Annuities are contracts issued by an insurance company (or sometimes by a bank) designed to assist soon-to-be-retirees in successfully maximizing their savings to last for the totality of the contract. An annuity contract can be a short-term contract, or it can be set up as a lifetime contract.
Generally, the purchaser makes a lump-sum payment at the start of the contract and the insurance company then invests that money, while in return, the purchaser receives regular disbursements, beginning either immediately (immediate annuities) or at a later point in the contract (deferred annuities).
While there are short-term annuities offered by insurance companies, the most popular annuity contract will provide the purchaser with lifetime income and is known as the lifetime annuity.
When Should You Purchase an Annuity?
Annuities can be powerful financial tools, but the devil is always in the details. One of the most important details to consider when purchasing an annuity is when the best time to purchase the annuity contract is for you. This answer is going to be different for everyone as we all have differing circumstances from each other.
The fact is that you can purchase an annuity at any age, but most advisors recommend purchasing an annuity between the ages of 45 and 55; however, there are numerous factors to consider, starting with the source of the lump-sum payment that the purchaser intends to use for the purchasing of an annuity.
If funds are already located in a retirement plan such as an IRA or 401k, then the best age to begin exploring an annuity is roughly at the age of 59. This is because most retirement plans have early withdrawal fees and are not eligible to be rolled over (reinvesting the proceeds of your retirement plan on a tax-deferred basis) into another investment until the investor turns 59 ½ years of age.
If your funds are not in a retirement account, but rather are liquid (such as funds invested in stocks or in a savings account), then you could begin looking into annuities at the age of 45.
The age you intend to retire must also be factored into your decision. If you intend to work until you are 70, then purchasing a deferred annuity (an annuity which will not begin sending you guaranteed income until a later date) at a young age will allow your funds to grow without you needing to worry about managing the investment yourself.
If your funds are currently in stocks, and you choose to purchase a lifetime deferred annuity at the age of 45, and you did not plan to start receiving income from until the age of 70, your funds would accumulate and build up the cash value of the annuity for 25 years. This is an excellent strategy, but it does not come without its downfalls. The main problem with this strategy is that if you ever needed to access those funds before the accumulation phase was completed, you would be forced to pay a fee which usually amounts to a 10% early withdrawal fee.
What are the Types of Annuities?
Just as the best timing for purchasing an annuity varies depending on your circumstances, choosing what type of annuity is also dependent on you are an individual’s unique circumstances. In other words, an annuity may be perfect for one person but could spell disaster for another person.
Insurance companies offer so many different types of annuities that there is one tailored specifically for your circumstances. But this is not a light decision and will require you to research the details of each contract to make sure you are getting the best bang for your buck. Having the help of a reputable, independent, fiduciary advisor to assist you through the process of choosing an annuity can make the difference between a perfect annuity and a so-so annuity.
As discussed above, annuities can be purchased on a deferred basis (allowing your investment to grow before receiving distributions) or they can be purchased as immediate annuities (there is no accumulation phase, and you begin receiving distributions immediately).
Choosing whether you get a deferred annuity, or an immediate annuity is just the first step of the process. Buyers have three annuity investment strategy options to choose from as well.
An annuity purchaser can choose between the fixed annuity, the indexed annuity or the variable annuity.
The type of annuity you choose is directly tied to the best time to purchase the annuity. Let us examine the differences between the three types of annuities.
A fixed annuity is often considered to be the safest type of annuity. These annuity contracts promise to pay the buyer a specific, guaranteed interest rate on the lump sum payment you make. It is advantageous to consider this type of annuity as it eliminates the element of surprise and offers predictable investment returns.
Fixed annuities usually are invested primarily in high-quality corporate and government bonds. These types of annuities allow the investor to avoid the variable ups and downs of the stock market. The insurance company pays you the annual rate promised at the contract signing and the investor has piece of mind that his investment is secure.
A variable annuity is an annuity which the value of the investment varies based on the performance of an underlying portfolio of sub accounts and/or mutual funds.
Variable annuities differ from fixed annuities in that fixed annuities offer a specific and guaranteed return while variable annuities have a variable rate of return. These types of annuities offer the possibility of higher tax-deferred returns and greater income; however, there is also a risk that the account could drop in value.
Variable annuities allow investors to benefit from rising markets by choosing from a menu of mutual funds offered by the insurer. When the markets are rising in value, having a variable annuity can be highly lucrative. When the markets are falling, the buyer is exposed to market risk which can result in losses to your principal investment.
Indexed annuities differ from fixed annuities and variable annuities and are often described as the best of both worlds. These types of annuities pay an interest rate which is based on the performance of a specified market index such as the S&P 500.
Indexed annuities offer the purchaser the opportunity to earn higher yields than fixed annuities when the markets perform well, while they usually provide protection against market declines.
The insurance company is able to offer higher yields when the index performs well and protection against market losses by setting limits on the potential gains at a certain percentage, which is referred to as the participation rate. The higher the participation rate is set to, the more gains you will receive when the indexed fund is performing well. An 80% participation rate or higher is usually the minimum amount the purchaser should aim for.
Some indexed annuities have a fluctuating participation rate which can change throughout the duration of your contract. A common strategy insurance companies use with indexed annuities is that the participation rate can be as high as 100% for the first year or two of your annuity, and then the rate begins to adjust downward in the latter years of the indexed annuity’s lifetime.
If you are shopping for an indexed annuity, it is crucial to understand what the participation rate is and if it will change throughout the term of your annuity.
When is the Best Time to Purchase an Annuity?
Unfortunately, there are so many variables to consider when purchasing an annuity that there is no simple answer to this question. What is right for one investor can be detrimental to another investor.
Your age, the source of your funds, when you plan to retire, when you want to start receiving guaranteed income and the type of annuity you choose will all factor into your decision of when the best time to purchase an annuity will be for you.