Close-Up: Annuities

n.

Annuity: A specified income payable at stated intervals for a fixed or contingent period, often an individual's life.

The Complete Book ofMoney

Stephen Pollan, writing in , believes that the single-premium, immediatefixed annuity is the magic bullet of personal finance.There are others who view annuities less favorably.Perhaps that's because annuities, which are certainlyunique among investments, can also be somewhat confusing.But carving away many of the embellishmentsthat surround different types of annuities, they are,quite simply, a contract that guarantees a lifetimeincome. Annuities are usually offered through insurancecompanies, although charities and large corporationsalso enter into annuity agreements.

According to Pollan, annuities are categorized basedon the income they provide, their premium, and theirpayout. For example, if the amount of the income isdetermined when the contract is signed, this is a fixedannuity. If the income level is determined based on theperformance of an underlying investment portfolio, it'scalled a variable annuity. Single-premium annuitiesrequire 1 lump sum payment made to the insurer; periodic-payment annuities spread smaller payments out fora predetermined period of time. Immediate annuitiesbegin paying income immediately after the total premiumis paid, while deferred annuities do not begin payingincome until a predetermined time (eg, when an individualreaches age 65).

SEEING THE GOOD

Pollan writes that there are 3 distinct advantages toannuities. The first is that they provide a lifetime income.While it is possible to outlive the income from virtuallyany other type of investment, that won't happen with anannuity. Second, an annuity provides a guaranteedincome. If you've experienced the stock market in thepast few years, you know you won't find any guaranteesthere. Interest rates are known to rise and fall, but theincome from an annuity never changes. If the annuityyou purchase says it will pay you an 8% return, it will, nomatter what the market's interest rates do.

In addition, a portion of the income you receivefrom an annuity will be tax-free. The reason is thateach payment you receive from an annuity is consideredrepayment of the money you put in, not incomeyou are receiving. And the way it works is that theolder you are when you purchase an annuity, the largerthe payment you'll receive, and, therefore, thelarger the tax-free portion.

UNDERSTANDING THE BAD

There are, of course, some disadvantages to annuities,because there is no absolute magic bullet. First, annuitiesare irrevocable. With whole life insurance, you can cashin the policy and receive back some of the funds you paidin. However, once you pay out the money to purchase anannuity, it's gone. In addition, annuities are subject toinflation. For example, the annuity you purchase nowmay seem as though it offers a nice fixed income in 2003,but when you receive the funds in 2013 or 2023, theymight not stretch as far.

Lastly, because annuitiesare not backed by thegovernment, they aresubject to insolvency.Your money is only ascertain as the financialsolvency of thecompany or organizationthat issuedit. If the issuer disappears,so does yourguaranteed income.

SIDE-STEPPING DOWNSIDES

Of course, there are ways to minimize the disadvantagesassociated with annuities. For example, if you'reconcerned that you might need money sooner thanexpected due to an emergency, and the annuity isirrevocable, simply take the proper steps to ensure thatyou're protected from financial disaster (ie, make sureyou have adequate home, auto, liability, health, andlong-term care insurance).

If you're concerned about inflation eating awayyour annuity, Pollan suggests purchasing an annuity aslate as you possibly can, and then purchasing only asmuch as you need at the time. As a general rule, thelater in life you purchase an annuity, the better ideayou'll have of what your income and expenses will bein future years. Then, purchase only what you need atthe time to offset any decline in earned income. Fiveyears down the road, if you find that your income levelhas dropped considerably further, purchase anotherannuity at the then-current rate.

Lastly, if insolvency is on your mind—and who couldblame you today—purchase an annuity only from high-ratedinsurers or solvent charities. You're counting onthat issuer to be solvent beyond your lifetime, so makeit a point to check the health of every insurer you'reconsidering.

What About Couples?

For those individuals with life partners, Pollan suggestspurchasing a joint-and-survivor annuity. Thistype of annuity will continue to pay an income aslong as one of the individuals is alive. In fact, federallaw requires that this option be offered to everyonepurchasing an annuity, and that spouses sign a waiverif it's not selected.

A joint-and-survivor annuity will offer a lowerincome than a single-life or period-certain annuity,because the amount to be paid out is being factoredover a longer period of time. However, the peace ofmind that comes from knowing that if either individualdies, the annuity will continue making paymentsfor the life of the spouse, often outweighs the lowerdollar amount paid out.

Additionally, you can lessen the effect of thelower dollar amount provided by the joint-and-survivorannuity by electing to take either two thirds orone half of the benefit once one of the individualsdies. Be certain to accurately determine the declinein expenses and needed income of the surviving individualbefore selecting this option. Otherwise, yourun the risk of running short on needed income.

CME Quiz

1) An annuity is usually issued by:

1. An insurance company
2. A charity
3. A large corporation
4. All of the above

2) What type of annuity establishes the income at thetime the contract is signed?

1. Fixed
2. Variable
3. Periodic payment
4. Deferred

3) Once you purchase an annuity, there is usually noway to get the money back.

1. True
2. False

4) To lessen the impact of inflation on an annuity, youshould purchase it:

1. By age 60
2. By age 70
3. With a large payout
4. As late as possible

5) Couples should purchase this type of annuity:

1. Spousal annuity
2. Joint-and-survivor annuity
3. Husband-and-wife annuity
4. Multiple-person annuity

Answers: 1) a; 2) a; 3) a; 4) d; 5) b.