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Annuities Simplified – Here’s How To Choose The Right Annuity By Learning These 5 Annuity Features


Introduction

Personal line insurance products such as car insurance, home insurance, renters insurance, etc., have one thing in common: they’re solely insurance contracts.

On the other hand, annuities have insurance and investment features associated with each product type. As a result, many consumers find annuities reasonably challenging to understand, but it doesn’t have to be!

What is an Annuity?

Let’s have a quick recap from my previous post: an annuity is defined as ‘a contract between you and a life insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.’

In layman’s terms, it’s what I like to call ‘income insurance.’

Understanding Annuity Products


Annuities are essentially assembled products and I’ve found that the best way to know how a product works is to disassemble it. 

Retirement annuity

How do annuities work?

Before we get ahead of ourselves and start taking each annuity product apart, you must first learn about the critical aspects of an annuity so that you’ll know how to piece it back together.


Elements of an Annuity

Over the years, I’ve learned to break down the fundamentals of an annuity into 5 different elements:

The Five Main Elements of an Annuity Are:

  • Growth Aspect
  • Annual Fees
  • Insurance Aspects
  • Surrender Cost(s)
  • Tax Status

Knowing these five elements will help you better understand the inner workings of the annuity product(s) you’re researching. More importantly, it will help eliminate unnecessary surprises when it comes time to use it.

Growth Aspect

How will your annuity assets grow? The primary insurance feature in annuities is the guaranteed income stream, which is why I refer to it as the “meat and potatoes” of an annuity contract. In my opinion, investors should not solely use the remaining elements to decide whether to purchase an annuity.

With that being said, how do you uncover how lucrative the income is from an annuity? I’ll share one of the methods I frequently used to determine that below.


Why Is The Growth Important?

The growth aspect is the first item I look at when evaluating an annuity product. Why? By dissecting the growth will help determine how fruitful the income guarantee is.


Growth vs. Annuity Benefit

You might be asking yourself how on earth can the growth strategy help you with that?!

Remember that the insurance aspect does not necessarily kick in as soon as you activate your income stream. The initial payouts distributed are simply deducted from your contract value. In other words, the insurance company returns your money over time.

An annuity’s growth aspect is essential in helping you obtain the estimated time frame the insurance aspect (income guarantee) kicks in.


When does the guaranteed income actually kick in?

If you’re still alive and your contract value is depleted, then that’s essentially when the insurance benefit kicks in because the insurance company now has to start paying you out of their pocket. Therefore, the estimated depletion timeframe is the key to providing insight into how beneficial the annuity’s income is.

The depletion time frame is longer if the growth of your contract value outweighs the potential income stream. The longer the depletion time frame, the longer it takes for the insurance aspect to kick in.

The potential income stream becomes more valuable if the growth on your contract performs poorly because the depletion time frame for your cash value will be shorter. The shorter the depletion timeframe, the quicker the insurance benefit kicks in.


Higher performance = longer depletion time frame

The longer the depletion time frame, the less likely it is for the insurance benefit to kick in.


Poor performance = shorter depletion time frame

The shorter the depletion time frame, the more likely it is for the insurance benefit to kick in.

See example below:

Life Annuity Benefits, Annuity Quotes

It would take you just under a minimum of 20 years to deplete your assets. Now, remember that the example referenced above is a simple calculation so that you can start scratching the surface of determining your annuity needs. Still, there are many other variables to consider, items that your advisor should help you dissect.

Additional items to consider are:

  • The ongoing interest the contract value can continue to earn
  • Any applicable annual fees associated with the contract

Unless the contract was formally annuitized, both the growth and annual fee(s) will continue even when income has started. These items will apply until the contract value *cash value is depleted.

Asset Depletion vs. Annuities

 

But isn’t it a good thing if I don’t run out of money?!

Ninety-nine percent of the time, yes, it absolutely is. However, that is not the case in terms of annuities…

Annuities were designed to protect individuals who may have a risk of running out of income during retirement. If you think you may be one of those individuals at risk, then the annuity fees, the opportunity cost, and fixed payments shouldn’t matter. You’ve determined an insurable need for income, so utilizing an annuity to “hedge” the rest of your assets makes sense.


Two scenarios to avoid:

Purchasing an annuity for the growth feature: Suppose you’re pitched an annuity, which was not presented for its insurance benefits but rather as another investment vehicle that provides retirement income.

