Demystifying Annuities

As the celebrated baby boom generation rushes headlong into middle age, more and more attention is being paid to accumulation vehicles that can provide financial security during retirement years.  Annuities are one such increasingly popular vehicle.

An annuity is, in its most simplistic form, an insurance policy that pays you back while you’re alive.  As the American population continues to age and realizes that social security and pensions may not be enough, annuities are gaining increased recognition as a funding vehicle for retirement.

Unfortunately, as annuities gain in popularity, so too does their complexity.  Much like adjustable rate mortgages — where what you first see, the initial interest rate — isn’t always what you get — it pays to look at the fine print before plunking your hard-earned money down on an annuity.

Paying for an annuity contract is simple enough:  either through a single premium up front or through smaller periodic premiums during the life of the contract.  Earnings are tax-deferred and payments are made in a lump sum or through installment schedules that range from monthly to yearly.  Sifting through the fine print, though, is not quite as simple.

Rule of thumb #1:

If the initial interest rate looks too good to be true, it probably is. Fixed annuities often offer extremely attractive initial interest rates, then are adjusted to prevailing interest rates.

But did you know that insurance companies can readjust your fixed rate, too?  It only stands to reason that an insurer can’t pay you eight percent while it’s earning less than that on its investments.  Look for an annuity’s guaranteed interest rate.

Some insurers also offer a bailout provision that allows policyowners to terminate their contracts, without incurring costly surrender charges, if the interest rate falls below a stated rate.  The best contracts offer a bailout provision when the surrender value falls below the premium you have paid into the contract.

Rule of thumb #2: 

Look for those hidden extras.  Surrender charges are just one example.  For instance, an annuity with the highest rate may also be non-surrenderable for five or more years.  That means your money, with very few exceptions, is locked in.

Now if you’re absolutely sure that you’ll never need access to your money, that your financial and personal circumstances don’t have a thread of a chance of changing during the next 1,826 days, then you’ll take the higher rate in return for a non-surrenderable clause.  But if you’re like most of us, look our for surrender charges which can leave you with little more than you put into the contract.

Rule of thumb #3:

Your annuity contract is only as good as the insurance company behind it.  Is the issuing company strong and secure? The A.M. Best Company grades insurance companies on reliability and strength. Best’s Reports can be found in most libraries.  Look for a company which has a financial strength rating of at least B+ or higher. It is also a good idea to find out how the company has treated its policyholders in the past. While not a guarantee, a company’s past performance can be a good indicator for how it may perform in the future.

Annuities no longer have to be a mystery.  By asking the right questions, you can find

one that is right for you.