An annuity is a financial contract between an investor, usually someone saving for retirement, and an insurance company. A person, typically the investor, pays an insurance company a sum of money; in turn, the insurance company will, at a later time, make regular payments to the person for a defined period or an indefinite period, usually from retirement until death.
Typical costs:
Insurance companies charge an administrative fee for maintaining the annuity account. Most companies charge a percent of the investment[1] of up to 1% of the total investment. At 1%, that's $100 each year for every $10,000 invested. Some insurance companies charge a flat annual fee of about $20 a year.
A fixed annuity has the least amount of investor involvement. The insurance company agrees to pay a predetermined amount, regardless of how well the annuity's money performs. Depending on whether the annuity does well or not, the insurance company could lose money or make money on the investment.
With a variable annuity, the investor secures a minimum regular payment, but has some say in what accounts money will be invested and the possibility of receiving more. The amount paid to the investor will vary depending on how well the annuity fund performs and the cost-of-living index. The person selling a variable annuity to an investor earns a commission, which can range from 6%-10% of the invested sum. For every $10,000 invested, that's $600-$1,000 taken out in this one-time cost. AARP provides a variable annuities overview[2] .
Both fixed and variable annuities have mortality and expense fees, which range from .25%- 3%, or $25-$300 each year for every $10,000 invested. These fees pay the insurance company for two risks it is taking on: that their annuity holders will live longer than their invested money lasts, and that their annuity will lose money in the accounts.
Insurance companies use money placed in annuities to invest in mutual funds, which have their own set of fees, which can be up to 2%.
Annuities shift the risk involved with saving for retirement from the retiree to an insurance company. Retirees who opt for an annuity have the security of knowing that they'll receive a set sum of money monthly, quarterly or annually, for the remainder of their lives.
Annuities are an option for those not interested in maintaining or updating an investment portfolio on their own, or who fear they may not be as capable of handling an investment portfolio as they age.
An annuity protects an investor against underperforming investments and the risk of outliving their savings. At the same time, that investor loses control over a large sum of his or her savings: like a pension, an annuity doles out a fixed amount regularly; otherwise, the annuity holder can't touch the money without facing stiff penalties.
Additional costs:
Variable annuities offer many options to customize the annuity. Called riders, these options come with fees of their own that can cost as much as 5%. Popular options include a death benefit for a benefactor should the insured die before the annuity account is exhausted and a long-term care benefit to secure care for the insured should they become seriously ill.
Annuities come with the option to withdraw a percentage out of the annuity account, typically about 10%. If the investor wishes to withdraw more than that, they are faced with a surrender charge. This charge is typically about 7% of the sum above the allowed amount.
Shopping for an annuity:
The U.S. Securities and Exchange Commission[3] , which regulates variable annuities and some indexed annuities, recommends thoughtful consideration of each option and benefit and their related costs.
Some employers are switching from defined benefit retirement plans (in which employees are guaranteed a set sum upon retirement) to more predictable and less costly defined contribution retirement plans (in which employees are guaranteed a set sum to be contributed into a retirement plan). In light of this shift and the increasing average age of death, the federal government is exploring ways[4] to encourage annuities as a secure income in retirement.
Some investment advisors, such as The Motley Fool[5] say that annuities are only a good idea for a small group of people. Other investment analysts, such as Morningstar[6] , maintain that annuities are often a good idea.
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