How Does an Annuity Work: Debunking the Myths

Is an annuity a good idea?
Is an annuity a good idea?

Annuities are often misunderstood, and the resources for defining them can be overwhelming. AARP found that half of surveyed workers described themselves as not too or  not at all familiar with lifetime annuities.

“Annuities have a bad reputation among some people — but not necessarily a well-deserved one,” says TIAA CREF in a recent advice post.

An annuity, or insurance product that pays out income, allows you to make an investment in the annuity and then makes payments to you — giving you a dependable income stream during retirement.

Here are 5 common annuity myths and the truths behind them:

1. Myth: Annuities are too confusing.

“I think a lot of people don’t appreciate the flexibility annuities can have or the cost of variable annuities,” says Spencer Hall, managing partner with Retirement Planning Services, LLC.

“The range of annuities available is so broad that a comprehensive list can easily make a client’s eyes glaze over,” Merrill Lynch says.

However, annuities can play a key role in providing an income stream in retirement once you understand that there are different types of annuities that offer different benefits—depending on the type you choose.

“The truth is, even though the mathematics behind an annuity may seem complicated, as a concept, annuities are not rocket science,” says Kerry Soudan, a financial advisor with TREW Financial & Benefits Group, Inc., with sites nationwide, including the Chicagoland area. “You give money to an insurance company and in return they give you a guarantee, such as a guaranteed interest rate, a guaranteed income for a specified period of time, or even guaranteed income for life.”

When you buy an annuity you are buying monthly income and there are a lot of additional riders you can add to that basic contract.  The basic idea of an annuity is not so confusing, but the options you have for tailoring the annuity to your specific needs can begin to get complicated.

However, if you take the time to understand each rider, then you can keep the annuity education process relatively simple and straightforward.

2. Myth: The insurance companies always keep the remaining money once you die.

One of the riders that you can add to a basic annuity contract is premium protection.  Premium protection guarantees that you will receive back at least as much money as you originally invested.

Furthermore, variable annuities have a death benefit, which protects consumers.

If you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount – typically at least the amount of your purchase payments, according to the U.S. Securities and Exchange Commission (SEC). Your beneficiary will get a benefit from this feature if, at the time of your death, your account value is less than the guaranteed amount.

For example, “You own a variable annuity that offers a death benefit equal to the greater of account value or total purchase payments minus withdrawals,” explains the SEC. “You have made purchase payments totaling $50,000. In addition, you have withdrawn $5,000 from your account. Because of these withdrawals and investment losses, your account value is currently $40,000. If you die, your designated beneficiary will receive $45,000 (the $50,000 in purchase payments you put in minus $5,000 in withdrawals).”

In addition, some variable annuities allow you to choose a “stepped-up” death benefit. Under this feature, your guaranteed minimum death benefit may be based on a greater amount than purchase payments minus withdrawals.

“The truth is, today’s annuities offer options that let your beneficiary receive any remaining value in your contract,” Soudan says.

3. Myth: Every annuity is a variable annuity

There are many different types of annuities.  The two main types of annuities are fixed and variable.

Fixed: Fixed annuities guarantee a certain base of income per month.  The amount of income you receive every month from a fixed annuity is exactly the same no matter what.

Variable: The amount of income you receive from a variable annuity can depend on underlying investments.  So if the investments behind the annuity are doing well one month, you would receive more money that month than you would when the investments behind the annuity are doing poorly.

Variable annuities are more widely held than fixed annuities (75% vs. 25%), according to the 2013  Gallup Survey of Owners of Individual Annuity Contracts.

Because variable annuities allow you to receive periodic payments, offer the death benefit, and are tax-deferred, it has become a popular product, the SEC says.

4. Myth: All annuities have high fees

The fourth misconception is that annuities will pull a fast one on your investment financials, industry experts say.

“There’s a lot that’s made in the financial press that really position variable annuities and other kinds of annuities as being very expensive in terms of the costs,” Hall says. “There are some annuities that may be very high in costs — they can be quite expensive. But, there are other platforms that have focused on reducing the fees significantly and they just charge a flat fee.”

The fact that interest or earnings on individual annuities are not taxed until they are distributed is a strong motivation for saving for retirement through an individual annuity, data show. In fact, almost nine in 10 of Gallup survey respondents cite the tax treatment of individual annuities as important to their savings decision.

Ultimately, it’s always important to meet with a financial planner to make sure you fully understand the product and type of investment you are making, experts agree.

“The truth is, while fees may seem higher when compared to other products, annuities provide a valuable combination of benefits that those other products can’t provide,” Soudan says. “Things like principal protection from market loss along with guaranteed income for life with flexibility and opportunities for increases…The insurance company uses these fees to help support the guarantees made to you. For a lot of people, that’s a fair tradeoff.”

5. Myth: Annuities have hidden expenses.

Unlike many other investments, the fees are pretty transparent on annuities.

“The truth is, any charges, fees and expenses associated with annuities are not hidden away from view,” Soudan says. “Every annuity comes with documents for you to review such as the Contract and Prospectus, or the Statement of Understanding that outline any charges, fees, and expenses.”

Furthermore, the fees and interest rates are usually determined by the types of riders you choose for your annuity investment so not only are they not hidden, but you have a degree of control over those fees.

NewRetirement Planner

Do it yourself retirement planning: easy, comprehensive, reliable

NewRetirement Planner

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