An annuity is a contract between an insurer and an annuitant whereby the annuitant makes a payment or series of payments in exchange for a lifetime payout. It is difficult to give advice about annuities in general, because there are several different types with significantly different permutations. Some annuities are immediate; others are deferred. Some operate with declared interest rates while others offer the variable returns of a mutual fund environment. Depending on your situation, an annuity may work well for you. Here are some things to consider before purchasing annuities:
1) The time left in your accumulation phase
Deferred annuities work best when you have at least 15 years for the accumulation to take place. Some people take annuities late and the compounding principle cannot properly offset the trade-off of owning an annuity. If you have 15 years or less to the time of your retirement, you may want to consider other options. You would always have the option of taking an immediate annuity later. Those would offer tax-free returns and above-average payout rates.
2) Liquidity risk
Before deciding how much to invest in annuities, consider that annuities have a higher liquidity risk as a long-term investment. This means that annuities generally lock in your investment for long periods with surrender penalties. Some annuities today may offer a penalty-free withdrawal provision with limits set. However, this provision goes against the premise of saving for retirement. It is best to be prudent. Do not stretch your income too much to finance your annuity.
3) The type of investment
Some annuities offer steady growth or evenly distributed payouts. Others operate with fluctuating returns. This applies to both immediate and deferred annuities. It is important to consider the potential returns and have a clear idea of the insurer’s performance in investing as well. Deferred annuities offer minimum guaranteed interest rates for worst-case scenarios. These should be considered as well before purchase.
4) Clauses that may be included in the policy contract
Some deferred annuities have anti-annuitant clauses that do not offer flexibility. I know of an annuity that would use your cash value to purchase a reduced paid-up annuity on non-payment of the premium. Ask about the stipulations regarding non-payment of premiums and flexibility of deposits when considering an annuity.
5) Whether you wish to leave an estate
This is a major consideration when it comes to immediate annuities. Immediate annuities are designed for those who do not wish to leave the sum invested to their estate. If you wish to leave an estate, immediate annuities should be approached carefully.
6) Tax structure
Tax deferral is a major benefit of investing in annuities. However, you need to realise that your payout would be taxed after maturity. If your payout is likely to increase your chargeable income by a lot in retirement, you may have to reconsider investing too much in a registered annuity. It may be better to develop an accumulated lump sum and invest in an immediate annuity where proceeds are tax-free.
7) Unregistered annuities versus registered annuities
Some annuities are really savings plans that happen to be registered with insurers. These plans are unregistered annuities. Typically, they offer no tax breaks and lower returns or interest rates. They are best for short to medium-term needs or accumulating a tax-free lumpsum at retirement.
Annuities may be somewhat complex and may not be easily understood by persons outside of the financial services industries. You do not need to become an expert on annuities to select one properly. All you need to do is ask the right questions and understand how your selection would impact you in the future.