Ultimate Guide to Understanding Annuities - Everything You Need to Know!

In their most basic form, the annuity is a contract between you and a life insurance company, which promises a stream of income for your lifetime, and that's in exchange for a lump sum premium, or it could be a series of premiums that you give the insurer. Annuities are popular among retirees, but they're sold to a wide variety of consumers. Chances are you've heard many opinions about these contracts, both positive and negative. I'm going to break it into bite-sized pieces on We're Talking Money. Stay tuned.

Welcome to another edition of We're Talking Money. I'm Phil Clark, founder and CEO of OmniStar Financial Group, and today we're talking annuities, and they are definitely not a one-size-fits-all product. While they do offer the advantage of tax-deferred growth, annuities are complicated instruments. Investors should be careful to avoid high-pressure sales tactics. They have features of both life insurance and investment products. Some would call it a hybrid, but they're only allowed to be sold by an insurance company. That should raise an eyebrow.

Fixed annuities, for example, provide a fixed rate of return, and that's provided by the insurance company who writes the contract. And that initial rate is usually guaranteed for one or more years, and then subsequent renewal rates are guaranteed to stay above usually a specific minimum rate. Oftentimes it's two percent, sometimes three percent. Because it provides several guarantees, however, a fixed annuity is viewed as a very conservative financial product. Now, most contracts include a guaranteed minimum rate of return.

Included in this definition is the ever-popular index annuity. Those are linked to an external equity reference or equity index, such as the S&P 500, the Dow Jones Industrial Average. Sales of equity indexed annuities, or EIAs, they have grown considerably in recent years. In fact, they may be one of the most popular annuities on the market. And one of the most important features of the EIA is the method by which the insurance company calculates the gain in this index that you choose, like I said, the S&P 500 or the Dow, for example. That calculation gives you what they consider your rate of return, and it's linked to these indexes. As interest is credited, the earnings are locked into the account value, and the account does not participate in any losses. Sounds pretty good, right? Stand by. There will be more to come on this part of annuities.

And then we have variable annuities. They place the risk and rewards of investment performance upon you, the annuity holder. So if you have one of these annuities, rest assured all risk is shifted to you. The annuity holder determines how the account funds can be invested, and they do this by selecting from usually a pretty small group of portfolio types that are offered by the insurance company. Now keep in mind, you do not have the flexibility of freedom to put certain investments inside of a variable annuity. The insurance company issuing the contract makes those decisions, and you choose from the investments that they give you. These are referred to as separate accounts, and they're similar to a mutual fund. So choices could include things like a money market fund, growth funds, or small cap, mid cap, international funds. And they may further refine what you're choosing from through different fund managers or sub-account managers, and so you could even see brand names like American Funds, or funds that you would recognize in the retail world.

Now, the ultimate value of the annuity holder's account and the size or duration of future periodic annuity benefits, that's going to be dependent upon the relative performance of the investment choices, again, that you make. The insurance company doesn't make these for you. Thus, the purchaser of a variable annuity contract is well advised to investigate the investment performance history. You want to do this in much the same way that performance history would be evaluated before you invested in something like a mutual fund or a managed investment program.

Now that we know the types of annuities, let's talk about the variations of these contracts. Let's start with immediate annuities. These guarantee payments which start right away for a specified period. Now, this contract is generally used for one thing, and that is to generate income payments.

Next, we have a deferred annuity. These grow tax deferred until the contract is annuitized, which means to put it into a payment stream, or until it is surrendered, which would be paying it out in a lump sum. A deferred annuity contract is chiefly a vehicle for accumulating savings and eventually distributing the value, either as a payment stream or as a one-time lump sum payment. Now, all varieties of deferred annuities have one thing in common: they increase in account value, and they are not taxed on those gains until they are withdrawn. Now, this is also known as tax-deferred growth. The tax-deferred status of deferred annuities, it has definitely led to their popularity.

Annuities can be established as qualified and non-qualified, but beware of this, because they're not always a good idea in the qualified space. If you're considering the use of an annuity as part of your retirement government accumulation or distribution, be sure you know the disadvantages before diving in. If you need guidance, please give us a call. Our professionals are here to help, and they're well versed when it comes to annuities.

Now let's go a little beyond the basics. These contracts are anything but basic and certainly not simple. Fixed annuities generally provide a guaranteed rate of return for a predefined period, which varies depending, again, on the insurance company that issued the policy or the contract. However, most insurance companies adjust the fixed rate of return at the contract anniversary or at a predetermined interval. Now, fixed annuities are popular among retirees and mostly investors with a lower tolerance for risk, someone who might need guaranteed income payments. And unlike a bank that has insured products, these annuities have surrender charges, and they can make it difficult to access more than 10 percent of the annuity's value. And of course, all growth is distributed as ordinary income. That can be a major problem.

