The subject of annuities is one that is somewhat misunderstood by many, a pariah by some in financial services and a topic of debate regarding their usefulness. This is not designed to be a counterpoint argument or an opinion concerning the efficacious nature of annuities.
Given that most people understand life insurance at a fundamental level, this is to draw similarities and differences between annuities and life insurance. For the purposes of this post we are focused on “fixed” annuities. The other type of annuity, that is “variable” annuities are securities and have less in common with life insurance.
Let’s look at the common ground.
They are Issued by Insurance Companies
It’s in the definition. An annuity is:
“A fixed sum of money paid to someone each year, typically for the rest of their life.” Or more appropriately…
“A form of ((insurance)) or investment entitling the investor to a future lump sum or future series of annual sums.”
The most recognizable annuity conforming especially to the latter is Social Security. You contribute to the fund during your working years through payroll deductions and at retirement collect a monthly payment for the rest of your life. The Federal Government in this case is the insurer.
If you are considering an annuity then it makes perfect sense to consider the strength of the company offering it to you. This is especially true if the annuity is larger (over $200,000) or it is designed to provide income for life or last a lifetime.
There are certain annuities called MYGAs (Multi Year Guaranteed Annuities) that have short durations as little as a year. Strength of the company is important with these as well, although size of the company not so much as these are short term instruments.
You can check on the strength of the annuity provider (Life Insurance Company) by checking their rating with A.M. Best, the most common rating reference to insurers. Larger companies especially may also have a Comdex rating. Comdex ratings are an aggregate of rating companies to produce a score with 100 being the highest.
They Have a Term
Annuities as the contracts they are have a term. With MYGAs this can be anywhere from one to five years commonly at the end of the term it “annuitizes” and you get your money back plus the guarantee rate of interest. In this way they act much CDs (Certificates of Deposit) and are routinely purchased as CD replacements as the returns tend to be higher.
Other annuities such as deferred or income annuities have terms retitled as “surrender periods”. A surrender period is essentially the duration of a contract that must filled in order to receive the guarantee in totality. Reaching the end of a surrender period does not necessarily terminate an annuity contract.
Especially in the case of income annuities these tend to be held for life, like permanent life insurance. Although you have the option after the surrender period to move to another annuity, having the option to retain it may be more financially prudent. This is similar to moving to another permanent life insurance policy at a later age in that it may be ineffective cost wise.
All that said, if you are at or beyond the term of surrender period (or quite close) it would be sensible to have some analysis that would reveal the performance of your current annuity compared to what is available.
They Have Guarantees
This should be most obvious. An annuity is a contract. The life insurance company holds your deposits and promises certain guarantees over time. They may come in the form of a guaranteed return on investment, a guarantee against market losses and other guarantees when certain triggering conditions are met.
All guarantees are “subject to the claims paying ability of the company”. Consider that a life insurance company must provide assets (reserves) to cover their contracts unlike a bank. It is still important to assess a company’s financial strength and size. This is especially true where the purpose of the annuity is to provide lifetime income.
All states have “State Guaranty Funds” established by regulation to satisfy claims against losses in the event however rare that a life insurance company becomes insolvent. Insurance companies that sell fixed annuities are required to be members of the state guaranty association as a condition of doing business in that state.
Fun fact: Since 2000 there have been 555 bank failures according to the FDIC. Correspondingly there have been less than 15 (small) insurance company failures, some of which were taken over by other companies without disruption to policy holders.
Especially in relation to the financial crisis of 2008, life insurance companies were remarkably resilient. Unlike a stock, ETF, mutual fund and the like, life insurance companies in addition to selling annuities also sell, wait for it, life insurance. As a result, they can counterbalance potential losses against what is referred to as “mortality credits”
Conversely a stock issuer may only issue debt to cover its losses.
They Have an Owner
Just as with term life insurance and all life insurance for that matter, there is an Owner. The owner is similar in that they are the one “paying the bill”; in the case of the annuity making the deposits. Also, they have control over both the Annuitant and the Beneficiary which also means…
They Have a Beneficiary
With term life insurance (and final expense insurance) the beneficiary receives the proceeds from the Death Benefit aka the face amount. A beneficiary in an annuity receives the balance of the annuity cash account. Unlike life insurance however the transfer of annuity funds to a beneficiary is subject to taxes.
They (May) Have Living Benefits
Especially with Indexed Annuities, there are some benefits that may be triggered due to certain health conditions. Annuities are increasing becoming the source for Long Term Care (LTC) funding as traditional LTC has become to costly and carriers are leaving the market. In more prevalent cases an indexed annuity may accelerate annuitization in the event that you are confined to a nursing home or similar facility.
Annuities, specifically fixed annuities, are growing in popularity especially with those in or close to retirement. There are many different types that we will address in detail including their customary and possible uses. In general, if you are looking to transfer risk (becoming or are risk averse) and still want accumulation potential, they are worth a look.
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