By: Prasanth S
Annuity – derived from the Latin word ‘annus’ – is basically an investment vehicle, quite similar to the Certificate of Deposits offered by banks. An insurance product sold by insurance companies through authorized agents, this type of investment facilitates a series of payments in the future, in a defined manner, in exchange for an up-front payment of money.
Here is the way annuities work: You, the customer, makes an up-front payment or a series of payments and the money deposited will grow in a fixed or variable rate, tax-deferred, during the accumulation phase. The insurance company – in return for your payment – agrees to pay you periodically for the rest of your life. This phase of pay back to the customer is called the payout or annuitization phase. Annuity also comes with a death benefit (insurance part), which entitles the beneficiary of the customer to the value of the annuity or a guaranteed minimum, which ever is more.
Annuities are classified into Immediate Annuity and Deferred Annuity. In common man's lexicon, the term 'annuity', if not specified, traditionally refers to Immediate Annuity only.
Immediate Annuity can be equated to an insurance policy that makes a series of increasing or level periodic payments to the customer, for a fixed number of years or until his/her death. Further, there is a variant of immediate annuity called Lifetime immediate annuity that offers an income for the lifetime of the annuitant. It is also called Pension.
Deferred Annuities are subgrouped into Fixed Annuity and Variable Annuity. In fixed annuities, a sum of money is paid to the insurance company and they in turn offer a guaranteed rate of return over the life of the agreement or the lifetime of the investor. On the other hand, in variable annuities, the money is deposited in separate accounts like mutual funds in a tax deferred manner. Here, the return on the deposit is not fixed, but variable according to the performance of the funds; you may watch your deposits reaping substantial gains at times or invariably plummeting to an all time low, depending upon the performance variations of the funds. Also, the fees are at a higher end with variable annuities.
But there are certain stringent rules and regulations governing the deposit that may not be customer friendly. One suggests that the customer cannot withdraw the money until he turns 59.5 years. Else he/she will be charged a 10% penalty for drawing the money prematurely.
Another draw back with annuities is that the earnings on annuities are taxable as income instead of being at a long-term capital gains rate. Also, the death benefit – mentioned earlier - cannot be called a benefit in its true sense. The customer is charged 1% annually for it and it pays off only when the customer dies and the account falling below the minimum guarantee mark.
So, who should be investing in annuities or why people should consider an investment option in annuities??
Honestly, one should not be thinking of annuities unless he/she is already contributing his/her maximum to other retirement schemes. Most retirement schemes give the same tax deferral on deposits and that with the expense of the fees charged in annuities. Also, the early-withdrawal fine and surrender fees make annuity an unsuitable option for short term saving.
Hence, if there is an annuity buyer, he/she must be the one who is currently making maximum contributions to other retirement schemes, who can survive without any monetary benefit from this until he/she is 59.5 years, and who falls within at least the 25% tax bracket in order to take advantage of the tax recess. For others, annuities should be the last option.
Prasanth S
Freelance Writer
prasanths@inbox.com
