Annuities Guide

1. What's an Annuity?
Simply put, an annuity is a retirement account with air bags. You invest one or more lump sums and in exchange you're guaranteed a steady monthly check for a set number of years or for life.

Issued only by insurance companies and sold by insurers, brokerages and mutual fund companies, annuities come in a range of flavors. All are marketed as investments that provide peace of mind during a period of life when fulltime work tends to slow and fears about outliving savings rise.

Annuities tend to be purchased by people under age 40, people nearing retirement age, and by professionals who use them for asset-protection purposes. But high expenses and fees can erode an annuity's performance and value-making careful shopping and comparisons with other investments essential. For instance, for some retirement-savers, a Roth IRA might be shrewder than an annuity.

The amount you will receive monthly from an annuity depends on the type of annuity you select, how much you invest, how your investment performs prior to retirement, and the features you add on-such as choosing to have your spouse continue to receive payments if you die first.

Annuity payments are subject to income taxes. Withdrawals made before age 59 ½ are subject to taxes and a 10% penalty.

There are two broad types of annuities:

• Immediate annuity -You invest a lump sum, and the insurance company starts making regular monthly payments to you right away. You decide in advance whether the amount of your monthly check will be fixed over the life of the contract or will fluctuate ("variable") based on the performance of the investments you select.
• Deferred annuity-You invest one or more sums with the insurance company years before your retirement date. During these years, your investments have a chance to grow, tax-deferred.

When you reach retirement age (over age 59 ½), the amount of your monthly checks will depend on the total size of your annuity portfolio.

There are three different types of deferred annuities-each with trade-offs and risks:

• Fixed deferred annuity -Your lump sum investments are placed in a low-risk asset portfolio and earn a guaranteed annual rate of return until retirement.
• Variable-deferred annuity -You invest in stock and bond funds offered by the insurance company. At retirement, your account can be worth more or less than your initial investment.
• Equity-indexed annuity -Your investment mirrors the performance of a broad stock index, such as the S&P 500. The insurance company protects against market declines by guaranteeing a minimum return on your investment.

2. Do You Need an Annuity?
Annuities sure sound like a great retirement-savings deal: Unlike a 401(k), IRA or SEP, you can contribute as much as you wish; your investment grows on a tax-deferred basis; and you can rest easy knowing you'll receive monthly payments for the duration of your contract.

But annuities may not be ideal if you already have assets saved that can produce enough income for you and your spouse during retirement.

Consider an immediate annuity if:

• You are near retirement age.
• You haven't saved enough in your retirement plans to provide sufficient income.
• You need steady retirement income in addition to social security payments and your other investments.
• You worry about outliving your savings.
• You have no family to support you if your savings run out.
• You want your spouse to continue receiving steady income if you die first.

Consider a deferred annuity if:

• You are under age 40. Investments in securities historically require 15 to 20 years to achieve a rate of return that exceeds low-risk investments.
• You are a likely target for litigation by former clients, creditors or a divorcing spouse. Doctors, lawyers and now even financial and real estate professionals are at risk. In most states, annuities cannot be attached in third-party claims against your assets.
• You want to swap out of a lousy annuity or poorly performing universal life insurance policy. Through what's known as a "1035 exchange," the IRS allows you to transfer the cash value of one insurance product to another without triggering taxes. The cash will still have a chance to grow tax-deferred, and the losses you suffered in the insurance policy can be used to offset the annuity's gains for tax purposes upon withdrawal.

Before you invest in any type of annuity, consider the drawbacks:

• Fees charged by insurance companies on can be relatively high, boosting the odds of reduced returns on annuity funds over time.
• Calculations used by insurance companies to determine rates of returns on some investments can be complex and suppress long-term earnings.
• Returns on an annuity investment over time might have been higher if assets had been invested in non-annuity mutual funds.
• Cashing in an annuity to withdraw your invested assets can be costly in terms of surrender charges.
• Rules of some annuities can cause part or all of your investment to be forfeited if you die.
• Sales pitches may sound good, but they still need to be carefully evaluated. For example, many insurance companies encourage you to roll your IRA into an annuity. But annual annuity fees can range as high as 3%, which is much higher than other long-term investment vehicles like mutual funds in an IRA or 401k, and your rate of return could be lower than expected.
• Inflation can undercut the value of a fixed monthly payment for life, especially after income taxes are paid.

3. Choosing an Annuity
There are tradeoffs with any annuity. An immediate-fixed annuity offers comfort but no real inflation protection. An immediate-variable and deferred annuity comes with market risk. And in both cases, steep fees and sub-par performance also are risks.

If an annuity makes sense for your needs, here's what you need to consider when narrowing your choice:

• Calculate the payout. How much monthly income are you likely to receive based on the sum you plan to invest? You can find a good calculator here.
• Check the strength. Buy annuities only from financially strong insurance companies. Check their ratings at A.M. Best or Fitch Ratings.
• Verify returns. Look carefully at how an annuity's investment returns are calculated. The returns on funds offered by insurance companies tend to be lower than equivalent open-end mutual funds due to higher fees and expenses.
• Add up the expenses. Find out exactly what you'll be charged in expenses, commissions and fees. Stick with variable annuities that charge no more than 2%.
• Explore the death benefit. What will your spouse receive if you die before deferred-annuity payments are due to begin? Consider an extra fee to boost the annuity's death benefit.
• Size up surrender fees. What will you be charged if you choose to cancel the annuity and withdraw your savings? Some annuities charge a penalty of 6% or 7% in the first seven years. In addition, your gains will be taxed as income, and you'll face a 10% penalty if you're under age 59 ½ at the time of withdrawal.
• Consider low-fee annuities. Variable annuities offered by major mutual fund companies like Vanguard, Fidelity and T. Rowe Price tend to charge lower fees-around 2%.

4. Grilling Guide: Questions to Ask Your Insurance Company
What's the financial health of the insurance company offering the annuity?
Each rating service defines its financial-strength ratings online. For example, at A.M. Best, ratings above B+ are considered "secure."

What are your spousal benefit options?
Before investing, ask for an annuity's complete list of spousal benefit options to compare what the feature will cost and how the benefit will be affected.

What are the total charges and annual fees?
Many variable annuities charge a contract fee ranging between $30 and $35 as well as annual expense calculated as a percentage of assets invested. According to Morningstar, the average is 2.44%.

What happens if I die after buying an annuity?
Under the terms of many annuities, your investment may be forfeited to the insurance company or considerably reduced unless you've added a feature that protects its value for your spouse or beneficiary.

What are the surrender fees?
Ask what you'll be charged to cash in your annuity and how the penalty fee declines over time.

Will I pay a penalty for withdrawing a lump sum in retirement?
Some variable annuities will penalize you for pulling all of your assets out in retirement.