Do You Need an Annuity?

Certain kinds of annuities grew in popularity amid the bear market and the relatively low-interest-rate environment that prevailed earlier in the decade. However, those considering an annuity should be sure to read up on these investments before buying in.

Annuities--which are part insurance policy and part investment product--often seem like some of the most complicated and intimidating financial instruments around. Sometimes, they resemble IRAs or other savings accounts, and other times they resemble pensions that generate income streams. In this article, we'll try to reduce the intimidation factor by reviewing the basic kinds of annuities and discuss when they do--and don't--make sense as part of your investment plan.

The Basics
An annuity is a contract with an insurance company. Usually, you pay premiums into a policy for the purpose of accumulating savings when you're younger and then have the company pay the savings back to you in a stream of income at retirement, making for a kind of self-funded pension. There are often mutual funds (typically called subaccounts) inside this policy. That's about it.

Here's where it starts to get a little complicated, though. There are two key types of annuity: deferred and immediate. Deferred annuities are also called savings annuities, because they help you save for retirement. Immediate annuities are also called income annuities, because they kick your money back to you in a steady stream of income in your golden years.

Deferred Annuity: What Is It?
As we've mentioned, a deferred annuity is what you'd use for savings or accumulating assets. It's a tax-deferred account and functions sort of like a Roth IRA except you can usually put as much money into it as you want. You can't take money out of it without penalty before you're 59 1/2 years old, but you don't have to start taking withdrawals until age 70 1/2. Also, you don't get any tax deductions for contributions to it, as you do with a Traditional IRA or a 401(k). Because the annuity has an insurance component (which is why the IRS allows you to dump a lot of money into it and have it grow on a tax-deferred basis), your heirs or beneficiaries are often guaranteed to receive what you've invested in the instrument, regardless of how the investments have performed. Deferred annuities can be fixed--meaning that you're guaranteed a fixed rate of return and have principal protection--or variable--meaning that you have a variety mutual funds at your disposal that will fluctuate in value.

How Should You Use It?
There's no better way to grow a nest egg than with tax-deferred savings. However, there are currently ample ways for investors to save on a tax-sheltered basis without annuities. For example, most people have 401(k) plans at work or can start self-employed retirement savings plans if they run their own businesses. Additionally, money can be socked into an IRA.

Only after you've fully exploited these other tax-advantaged options should you consider a deferred annuity. The reason for this is that annuities have an additional expense, called a mortality and expense charge, associated with their insurance components. That expense can gnaw away at the returns you earn. Also, annuities typically have limited investment options (the mutual funds or subaccounts in the contract), sometimes making it difficult to build a fully diversified portfolio. If you're maxing out all your tax-deferred options and want to contribute to an annuity as well, make sure you choose one that has a mortality and expense charge of no more than 0.50% and has a good variety of low-cost stock and bond options. Finally, make sure you choose an annuity without "surrender charges," so you can exit in case of an emergency without additional penalty if you need to cancel the contract before you're 59 1/2. (Tapping an annuity before you hit that age is never a good idea, though, because you'll owe a 10% penalty in addition to taxes on the gains you've made.)

We'd also urge most investors to steer clear of fixed deferred annuities, which guarantee your principal but don't offer much of a return. Also, fixed deferred annuities can often use teaser rates to lock up investors when money markets have paltry yields. Although these teaser rates often have a floor below which they won't go in subsequent years, they often disappoint annuity owners when money market rates recover and annuity rates reset at their original or even lower levels. Even if we set this problem aside, chances are you don't want long-term money locked up in a money-market-like instrument anyway.

Immediate Annuity: What Is It?
An immediate annuity is a stream of income that an insurance company begins returning to you immediately from a slice of your own money. That money could be in a deferred annuity to begin with, or it could come from another source. If it comes from a deferred annuity, the process of switching from savings mode to distribution mode and having the insurance company start paying you out is called "annuitization." In any case, an advantage of this annuity is that the insurance company sends you checks regularly (just like a pension) for as long as you live. In other words, you can't outlive your money. That sounds like a raw deal for the insurance company, but if you should die soon, they often get to keep the money. So, this can be an especially appealing option if you're in good health and have a family history of longevity.

In addition to receiving payment for the rest of your life, you can also choose to have the immediate annuity's payments made over two lifetimes--yours and your spouse's or even yours and your child's. This, of course, cuts the amount of each payout. Moreover, you can choose to have a "term-certain" feature, which gives your heirs access to the capital--or what remains of it after each payment--for 10 or 20 years in some cases.

As with deferred annuities, you must choose whether you want a fixed immediate annuity or a variable annuity.

How Should You Use It?
Putting part of a nest egg into an immediate annuity can make sense for many investors. You're basically depleting your investment over a certain period of time though, even though the payments continue, so you probably don't want to put all your money in this kind of investment. If you need to make a large, unexpected purchase, such as a car, or finance a major house repair, you may be in trouble if all your assets are tied up in the annuity. Those who use immediate annuities typically put up to one third of their assets in one.

Another way to think of how much you should invest is to consider what it will take to cover  your necessary expenses in retirement. If you're lucky enough to have saved a sum of money where some part up to, say, half will cover your necessities, then using an immediate annuity for that purpose may make sense.

Most couples will choose to do a joint annuity, which will pay income over two lifetimes. If you're single, consider adding a child, though that could cut the payments significantly.

Just as a variable deferred annuity makes more sense than a fixed deferred annuity in most cases, when it comes to immediate annuities a fixed option is usually the better bet. It's true that a variable immediate annuity can help you combat inflation by allowing you to invest your lump sum in mutual funds. However, that will make your payments fluctuate in line with market movements, and it will also involve fees. Although some of the better variable immediate annuities have eliminated fees charged over and above the expense ratios of the underlying funds, most investors prefer to have their annuity payment stay stable. According to recent quotes we've received, a 65-year-old man can receive roughly $650 dollars per month by funding a fixed immediate annuity with $100,000. Part of that return is interest, and part is principle. If you keep a hefty portion of your assets out of the annuity, you can use that to invest in some stocks or stock funds and potentially combat inflation more effectively. Also, fixed immediate annuities now have inflation-protection features, which we recommend.A version of this article appeared on Morningstar.com on Jan. 30, 2007.