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How To Understand Variable Rate Annuities
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Business New Haven
11/22/1999
By: Susan Banfield
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Annuities are an investment product offered by insurance companies and intended principally as a retirement vehicle. As such, annuities offer handsome tax-deferment benefits, the possibility of a guaranteed retirement income, and certain estate planning benefits.
Annuities have had a bad rap of late, but that is principally because some investors have wanted to use them for purposes other than retirement. In doing so they have found that some features of the product, such as high management costs or the impossibility of retrieving your principle after a decision to annuitize, were no longer outweighed by benefits.
Recent changes to annuities have made them a more attractive investment option for a variety of purposes, and further enhanced their benefits as a retirement vehicle.
There are two types of annuities: fixed and variable. A fixed annuity is much like a bank CD. There is a guarantee of the principal. There is also a fixed rate of interest for a defined period. Most fixed annuities are one-year renewable investments, but others allow the customer to lock in a rate for five or even ten years.
The difference between a fixed annuity and a CD is that you have to pay taxes on the interest earned on a CD. With an annuity, you don't pay taxes until you take money out of the annuity. As with an IRA, the government has established that, in order to earn this benefit, the money must be left in until you are 59 1/2. If you withdraw it sooner, just as with an IRA, you are subject to a penalty - in this case an additional ten-percent excise tax.
With variable-rate annuities, there is no guarantee of principal, or a rate guarantee. Instead, your money may be invested in any of a number of funds, with the rate subject to fluctuations in the market. Just as with fixed annuities, the interest earned is not taxable.
You can also sell your investment in one fund and invest the money in another without tax consequences. The latter helps to explain why annuities became popular for purposes other than retirement: they offered a way to participate in the stock market and not be subject to capital gains and other taxes.
Variable annuities allow investors to name a beneficiary (or beneficiaries) who will receive what is in your fund should you die before you reach retirement. Annuities have the attractive advantage, similar to life insurance, of allowing the money to pass to the beneficiary without having to go through probate. Many variable annuities also have a death benefit, which guarantees that your named beneficiary will receive the amount you initially put into the fund, even if the market has since fallen 20 percent. These, of course, have higher administrative costs than regular annuities.
The retirement benefits of annuities are considerable. The first is that, unlike IRAs or 401(k)s, they allow you to salt away an unlimited amount of money toward retirement. This makes annuities especially attractive for people who want to save a lot of money during the last decade or so of their working life.
Another important benefit of annuities is that they offer the possibility of a fixed income for the rest of your life. When you hit retirement age, you annuitize your contract. This means that you give the company the base of the investment, and in return you receive a guaranteed monthly check for life. In essence, you surrender ownership of the principal in exchange for the monthly guarantee.
The situation is rather like a wager: If you live a long time, you win (as the company ends up paying out more than the amount of your base); if you die young, the company wins (as it gets to keep the unused portion of your principal).
Lately, companies have made changes to annuities that have made them more attractive to people looking for other than retirement benefits. One of the chief drawbacks to variable-rate annuities has been what are called mortality and administrative expense (M&E) charges. These can range from 90 to 160 basis points (with 100 basis points equaling one percent). While these are largely offset by the benefits accrued following retirement, they are a deterrent to investors with other purposes. Recently, however, companies have made an effort to offer products with lower M&E charges.
Annuities also have what is called a “surrender” period during which, if you withdraw your money, you surrender money to the company to cover their expense. Typically, the surrender period was as long as five to nine years - inconsequential to people who intended to leave their money in the fund until retirement. Now, however, some annuities have no surrender period. (They do, however, have higher management fees.)
Another drawback to annuities has been the fact that you forfeited ownership of your principal once you annuitized your fund. For people who prefer to reserve the option to collect the principal even after retirement, newer annuities allow you to make a systematic monthly withdrawal and retain the option to withdraw the capital. There is, however, no guarantee as there is with a standard annuity.
If annuities seem like an attractive investment option for you, speak to a qualified person in order to purchase one. Anyone who sells annuities - fixed or variable - must be a licensed insurance agent. In addition, to sell variable annuities one must also be a licensed stockbroker. Individuals qualified to distribute annuities are found at banks and financial-planning firms.
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