Most people first hear someone else explain annuities as part of a sales pitch. Very often annuities are peddled to people nearing retirement who are concerned about whether they'll have enough money to last the rest of their lives. Annuities are presented as a solution to this dilemma, and they certainly can be, but they're not the perfect investment for everyone.
It Can Be Challenging to Explain Annuities
It's hardly surprising that the people who most often explain annuities are financial services professionals. Annuities have some features in common with bonds and some aspects of retirement plans, but unlike bonds and retirement plans, annuities are created by insurance companies. All types of financial services firms sell annuities, but again, insurers are the ones that make this particular investment product, through a process that the pros call underwriting.
How They Work
There are many variations on the basic annuity structure, which is a fixed income investment. The value of an annuity is paid out to the investor in monthly installments until eventually the contract expires. The monthly payments have interest added to them as a premium. That premium comes from earnings that the insurer gains from investing the annuity's principal into other types of investments.
The investor usually buys the annuity for a lump sum up front, and receives that money back with interest in monthly payments over a period of years. Sometimes the duration of the annuity is fixed ahead of time so that the expiration date -or maturity- is known to the investor. Other annuities last until the investor passes away. The former type of annuity can be inherited by next of kin or designated beneficiaries if the original investor dies before the expiration date. Annuities that have expirations tied to the investor's date of death cannot be inherited.
Taxes and Annuities
Like retirement plans, purchases of annuities can be tax deferred. Unfortunately, that doesn't mean tax free. Rather, it's possible to purchase annuities with pre-tax money, similarly to the way contributions to 401(k) plans work. However, the monthly distributions of annuity payments are subject to income taxes. Don't confuse this with capital gains taxes. Capital gains taxes are a lower percentage rate than income taxes usually are and apply to gains earned from the sale of investments. Annuity payments may seem like capital gains, but they're not, at least not in the eyes of the Internal Revenue Service.
Pricing may be the only thing about annuities that resemble other types of products sold by insurance companies. The same sort of actuarial math that insurers use to determine premiums on insurance plans is often used to set the prices of annuities. This is especially true for annuities that expire upon the investor's date of death, although actuarial math does have a role in pricing annuities that have predetermined maturity dates.
Sometimes the pricing has to do with the stock market's overall performance, as is the case with so-called index annuities. These annuities pay interest rates based on the performance of a group of stocks, typically the Standard & Poor's 500. The interest rate on an index annuity is also limited to a fixed range in order to provide the investor with some protection against the risk of the stock market going down. However, that same protection of the investor also extends to the insurer that issues the index annuity: the insurer doesn't have to pay more than the maximum limit, even if the stock market outperforms the target range of interest rates.
Annuities certainly look like a good deal, at least upon first glance, because they provide a guaranteed cash flow with some form of interest. However, annuities may have hidden fees since the investment professionals who sell these products oftentimes earn higher commissions than what other types of investments pay. So it is in the best interests of brokers, financial advisers and personal bankers to sell as many annuities as possible.
Just because something is good for an investment professional to sell doesn't mean that the product is the best thing for everyone to buy; the hefty fees that investment professionals earn on selling annuities comes from money that could otherwise go to investors.
Be Aware of What You Buy
Anyone interested in possibly buying annuities would do well to read through the promotional literature very carefully and scrutinize the material written in fine print that is designed to explain annuities. If you want a guaranteed cash flow for retirement and don't desire to leave an inheritance for your surviving relatives, then annuities might prove to be a worthwhile investment. Just be sure you know all the facts about an annuity before making a purchase.