Understanding the Basics of Annuities
- Aug 3, 2021
For most, the sound of the word “annuity” doesn’t evoke a positive reaction. However, not all annuities are the same and, as with all financial products, an educated consumer is the best consumer. So hang in there when an advisor discusses an annuity strategy.
Some might fit your situation and preferences, some may not. Some have high commission costs, and others do not. Avoiding them completely is like ignoring a tool in your toolbox that might be exactly what you need. There are many types of consumer annuities available; each with its own unique characteristics. Below are the most popular:
Single Premium Immediate Annuities (SPIAs)
SPIAs provide contractually guaranteed income. Normally, the holder, in exchange for a lump sum up front, is provided a lifetime income stream starting as soon as a month or within one year.
Deferred Income Annuities (DIAs)
DIAs works much like the SPIA, except the start date is deferred. The retirement income stream payment will be a set amount for the rest of your life. However, the lifetime payments can start as soon as 13 months and as far out as 20 to 40 years.
Qualified Longevity Annuity Contracts (QLACs)
This is a way to structure a DIA and can only be used in a qualified retirement account (usually a traditional IRA). It can be set up joint life with your spouse even though it’s in your IRA. This DIA provides a lifetime stream of income starting at a future date. You (or you and your spouse) receive payments regardless of how long you live. The primary purpose of this type of annuity is to mitigate the effects of required minimum distributions. The holder can structure this so the amount placed in a QLAC is not considered in the required minimum distribution (RMD) calculation until as late as the age of 85. Unfortunately, the amount that you can contribute to a QLAC is maxed out at 25% of your retirement accounts or $135,000, whichever is less.
Multi-Year Guarantee Annuities (MYGAs)
This is the annuity industry’s version of a Certificate of Deposit (CD). You choose the fixed period of time and the amount of money (i.e. lump sum payment) you place in the policy. The primary object is principal protection with a guaranteed fixed annual interest rate.
Fixed Index Annuities (FIAs)
Also known as Equity Indexed Annuities, FIAs look to protect principal protection with CD or enhanced CD returns. You get a portion, but not all, of the upside of a market index call option. In exchange, your downside is either minimized or eliminated. For instance, you might have cap of four percent and the S&P 500 earns 12 percent, you only get the four. If the earnings go negative, you principal amount stays locked in.
Variable Annuities (VAs)
VAs are deferred annuities that provide non-guaranteed returns that are based on the performance of how mutual funds and the markets perform. With their sometimes high commissions, VAs are what have given annuities a bad reputation, but that should not keep you from looking at them. Variable annuities are security products. In order to sell the variable annuity, the agent will need a securities license. With the other annuities listed above, the agent needs a life insurance license.
Different annuity types come with different costs. Commissions and fees are generally higher for complex financial products than they are for straightforward investments. In general, the more complicated the annuity, the higher the costs to the consumer. A fixed income annuity (SPIA, DIA, QLAC and MYGA) will have much lower costs than a variable or an indexed annuity. That’s because fixed income annuities are relatively simple. They’re not linked to investment portfolios or indexes like the S&P 500. They pay at a rate that is specified in the contract and have less complicated rules.
Annuities can play a very large part in the financial planning for individuals. Commissions and fees can add up, particularly if you are not asking the right questions. It’s important to make sure you are dealing with an experienced and trustworthy agent before purchasing an annuity.
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Daniel Gibson provides accounting, tax planning and consulting services to real estate and services industries and is a member of the AICPA and New Jersey Society of Certified Public Accountants.
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