
Misconception #8: Annuities aren’t safe.
Now if you are talking about comparing them to FDIC-insured bank products, annuities are not FDIC-insured and are not backed by the federal government. They are backed by the same insurance companies that protect your house, car, life, health and virtually everything else of value. A review of the factual history of fixed annuities shows that they are very safe. In fact, during the Great Depression, there is no history or record of any insurance companies failing to pay claims on their contracts during what was the most turbulent time of our country’s history. Still, it would be good for you to check with your State Department of Insurance (the government agency that regulates insurance companies) to confirm something called the State Guarantee Association Fund. Your state’s guaranty fund was established to protect citizens holding annuities and other insurance policies. Of course, just like FDIC dollar limits, these funds do have limits that vary by state.
Misconception #9: Annuities pay huge commissions to agents.
Insurance agents (the agent or advisor must hold an insurance license to sell any of the four types of annuities mentioned earlier) mainly live off commissions—a one-time reward paid to the agent for bringing the insurance company other people’s money. You can choose to purchase a fixed annuity with an insurance agent (agent will be paid a one-time commission) vs. putting the same amount of money into a growth mutual fund with Wall Street (Wall Street charges commissions up front, but always gathers fees each year based on the value of the account). For example, with a fixed annuity even though an agent receives a one-time commission from the insurance company, your entire (100%) investment is still working for you (assuming the contract is not surrendered during the surrender period). In other words, the “hired help” is paid by the insurance company, not directly by you—the investor.
Misconception #10: Annuities are good replacements for life insurance.
Just because annuities and life insurance are both contracts issued by insurance companies, it doesn’t mean they are created equal. While the primary purpose of an annuity is income, life insurance is meant to provide “tax-free, cold-hard cash” upon death. In fact, the ideal scenario is to have a retirement game plan that includes both annuities AND life insurance.
While annuities may provide a cash balance to your heirs upon your death, or even have what is termed a “death benefit,” the money is not passed tax-free. With an annuity, any money above your original premium (with an annuity, this is called your basis) will be taxed at ordinary income rates—just like a 401(k)/IRA. However, with life insurance, the money left to your family at death will go to them completely tax-free, giving you the freedom to use and enjoy the rest of your money for the rest of your life.
Be sure to talk to your financial advisor about your retirement options, especially annuities. You’ll be glad you did… and will most likely worry less about your retirement as a result.
The Retirement Pros (Tony Walker, contributing author)