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It’s an Insurance Thing: A Fresh (or First) Look at Annuities

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March 5, 2013
Annuities Renaissance

Where insurance meets investing, there can be a few potholes. New products soothe the sting of costs and offer customization. That means annuities deserve a fresh look.

If you’ve heard of annuities, you fall into one of three categories: you love them, you hate them, or you don’t have the slightest clue as to what the darn things actually do.

Wherever you fall, annuities deserve a thoughtful exploration. Like any financial tool, annuities have their use, especially for investors left rattled by the last few years of volatile stock markets and economic upheavals. They’re not necessarily a silver bullet for every problem, or for every investor. Yet, increasingly, they may have earned a spot in your portfolio, which simply means asking yourself some key questions about financial comfort.

“Most investment products are all about maximizing return, but annuities are doing something different, which is acting as a hedge against market volatility and longevity risk,” says Matt Sadowsky, Director of Annuities at TD Ameritrade. “The primary reason we offer annuities is to help clients hedge the risk of outliving their assets. And once investors remove fear from part of the equation, they are better positioned to make smarter, less emotional decisions with the rest of their portfolio.”

For example, rather than systematically withdrawing from a portfolio at a 4% rate but living in fear of running out of money one day, with an annuity, you can lock in a distribution rate at a potentially higher level and you never have to worry about depleting your portfolio.

What Are They?

Annuities are insurance contracts. You put up a certain amount of money, either all at once or over time, and an insurance company agrees to pay you a minimum amount, or rate of return, for a set period of time. The amount you get paid can be fixed, or can vary, and the term of the annuity can range from a fixed number of years, until long after you die. However, some annuities can be inflexible and expensive or they can be just the thing to level out hot-and-cold investment returns, and keep a minimum amount of cash coming in during your golden years.

Remember this: when you invest in stocks, bonds, and mutual funds, you’re focused on accumulating a nest egg. When you buy an annuity, focus shifts from building up a pile of cash to establishing a foundation of security and certainty, often in the form of a guaranteed payout. Annuities give an individual the opportunity to create their own income stream personal pension plan—so he or she doesn’t have to worry as much about making the nest egg last.

Annuities are typically thought of as: immediate or deferred, fixed or variable. Immediate and deferred refer to when you get your money. Fixed and variable refer to the payout—either a set payment or rate of return, or one that is based on underlying investment performance. Of course, fixed annuities can be immediate or deferred. Same for variables, although they are usually deferred.

Buyers can also add a combination of other optional benefits—ranging from an insurance payout, to a guaranteed return of principal, called a rider. These benefits let you customize an annuity. Of course, each rider can push up the cost.

The Nuts And Bolts

The simplest annuity is perhaps the fixed immediate variety. You fork over a lump sum, and receive a stream of guaranteed payments—either for a number of years, the rest of your life, the rest of your life and your spouse’s life, or a set number of years after you’re gone. The longer the guaranteed period, the lower the payment.

With a variable annuity, the investor either pays a lump sum up front or can continue to add funds, but his money goes into investments, which are held in sub-accounts and act similar to mutual funds. The contributions can grow tax-deferred until you start taking withdrawals, making them similar to a 401(k) or Individual Retirement Account. This allows the investor to enjoy some gains if the investments do well, but also lowers the payout if the sub-accounts lose value. For an extra cost, variable annuities can come with a guaranteed minimum income rider.

Shaking That Rep

The drawback to annuities? Historically, cost, and the fact that your money is more or less locked up. Commissions and annual fees tend to make annuities more expensive than many mutual funds and exchange-traded funds, which is the price you pay for tax deferral and potential guaranteed income or returns. Taking money out of an annuity means you could be hit with “surrender fees” for the first several years. And unless you buy a death or survivor benefit rider, once you die, you can’t necessarily pass on the annuity to heirs.

Taxes also can be an issue. Some income from annuities can be taxed as regular income. You’d potentially pay a lower rate on capital gains or dividends, from a taxable investment account (assuming lower tax rates on gains and dividends remains in effect; consult a tax professional for clarity on current law). The tax treatment of an annuity can also become a burden for heirs.

Annuities certainly have faced their share of negative coverage over the years. For instance, the relatively high costs and lock-up and surrender periods on variable annuities have been criticized compared to mutual funds or other options. And, with a fixed annuity, you also face the risk that inflation will erode the value of your payments over time.

“Not all annuities are created equal. Not all annuities have benefited from cost reductions, not all are introducing new features, and it’s not always true that low cost means good value. So it’s important to sift through and find the best potential products,” Sadowsky says. “TD Ameritrade has done that. We’ve been highly selective in determining which carriers and products are invited onto our annuity platform. We focus on carriers with demonstrable financial strength and require a minimum S&P credit rating of AA- or better. And we require the variable annuities on our platforms to have no surrender charge and be low cost.”

Financial planners generally advise that no more than 30% of assets should go into annuities. Given the plethora of options and the wide range of fees on annuities—as well as the pros and cons of locking up your cash for years to come—it’s best to educate yourself about specific products.

Good Fit?

Find out if an annuity makes sense for you, or if you could save money by switching to TD Ameritrade.

Call 800-417-7423 to chat with an Annuity Specialist

Investors should carefully consider a variable annuity’s risks, charges, limitations, and expenses, as well as the risks, charges, expenses, and investment objectives of the underlying investment options. This and other important information is provided in the product and underlying fund prospectuses. To obtain copies of the prospectuses, contact an annuity specialist at 800-347-7496 or email annuities@tdameritrade.com. Please read them carefully before investing.

The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.

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