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How Do Annuities Work? Find Out Before Taking the Plunge

Key Points
  • In essence, annuities are investment and insurance products rolled up into one.

  • Annuities can be complex and there are many types to choose from, but in general, they provide potential for outsized gains in return for a predictable income stream for life.

  • Annuities are best suited for those who are either in or approaching retirement.

Editors' Note: This article is excerpted from The Charles Schwab Guide to Finances After Fifty, available in bookstores nationwide. Read more at http://schwab.com/book.

As you contemplate the time when you’ll no longer be earning a regular paycheck, how confident are you?

According to the annual national survey on retirement confidence conducted by the Employee Benefit Research Institute, in 2013, only about 13% of Americans responded to this question by saying that they were "very confident" about their prospects. In other words, if you have a hefty portfolio or a pension, you're among the lucky few. And if you have minimal savings, you probably shouldn’t tie up your cash in an annuity. But if you fall somewhere in between—that is, you have a fair amount of savings, but not enough to guarantee a comfortable retirement—an annuity might be the answer.

In essence, annuities are investment and insurance products rolled up into one. There are many different types of annuities, but in general, you give up the potential for outsized gains in return for a predictable income stream for life. Because of this, annuities are best suited for those who are either in or approaching retirement.

Over the years annuities, have developed a somewhat bad reputation—certainly not without cause. Not only do many carry hefty fees and commissions, but they can be so complex that it’s almost impossible to understand exactly what you’re getting for your money—or to compare your return to another investment.

Fact: Close to half (44%) of Americans grade themselves a D or F on their annuities awareness, according to a 2013 Charles Schwab Retirement Survey.

That said, some annuities are better than others—and there are definitely circumstances when purchasing one can be a smart financial move.

For example, consider the following:

Terry is 65. She has $1 million of assets and wants to spend $60,000 a year in addition to Social Security. As an example, she should withdraw only about 4% of her portfolio each year ($40,000) if she wants to be 90% confident that she won't run out of money. Instead, she decides to put $400,000 into an annuity that pays $36,000 a year for life, with cost-of- living adjustments. She can then withdraw $24,000 from the remaining $600,000 (which is 4%). Combined, she has $60,000 of income that will grow with inflation. In this case, the math works. But you have to compare policies and do your own calculations—most likely with the help of an objective and trusted financial advisor. In the following pages, I review two different types of annuities that may be worth considering.

Annuities 101

Annuities can be divided into two broad categories: fixed and variable. Both are contracts with an insurance company. You pay a premium (or series of premiums) and then receive payments at regular intervals for a stated period of time.  

Contributions to an annuity are not tax-deductible, but taxes on earnings are deferred until you make a withdrawal—at which time you pay ordinary income taxes on your gains. There is a 10% penalty for withdrawing earnings before age 59½.  

Both fixed and variable annuities can be either deferred or immediate. An immediate annuity will start to pay out right away, continuing for a specified period of time or for life. Deferred annuities have two phases: accumulation, when you earn interest on your investment, and distribution, when you take withdrawals at a predetermined future date.  

Fixed immediate annuities behave much like a pension. Provided the insurance company remains solvent, you can count on receiving payments for a set number of years, for life, or for the life of a beneficiary.  

Variable annuities are somewhat like other tax-deferred investments but with extra protections and extra fees. You invest your money in a "subaccount" composed of stocks, bonds, or other vehicles, and your return will vary depending on their performance. For that reason, payments aren’t as predictable as they are with a fixed annuity (however, as discussed below, you can also purchase a rider that guarantees a minimum payment, generally subject to certain restrictions and conditions).

Start by asking yourself a few questions

Intrigued? Before you get immersed in too many details, consider the following:

1. How important is it to you to guarantee income for life? The whole point of an annuity is a reliable income stream. If you're confident that you’ll be able to generate enough money from your portfolio, you don’t need an annuity. But if you’re concerned that your portfolio and other investments won’t be able to sustain you, an annuity could make sense.

2. Do you want to leave your assets to your children? Annuities are designed primarily to protect you, not your heirs. If you want to pass on these assets, an annuity is probably not the best vehicle.

3. Have you maxed out your retirement accounts? If you're still working and you haven’t contributed the maximum to your 401(k) or IRA, it’s probably best to start there. Otherwise you’re walking away from tax benefits that can save you big in the long run. However, if you have contributed the maximum to your retirement accounts or you’re no longer working, and you want to supplement your retirement savings, an annuity could make sense.

Caution: The experts at the Schwab Center for Financial Research generally recommend that you not put more than half of your assets in an annuity. That way, you will retain some liquidity and the potential for growth on top of the security of a reliable income stream.

2 options worthy of your consideration

Of the literally dozens of different kinds of annuities available, the Schwab Center for Financial Research has given its conditional approval to two: single premium immediate fixed annuities (SPIAs) and variable annuities, particularly those that have an optional guaranteed lifetime withdrawal benefit (GLWB).

An SPIA is most appropriate for someone who is either on the cusp of retirement or is already in retirement. A variable annuity with a GLWB rider might make sense if your retirement is 5 to 10 years away.

  • Immediate fixed annuities: With a single premium immediate fixed annuity (SPIA), you irrevocably turn a lump sum over to an insurance company in exchange for an immediate stream of guaranteed income for a set number of years or for life, depending on the annuity. In other words, you’re buying a reliable cash flow, much like a pension. The biggest downside is that once you commit, you can’t change your mind and get your money back.

