Annuity is a contract offered by an insurer that is to pay investor money during or after the retirement age. The contract is concluded between an insurance company and the beneficiary. An individual contributes lump sum or periodic payments to the insurance company, which later pays the beneficiary the sum invested including the interests accrued either in lump sum amounts or periodically.
The payment to the beneficiary may be a lump sum or periodic depending on the initial contract agreement between the investor and the insurer. According to Shapiro & Streiff, 26 annuities typically offer tax-deferred growth of earnings and may include death benefit that will pay one’s beneficiary specified minimum amount such as the total purchase payments.
While tax is deferred on earnings growth, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, and not capital gains rates (Shapiro and Streiff 86). Essentially, it is during the withdrawal the savings are taxed. The essay critically evaluates the advantages as well as disadvantages of various types of annuities. This is very important since it guides a person to make rational decision when choosing the company to invest in.
Different authors have different categories of annuities. According to Shapiro and Streiff, the annuity is classified as fixed, indexed and variable (156), whereas according to Williamson, the types of annuities are level increasing and investment linked (15). Generally, there are two broad categories of annuity, namely, deferred and immediate.
This is the annuity when an investor deposits money to the insurer over an agreed period. The savings thereafter is ‘annuitized’ meaning that an investor will withdraw the saving over a long period (Shapiro and Streiff 186)
This is the type of annuity according to which an investor invests a lump amount of money in a life insurance company, and in return, the first receives monthly payments. This type of annuity has a higher interest rate as compared to deferred annuity.
This is the annuity which interest rate is fixed. In the contract, the interest rate with which the money will gain interest is specified. Alternatively, the payments may be made in an increasing trend but with a fixed rate (Williamson 122).
Advantages of Fixed Annuities
There is deferral of tax till the time of withdrawal. This annuity has high interests rate as compared to other annuities and money markets. Deferred fixed annuity allows long term investment which is essential for retirement.
Disadvantages of Fixed Annuities
There is 10% penalty per case if an investor withdraws the income before the set age of 59.5 years. The income is taxed based on the market values which essentially may give a minimum gain or even no outcome at all. The premium is deposited once, and in case of any deposits, a new contract has to be made.
This is the annuity where payments are made based on the market trends. The insurer does not indicate a fixed interest rate on the contract but rather leaves it to be determined by the market forces.
Advantages of Variable Annuity
Whenever market prices go up, an investor is able to make profits since the payments are subject to the determination of the market forces.
Disadvantages of Variable Annuity
As suggested by Williamson (68), there is the IRS which allows 10% penalty per case if an investor chooses to withdraw the money before the age of 59.5 years. There is the issue of a penalty in the event that withdrawal exceeds the annual allowance. Earnings will be less in such a case as the investments are withdrawn before the agreed time as it was set in the contract. There is a risk of losses caused due to the payments being determined by the market forces. Essentially, this is eminent when market prices fall to a level that is too low.
It is worth mentioning here that indexed annuity is the type according to which the investor pays his/her contributions in regard with specific index performance. “Issuers of index annuities always specify the level at which index annuity owners will be “in the market” (Horowitz 173). This level is called the participation rate, and reflects how closely the annuity follows the index’s performance (Shapiro & Streiff, 86). This kind of annuity prevents investors from market losses.
Advantages of Indexed Annuity
There is a minimum guarantee rate regardless of the market drops. There is always a baseline rate of 1-3%. There is as well low risk of losing savings since the contract is based on the market indexes. This contract is essential for retirement since it is to protect during the period when market forces are unfriendly. The annual rate of returns is variable.
This is because the index markets determine the amounts of returns one will get. Another advantage is that they are available for short, medium or long term investors. This essentially means that this diversity can satisfy a variety of customers. There is also the privilege of investing as much sum of money as one may want without any limitations. In case of deaths, the beneficiary can be easily transferred to the dependants without much complication (Cannon and Tonks 34).
Disadvantages of Indexed Annuity
According Williamson (212), there is the IRS which allows 10% penalty in the event that an investor chooses to withdraw the money before the age of 59.5 years. There is a penalty in the event that withdrawal exceeds the annual allowance. Earnings will be less in the event that it is withdrawn before the agreed time. It only allows single premium deposits. In case an investor wants to deposit other premiums, then they have to get into another new contract with the insurer.
Lifetime and CD Annuities
This type of annuity is a short-term one as well as long term investment is suitable for one to save in case of retirement. Moreover, note that lifetime annuity is when the investor benefits from his/her contributions till he or she dies. The holder does not purchase it in one lump sum payment. The problem with this type of annuity is once the holder dies, the insurance company will revert the remaining sum back to the company (Cannon & Tonks, 124).
Basically, the different annuities have been examined and researched. The advantages and disadvantages have been illustrated. There is a need for every person to plan on retirement benefits since at this age, an individual is weak and can do little to ensure that he or she fends for himself / herself. The only way to ascertain that retirement is taken care of is to invest in annuities or other investments which will bring benefits after one retires.
Essentially, annuities have been good for retirees. It is advisable that one gets a clear understanding of the different types of annuities before choosing the one. The advantages and disadvantages of each and every type should be analyzed before settling on one that an investor considers suitable. It is worth noting that the various types of annuity critically evaluated are indexed, immediate, fixed and variable annuities.
Cannon, Edmund and Tonks, Ian. Annuity Markets. Oxford: Oxford University Press, 2008. Print.
Horowitz, Andrew. The Disciplined Investor: Essential Strategies for Success. Florida: HFactor Publishing, 2008. Print.
Shapiro, David and Streiff, Thomas. Annuities. New York: Dearborn Trade Pub., 1997. Print.
Williamson, Gordon. Getting Started in Annuities. New York: Wiley, 1998. Print.