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Common Annuity Shopper Questions

For many investors, shopping for an annuity is about as enjoyable as shopping for a new car. Everyone enjoys driving off in a new car, but the experience leading up to that point is usually laden with information overload, confusion, frustration and endless sales pitches. The more informed you are about your automotive needs and the cars that are best suited for your priorities and preferences, the quicker and easier the shopping process becomes. Shopping for annuities is no different. The more questions you can have answered before you are confronted with the buying decision, the better your experience will be.
Here are some more commonly asked questions by annuity shoppers:

Is an annuity right for me?

This is probably the most important question, so it deserves an in depth answer. The problem is that it can only be answered after you have done a serious assessment of your own financial situation. Annuities can meet a variety of financial needs, but generally, they are best suited for investors who have a long term time horizon who are seeking growth, stability and tax advantages on their assets. You should only consider annuities if you have maximized your savings in your qualified retirement accounts.

What exactly is an annuity?

Annuities are investment products issued by life insurance companies which offer investors a way to save for retirement on a tax deferred basis. Most annuities guarantee a minimum rate of growth, a return of principal, and a guaranteed income at retirement.

What’s the difference between an annuity and an IRA?

While annuities do provide tax deferral on earnings in their accounts, they are not issued as “qualified” retirement plans as defined in the U.S. tax code. The tax deferred earnings from annuities are treated similarly to qualified plans in that they are taxed as ordinary income upon withdrawal, and withdrawals made prior to age 59 ½ may be subject to a 10% penalty. Qualified retirement plans, such as IRAs qualify for additional tax benefits such as tax deductible contributions (traditional IRAs) or tax free withdrawals (Roth IRAs).

Are annuities guaranteed like Bank CDs

Annuities offer several layers of protection that bank CDs don’t. While CD deposits are covered by FDIC insurance, the coverage is limited to $250,000 per account, per bank. Also, few people realize that the FDIC is only fractionally funded, and it is technically not backed by the U.S. government. Banks are only required to maintain a very small fraction of reserves compared to outstanding obligations. Conversely, life insurers are required to maintain a level of liquid reserves, up to 95% of outstanding obligations. Additionally, each state maintains a guaranty association that covers policyholders up to $500,000 (coverage varies by state).

Are annuity rates guaranteed?

Yes. With most fixed annuity rates, there are actually two rate guarantees. The first one is a guarantee on the initial rate which can be fixed for a period of time (one to 10 years). The second guarantee is for a minimum rate that is paid after the initial rate guarantee expires. After the initial rate guarantee expires, the contract calls for resetting the rate based on a formula or based on prevailing interest rates. The minimum rate guarantee ensures that the adjusted rate cannot fall below the guaranteed rate.

Is my principal guaranteed?

All annuities guarantee that the principal will be paid in full at the death of the annuity owner. During the accumulation phase, the principal is fully backed by the assets of the issuing life insurance company. As indicated above, life insurers must maintain an adequate reserve that could meet the obligations of all of its annuity owners. These reserve levels are strictly monitored by state regulators to ensure complete solvency. In the 200 year history of life insurance issued annuities, no annuity owner has ever lost a penny of principal.

Do I really need the tax deferral of annuities?

If you pay income taxes at a high rate, 40% or above (state and federal combined), you could benefit from tax deferred earnings. Essentially, for every dollar earned and not taxed you are receiving an instant boost on your return. So, when left to compound, your earnings will grow faster. They will eventually be taxed at your ordinary income tax rate when they are withdrawn, however, many investors assume that they will be in lower tax rate when they retire.

Are there any minimum withdrawal requirements?

No. Unlike IRAs and other qualified retirement plans, annuities are not subject to Required Minimum Distributions, so your funds can be left to accumulate, tax deferred.

How liquid are annuities?

Annuities should not be considered as an investment unless you are able to commit to a long term time horizon. That’s the way to ensure you receive the maximum benefit from tax deferred earnings. But, things do happen, and annuity contracts do allow for access to your funds. One withdrawal per year is permitted, and, as long as it doesn’t exceed 10% of your annuity value, it can be made without any surrender charge. After the surrender period expires, from seven to 12 years, you can withdraw as much as you’d like without a fee.

What are the expenses associated with annuities?

Annuities have certain costs associated with them that you might not find in other investments, such as mortality and administrative expenses. The life insurer needs to cover its costs for insuring your life (guaranteed death benefit) and for administering the contract. These fees range from .5 to .8 percent of your annuity value and are deducted annually. Variable annuities charge for the professional management of the separate accounts, similar to mutual funds investment fees. These fees vary depending on the type of investment (stocks, bonds, real estate trusts, fixed yield) and how actively they are managed. They range from .5 to 1.5%.

How does an annuity guarantee a lifetime income?

Great question, because this was the original purpose behind annuities when they were offered centuries ago. Essentially, a life insurer guarantees a stream of payments calculating how much income can be generated from your account value by dividing it by the number of payment periods and factoring in earned interest. The payments consist of both earned interest and a return of principal. Should you live beyond your life expectancy, the life insure is obligated to continue your monthly payments for as long as you live. This “insurance” against living to long, is paid for with the mortality expenses deducted from your account value.

Does it matter where I buy my annuity?

There are dozens of insurance companies offering hundreds of different annuity products, and, as with any type of product, some are of higher quality than others. Annuities are serious commitments involving serious money, so it would important to deal with the most established and reputable providers. You can quickly narrow down your choices by limiting your search to those life insurers who rate the highest by the independent rating companies. Companies that are rated ‘A’ or better (AAA+ is the highest rating), are considered to be financially strong and able to meet their obligations in the worst of economic climates.