Annuities Explained (In Plain English)
January 4, 2018 by Bob MacDonald
It may not seem this way, but fixed annuities are actually simple and easy to understand. And they can play an important role in an individual’s financial planning, especially when it comes to retirement. What makes fixed annuities appear complicated and confusing is that insurance companies have mucked them up by adding all types of byzantine indexes, options and riders.
Why would insurance companies do this? Well, annuities are not very sexy, especially when compared to different investment options, so, in an effort to compete against investments, insurance companies dress up annuities to look like investments in drag. But, no matter how annuities may be cloaked with the aspects of investments, they are not investments. Trying to make annuities look like something they are not simply results in complication, confusion and consternation.
In truth, the core strength and value of an annuity is the safety of the funds that emanates from the guarantees that only an annuity can promise. When it comes to the safety of your funds — especially in retirement — the mundane, humdrum nature of annuities can serve as a counterbalance to the excitement and risk of investments.
So, what is an annuity and what role can it play in your retirement planning?
An annuity is a long-term agreement (contract) between you and an insurance company that allows you accumulate funds on a tax-deferred basis for later payout in the form of a guaranteed income that you cannot outlive.
For its part, the insurance company guarantees that the funds you deposit will be safe; they are obligated to credit at least a minimum amount of interest to the funds and to assume the risk that once you elect to start receiving income, the payments will last as long as you live. Your part of the agreement is to put up the funds and leave them to accumulate in the annuity until such time as you elect to receive a guaranteed income.
When considering the purchase of an annuity, don’t be distracted away from its simplicity. Insurance companies will offer a cascade of options and riders that may be of some value, but they often only make the annuity more convoluted and confusing. There are two reasons why insurance companies are motivated to offer these add-ons: They want to divert as much of your available funds as they can away from investments, and they want to enhance their profits by increasing the fees and expenses they collect from you.
The most effective way to shop for and consider the purchase of an annuity is to demand a clear explanation of the basic value, benefits, fees and guarantees of the contract. Once that has been determined, you will be better able to assess the cost and value of proposed options or riders.
What is the value of annuities in a retirement plan?
When you think about building your retirement plan, think of it as similar to building your dream home. The plan needs to be well thought out, solid and strong because it is going to have to last for the rest of your life.
The first step in building a dream home is to make sure that it has a sturdy foundation that will support the house. There is nothing sexy about a home’s foundation, and when your friends visit, they may compliment you on how lovely your dream home is, but chances are they won’t comment on the quality of the foundation. But you know that, without a strong foundation, the house is not going to look very good for very long.
Annuities are intended — and, indeed, structured — to be a rock-solid foundation for your dream retirement plan. Without the solid underpinning of the security, guarantees and income that an annuity can provide, any retirement plan is susceptible instability.
So, don’t fall prey to those who tell you that annuities have no place in your retirement plan. Likewise, don’t be taken in by those who try to present annuities as more than a foundation for your retirement needs, because doing so simply makes annuities complicated and confusing.