In that case, the items I referenced above, such as annuity fees, growth limitations, and fixed income payments, do and should matter to you.

Due to the fees and stipulations associated with the guaranteed income, I believe that annuities should be utilized as a safety net for your primary income strategy.

Without an insurable need, a considerable amount of time should be spent evaluating whether or not the same income stream that the annuity offers can be replicated outside of an annuity in a more cost-efficient and growth-efficient strategy.


• Purchasing an annuity with marginal benefits: The depletion timeframe also helps individuals that has determined a need for an annuity. As mentioned above, it can help provide insight into how lucrative the annuity income is.

Based on the available income and the depletion timeframe, you will be able to see whether or not you’re essentially paying a fee to take your own money back for an extended period or whether the contract benefits actually outweigh the cost.


Annual Fees

Why are the annual fees on an annuity contract important?

Understanding the total annual fees of your contract will help you determine:

  • Whether the cost of the insurance contract justifies the benefit.
  • How your potential growth could be affected.
  • Lastly, the annual fees also play a part in determining the estimated depletion time frame.

Unless you formally annuitized the contract, the annual fees and growth do not stop the second you start taking income from the annuity. So adding those two variables into the mix provides a closer estimate of the depletion timeframe.


Insurance Aspects

Why Are The Insurance Aspects Important?

Having a thorough understanding of the insurance features of an annuity contract is vital for current contract owners as well as potential contract owners.

Consumers gravitate towards annuities for many reasons, such as the guaranteed income stream, enhanced death benefit, long-term care rider, tax deferral feature, a conservative investment option, etc.

So my goal for this post is to try and eliminate or, at the very least, minimize unpleasant surprises down the road, and helping you better understand the inner workings of contract features and insurance benefit(s) should do just that.

Let’s not forget that annuities are insurance contracts, so the benefits offered have stipulations attached.

Again, the stipulations may or may not negatively affect you. Still, it’s best to understand this before purchasing your annuity since these are considered “long-term investment” products.


The growth, annual fees, and insurance aspects will help you weigh out the cost(s) of the annuity against the benefits.


Surrender Costs

Why Is The Cost To Surrender Important?

First lets re-review on what a surrender fee is. When you purchase an annuity, you’ve entered into a contract with the insurance company. Those contracts generally stipulate that you must own the annuity for a certain time (specified by the insurance company). A penalty will be assessed if you choose to terminate the contract before that period ends.

Potential fees that could apply in addition to the surrender charge:

  • Pro-Rated Annual Fees – if applicable, this fee will apply for the contract’s life, not just during the surrender period.
  • Market Value Adjustment
  • Premium Bonus Recapture Fee

Annuities should be viewed as long-term investment tools. To ensure you are comfortable with such a commitment, every contract owner or prospective contract owner(s) should know each applicable penalty if the contract is surrendered during the penalty phase.

Understanding any applicable fee(s) that may arise if you elected to surrender the annuity helps eliminate unwanted surprises and may even assist with the roadmap to your new financial plan as you go back to the drawing board.

To ensure you’re comfortable with such a commitment, every contract owner or prospective contract owner(s) should know each penalty that is applicable if the contract is surrendered during the penalty phase.

Tax Status

Why Is The Tax Status Of An Annuity Important?

Whether the annuity funds are withdrawn as a lump sum, one-time withdrawal, annuity income payments, or distributed as an annuity death benefit, it is vital to know the tax status of the annuity to plan accordingly.

Both “Qualified” (before-tax money) and Non-Qualified funds (after-tax money) can be used to fund every annuity product (except for QLAC’s, which can only be funded with “qualified” funds).

So, before you take a withdrawal, surrender the contract, or start your income, please confirm the tax status of your annuity assets and consult with your tax advisor.


Takeaway

In summary, having a keen awareness of these five elements helps:

  1. Uncover how advantageous the features are.
  2. Eliminate unpleasant surprises.
  3. Most importantly, it provides peace of mind and buyer confidence. You now have a product you understand well enough to piece back together, which is extremely valuable regarding retirement planning.

Now that you’ve learned the different aspects of an annuity, it’s time to take a deep dive into specific annuity products!


Disclaimer: The opinions expressed in this blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security, investment, or insurance product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.


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