Then we have these variable annuities, and they've gained in popularity, particularly among brokers, and they use them as an alternative to traditional investing. Now, these contracts provide the investor with a limited number of sub-accounts, similar to the mutual funds that we talked about, which allow premiums to be invested in the stock market or the bond market. Variable annuities are used for general investing, and sometimes you'll find these in qualified retirement plans, something that I am not a fan of, and I'll explain to you why in a few minutes. Variable annuities tend to have way above average cost when you compare that to traditional investment programs, and higher fees can greatly affect total return.

Now, back to that equity index annuity. They're among the most popular in today's marketplace. They combine the features of a fixed annuity and the variable annuity, but the equity index annuity is not subject to investment losses. Big difference here. Equity index annuities, they are unique in that investors have return potential based on popular market benchmarks such as the S&P 500, but they don't have to participate in the downside of those markets. Now, the index annuity is widely marketed as an alternative to traditional investing, and so these insurance agents will happily sell them to all types of investors. That is all you need, by the way, is an insurance license to sell index annuities. These are not securities products. I like to say at this point, buyer beware. Earnings are credited using complex formulas, and these formulas can make it difficult for untrained investors to understand really how their performance is going to be generated or how it's going to be added to their account. Now, the most common sales pitch: this contract allows you to invest in the stock market without any downside risk. In the case of the index annuity, if it sounds too good to be true... well, let's move along.

Some things that you should consider, I want to dig into those now before you take the annuity plunge. So, irrevocable consequences, for example. Once you annuitize, meaning you turn your annuity into an income for life or a period certain, as it's called, it usually becomes irrevocable, and that means you can't make changes. You often give up the ability to get your lump sum back or even pass it to beneficiaries. In other words, when your life ends, so too does the income. Everything's gone.

And then delayed access. Once you purchase an annuity, funds are often subject to early withdrawal excise taxes of 10 percent, and that lasts until age 59 and a half. Now, withdrawal options: on many of these contracts, annual withdrawals of up to 10 percent of the previous contract year's annuity value are generally available without surrender charge. So most of the time you'll hear this referred to as the 10 percent free out.

And then taxes. Withdrawals from non-qualified annuities, that's the ones that are not part of your retirement programs, so these would be called non-qualified annuities, they're treated as ordinary income rather than the more favorable long-term capital gain treatment that you would find in traditional investing. Something else to keep in mind is death benefits may also become taxable.

And then we have surrender charges. Surrender charges, typically say three to 12 years, they can add another layer of distribution expense. Pretty soon these expenses add up, and they can really change the end result or the outcome of what you thought was a good deal.

Now, commissions. This is something we haven't mentioned, but it's an important part of annuities. Remember, I said insurance agents sell these. Most annuities are commission-based products, not all of them, but most, and with commissions ranging from say two percent to as much as 10. I've seen more agents reap large rewards for selling these contracts at the high end of the scale. That's about ten thousand dollars in commission for every hundred thousand that you invest. As an investor, you should be aware of this potential conflict of interest.

Annual fees, administrative charges, mortality expenses, another common phrase in the annuity world. Annuities can have many layers of fees, which at the end of the day, they impede investment performance. Annuities have been around for decades AIDS, yet they've earned the stigma of being overpriced. They're overcomplicated. They keep you there for a long time, and they do that with expensive surrender charges. Many of these things are true, but it's important for investors to understand annuities are a tool best used to transfer risk. This means if we try to use them for something in which they were never intended, you will likely be disappointed. For example, growing your assets using a variable annuity. The cost of a variable annuity can exceed four percent annually. That is a huge expense. Now, I understand they have bells and whistles and so-called guarantees, but not only is this cost extreme, it makes the variable annuity incomparable to non-annuity investments.

Used correctly, annuities can fill a void, and they can work really well at helping investors remove risk from their total investment strategy. Creating a predictable outcome, in our opinion, it's best achieved through a well-constructed financial plan. Solid planning includes growth phases and distribution phases, charitable goals, legacy planning, and all elements associated with wealth managements. We refer to that as the 10 Elements of wealth management. Done correctly, investors, you can appreciate different approaches, and ultimately you can select a plan best fits your intended outcome.

Now, I hope this episode of We're Talking Money has inspired you to gain a better understanding of annuities before taking the plunge. If you enjoyed today's content, please subscribe to our channel. We appreciate that so much. And ring that bell so you never miss a great episode of relevant and helpful information. You can also find us on Instagram and Facebook, and of course, please visit our website, omnistarfinancial.com. I'll see you next time on We're Talking Money.

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