If there’s one investment that causes controversy in the investment business, it’s variable annuities. It seems that no one is in the middle on annuities- a lot like our politics today. Some financial advisors love them, because they can offer many choices. Others hate them and think they’re very expensive. So, here are some surprising reasons why people own annuities.
Investopedia defines an annuity as a contract sold by financial institutions. It’s a contract, because an annuity is an insurance contract. If you own a variable annuity, you pay premiums for two products:
- Life insurance, which provides a death benefit
- Investments, which can grow inside the annuity
Say, for example, that you purchase an annuity with a $100,000 investment. Some of those dollars go toward a $75,000 death benefit. The remaining dollars ($25,000) represent value over and above your death benefit. Those dollars can be invested in a variety of investments. In fact, many of the annuity investment choices mirror investment choices in a mutual fund.
Understand the bucket
The best way to understand an annuity is to think about a bucket. As you invest more dollars (more premiums), some the money in the bucket pays for a death benefit ($75,000). Think of those dollars at the bottom of the bucket.
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Eventually, you can pay enough in so that your annuity has more value than just the death benefit. The value above the death benefit is your cash value. In this example, your cash value is $25,000.
Filling up the bucket
In the accumulation phase, you pay premium dollars into the bucket. Those dollars are invested in securities inside your variable annuity. At some point, you can choose to annuitize. Think about cutting a hole in the bucket.
Your insurance company can agree to pay a monthly income to you, based on several factors. Those factors include the amount of money in the bucket, and your life expectancy. This brings us to the first reason to buy an annuity:
#1- The investor wants to earn an income stream for life
It is possible to earn a monthly income for life from the assets in your annuity. The more money you have in the bucket, the higher your monthly income. The insurance company’s risk changes. Instead of the risk of having to pay a death benefit, the insurance company is now on the hook to pay an income stream.
#2- Tax deferral
Your ability to invest on a tax-deferred basis is both becoming more limited each year. An annuity allows you to defer the tax on capital gains, and income from bond interest and stock dividends.
Under certain conditions, you can borrow the cash value in your annuity. Borrowing the cash value allows you to get access to cash without taking out a traditional loan.
The downside: Why investors shy away from annuities
#4- They are expensive
Owning an annuity is expensive, because you paying for insurance coverage and for investment management. Many feel that the costs eat up too much of your potential investment earnings.
#5- Investment value below death benefit
It’s possible that, in a down market, the value of your annuity (the money in your bucket) may fall below the death benefit value on the insurance portion of your contract. You may have to add premiums dollars to maintain the death benefit coverage.
#6- Simply too complicated
The SEC requires securities to be sold by prospectus. The typical prospectus for a variable annuity can be very long. The complexity can be intimidating to a new investor.
The best way to get informed is to find a friend who owns a variable annuity. Why did they buy it? Has it met their expectations? Can they read and understand their statements (a big issue….). Talk with people you know, then look at some variable annuity website. Given the complexity, you may want to speak with a financial advisor.
Have used any of these tools? I’d love to hear from you.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
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