With an SPIA, like a fixed pension, the longer you live, the more you benefit. Your payment will be based on the insurance company's calculation of your life expectancy. Therefore, if you live longer than your cohorts, you'll collect payments for a longer time, increasing your rate of return. Also, the older you are at the time of purchase, the higher your monthly payment will be, because the insurance company anticipates paying you for fewer years.

An immediate fixed annuity makes the most sense for someone who wants income now without having to worry about the stock market. If you’re one of the many people who lost sleep during the market crash of 2008, and you're concerned about outliving your portfolio, the security of an SPIA could be worth the cost.

Alternatively, if your primary fear is living into very old age (what actuaries call "longevity risk"), you can consider purchasing an annuity that won't start payments until you reach a certain age—say 80 or even 85. This will be a lot less expensive than purchasing an annuity that starts paying you earlier.

Caution: With interest rates at historic lows, this may not be the ideal time to put a big chunk of your money into an annuity. Instead, consider staggering your purchase over time so that you can potentially get a better return. One caveat is that annuity contracts can have "break points"; if you buy a smaller contract you may not get the best rate.
  • Variable annuities: Our research shows that we're most vulnerable to the impact of a prolonged market downturn during the last 5 to 10 years before retirement. On the other hand, you probably don’t want to be out of the market, either, because your retirement could last for several decades.

One way to resolve this conflict is with the protection of a variable annuity, which offers professionally managed investments along with a guaranteed stream of income for life (subject, of course, to the insurance company’s financial strength and ability to pay claims). Adding an optional GLWB rider, available at an additional cost, provides added protections by guaranteeing your income against market risk.

Under the terms of a GLWB, you don’t have to "annuitize" your contract—or irrevocably hand it over to an insurance company in order to receive a guarantee d stream of income for life. You retain control of your money and, at retirement, you can withdraw a guaranteed minimum level of income each year regardless of how the investments that are held within the variable annuity perform.

You should be aware, however, that the GLWB does not protect the value of your investments held in the annuity. It only protects the guaranteed minimum level of income that you can take from the annuity (for life, even if the promised minimum withdrawals and market losses deplete the value of the investments held in the annuity to zero). The actual value of the investments will fluctuate based on the performance of the market and will be reduced with each withdrawal. Also, if you withdraw more than the minimum level promised in your particular annuity contract in any year, that may decrease the minimum amount of future annual income.

On the surface, this may sound like a win-win. You're guaranteed to receive a set level of income no matter how the portfolio performs, and you also have the potential for growth if the investments do well. But be aware that all of this comes at a cost. In general, a variable annuity with a GLWB provides a lower guaranteed payment than an SPIA. In effect, you may be exchanging a higher guaranteed payment from the insurance company in exchange for upside potential as well as access to the investments held in your annuity if you need them.

No matter how you slice it, these vehicles come with a lot of fine print. Be sure to talk to an advisor who has experience with these products before you move ahead.

Smart Move: Before you purchase an annuity, check out the credit rating of the insurance company. The FDIC does not insure annuities. Therefore, if you're investing a very large sum in annuities, consider diversifying between several companies. Even if you have to give up a little on return, buy only from the highest-rated companies.

Calculate the Return

Before you purchase an annuity, it’s important to understand how its return compares to another annuity’s or to another secure stream of income—say from a laddered portfolio of CDs or high-quality bonds.

I'll give a simplified example for an immediate fixed annuity here, but there can be a number of variables that make the calculation much more complicated (for example, a cost-of- living adjustment, available at an extra cost). Unless you’re extremely adept at number crunching, I highly recommend that you enlist the help of your financial advisor or CPA to run various scenarios.

Example: Let's say that you’re 65 and have $300,000 to purchase an immediate fixed annuity. You are quoted an annual payment of $24,000 per year for the rest of your life.

At first glance, $24,000 a year seems like an 8% annual return. But the payment is made up of the return of your principal as well as interest, so the actual return is lower—and will vary depending on how long you live.

For example, if you live for another 18 years, this annuity's annual yield is 4.45%. If you live to 90, the annual return goes to about 6.6%. If you live to 95, it’s 7.3%.

Once you have a good sense of the return, you can then compare one annuity to another as well as to other investments.

Caution: Most deferred annuities have a surrender charge for the first 6 to 8 years of the accumulation phase. You’ll be able to withdraw your money, but you'll pay a penalty. Often that fee will decrease each year until it disappears. You may also pay a penalty for withdrawals before age 59½, plus taxes. Also note that a 1035 exchange will allow you to transfer from one annuity to another without tax implications, but you may still have to pay a surrender charge. There could also be a loss of guaranteed benefits or other factors that could reduce or eliminate the benefits of the exchange.

Shop Around

If you think an annuity is for you, compare products and their expenses from a number of highly rated companies before you commit. Because annuities can come with a dizzying array of features (all of which up the price), be sure you’re making an "apples-to-apples" comparison by using the same set of scenarios for each quote.

Next Steps

  • Read more annuities content in our retirement library.
  • Ready to get started?  Find out about Schwab’s annuity products.
  • Or request annuity information by mail or call a Schwab Annuity Consultant at 888-311-4889.
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Important Disclosures

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The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. 

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