Don't surrender that annuity just yet!
Part 1 of I Hate Annuities...
Are you feeling regret or unsure how to get out of an Annuity?
Annuities can be complex. There are many different types and variations of annuities that people purchase. First, lets understand the basics of an annuity.
Annuities by definition are a series of payments for your lifetime in exchange for a lump sum of money. Simply, you write an insurance company a check and in return you can get a monthly income that will last your lifetime.
Annuity contracts are typically issued by life insurance companies. In theory, life insurance companies have two types of products in the "life insurance" business. First, is life insurance, in its simplest form, life insurance protects individuals from an early death. The insurance company collects a premium, in exchange for the promise of a "lump sum" death benefit. Annuity contracts on the other hand is purchased from customers to protect themselves if they live longer than a the average life expectancy.
There are two phases of an annuity contract. The accumulation phase and the distribution phase. An annuity that is in the accumulation phase is termed "deferred annuity". When the money has grown to an amount that a customer is ready to retire and collect, there are 2 initial and basic choices. We will start with understanding the distribution phase first.
- Withdrawals - Taking a certain amount of money from the accumulated funds. For example, if your annuity account value is $100,000 and you take out $1000, your account value is now $99,000.
- Annuitization- This takes us back to the definition of annuities, in the example above, this would take you account value, giving it to the insurance company, in exchange for a lifetime of income payment. The money now belongs to the insurance company, and you get a contract detailing the amount you will receive for the rest of your life. There are a few factors that help determine the amount of income you would receive, your age, amount of money, and current interest rates. Some other factors that will affect the payments received would be the "strings" you ask the insurance company to provide. Some of those strings are, electing a period certain.
- Life with 10 years certain, simply put, the payments will last your lifetime or 10 years, whichever is LONGER. If you take this option, and collect 3 years of payments, and pass away, your beneficiaries will receive 7 years of payments.
- Life Annuity 50% Joint and Survivor. This option would pay you, the annuitant, for your lifetime. When you pass away, your beneficiary, typically a spouse in this circumstance, will then collect 50% of what you were receiving for the rest of their life. Most times with this option, if you beneficiary/spouse, predeceases you, your payment will not be increased or decreased.
There are many types of annuity contracts that have different ways, and investment choices to help a customer to grow their account. There can be many hybrid versions, but they really fall into the following categories.
- Fixed Annuity - The growth of your account value is based upon a fixed interest rate, set by the insurance company at the time of issue. A few items to be aware of, what is the initial interest rate, how long is that rate guaranteed, after the guarantee, what is the minimum interest rate.
- Variable Annuity - The growth of your account is based upon the investments that you choose from a menu provided by the insurance company. In this type, your value can fluctuate with the ups and downs of the stock market.
- Indexed Annuity - There are many types of indexed annuities, for this blog, we are going to reference the type that you invest in certain indexes provided for by the insurance company, they will cap the amount that you can make. In exchange for the limit on the positive returns, you get a loss buffer for which the insurance company will "credit back" all or part of the loss depending on the contract. For my purposes, we will assume that you chose the S&P 500 index with (hypothetically) a 15% cap and 10% buffer. There are many outcomes of this, but for simplicity we will just outline a few.
- The S&P 500 grows by 20%, in this example, your account would grow by 15% because of the 15% cap.
- The S&P 500 grows 10%, your account would increase by 10%
- The S&P 500 loses 9%, your account would be credited back that 9% loss and your account would remain level.
- The S&P 500 loses 14%, your account would be credited back 10% (the full buffer) and you would then see a 4% decline in your account value.
Part 2 of "I hate annuities" will feature some of the benefits insurance companies add to annuity contracts to protect against certain curves that life may give.