An annuity is a contract between an investor and an insurance company in which the insurance company promises to make payments to the investor either immediately or at a future time. An immediate annuity, as its name suggests, offers payments that start immediately. With a deferred annuity, payments are delayed to a future date. You may be able to purchase an annuity either with a single payment or with a series of premiums. Details of annuities vary considerably, and it is important to familiarize yourself with the particulars before making a purchase.
Depending on the underlying investment, you may have a choice of a fixed annuity, a variable annuity, or an equity-indexed annuity.
Fixed Annuities
As their name suggests, these annuities typically present a guaranteed interest rate that is locked in for an initial period and may be adjusted thereafter, often annually. Earnings on the underlying investment accumulate tax-deferred and are not taxable until they are withdrawn, when they are taxed as income. Withdrawals before age 59 1/2 may entail a 10% penalty. Withdrawal options may include a lump sum or a lifetime stream of income. With a deferred fixed annuity, there may be surrender charges on withdrawals during the first several years of the annuity contract. Once the surrender period has expired, you generally can access your money without penalties.
Variable Annuities1
This type of annuity, in contrast, generates investment returns that fluctuate depending on how underlying subaccounts are invested. Generally, an investor (called an annuitant) may make an investment selection that may include stock, bond, cash equivalent investments, or some combination of these. As with many investments, the value of a variable annuity will change depending on the performance of the investments you choose.2
Risk tolerance and costs are important considerations to investigate when researching variable annuities as these types of investments are subject to investment risk, fees, and expenses. Expenses can include surrender fees, contingent deferred sales charges, mortality and expense risk charges, administrative fees, and annual contract fees. Any riders added to the annuity can also be subject to additional costs. The benefits of riders and annuities are subject to limitations and restrictions. Withdrawals are taxed as ordinary income.
Equity-Indexed Annuities (EIAs)
EIAs are another variation of annuity. They frequently offer a guaranteed minimum interest rate combined with an interest rate linked to the performance of a market index. The guaranteed minimum typically is 90% of the premium paid at a 3% annual interest rate.3 The index-based return is tied to an index, such as the S&P 500, that is identified in the prospectus.
The index-linked interest rate may be computed in a variety of ways. Some annuities present a participation rate (for example, 80%) that determines how much of the index’s gain is credited to the annuity. There may also be an interest rate cap on how much an EIA can earn. For example, if an index linked to an annuity gained 8% and the cap rate was 6%, then the gain would be 6%. There are also a variety of indexing methods used to calculate the index-based return. When reviewing EIAs, be sure to read the prospectus for details and ask questions about any you do not understand.
Determining Suitability
Whether an annuity is right for you may depend on how much you anticipate receiving from traditional sources of retirement income, such as Social Security or an employer pension. Also, many annuities require fees that impact an investor’s total return. But if you need an additional source of retirement income, and the particulars are suitable for your situation, annuities may be worth a look.
1Variable annuities are long-term, tax-deferred investment vehicles designed for retirement purposes and contain both an investment and insurance component. They are sold only by prospectus. Guarantees are based on the claims-paying ability of the issuer and do not apply to a variable annuity’s separate accounts or underlying investments. The investment returns and principal value of the available subaccount portfolios will fluctuate so that the value of an investor’s unit, when redeemed, may be worth more or less than their original value. Withdrawals made prior to age 59 1/2 may be subject to a 10% IRS penalty. Surrender charges may apply. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal.
Not FDIC/NCUA Insured — May Lose Value — Not Bank/CU Guaranteed — Not a Deposit — Not Insured by Any Federal Agency
2Before investing, investors should consider the investment objectives, risks, charges, and expenses of the variable annuity and its underlying investment options. The current contract prospectus and underlying fund prospectuses, which are contained in the same document, provide this and other important information. Please contact your representative or the offering company to obtain the prospectus. Please read the prospectus carefully before investing or sending money.
3Source: www.finra.org, “Equity-Indexed Annuities: A Complex Choice,” April 22, 2008.
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