To answer your question about what are annuities, you first must know that annuities occur in numerous flavors. The guidelines and consequences are unique for each type of annuity. This, what are annuities, explanation describes what an annuity is, the way an annuity works, and what the benefits are. We wish to assist you, the citizens of your state and neighboring areas, choose the soundest annuity for you.
So, what are annuities? An annuity is a financial product offered through financial institutions. The institutions accept and multiply funds from a person. Upon annuitization, they disburse a series of payments to the person. Annuities are mainly applied to obtain a fixed cash stream for a client during retirement.
Annuities are handled through registered representatives. To offer an annuity in your state, the insurance corporation and the representative must be evaluated and certified in your state.
Every state’s insurance boards inspect insurance corporations to verify that they maintain extra resources (state legal reserve pools) to safeguard stockholders. If an insurance company goes insolvent, other insurance businesses authorized in that state have to accept the liquidated insurer’s debts and liabilities. This fully protects only the owner of a fixed-rate annuity; less safeguard is offered to the owner of a variable-rate annuity.
Any annuity has three main advantages:
- Tax deferment
- Avoidance of probate
- Certain income for a preset period or certain earnings for life
This article considers the following forms of annuity:
- Fixed-rate annuity
- Variable-rate annuity
- Indexed annuity
This commentary additionally considers fixed-annuity resales and pension resales, which interest numerous investors who pursue both low risk and great returns.
What do these contract fees pay for?
Some of the fees pay for the insurance benefits that variable annuities contracts provide. Other fees pay for the operation and management of the individual investment portfolios.
Management Fees
Asset-based management fees are used to pay the investment portfolio manager as well as other expenses associated with administering variable annuities. These fees are described in the prospectus, and are sometimes broken down into an investment advisory fee and an operating expense fee. Or they’re aggregated under the management fees heading. These fees don’t appear as a separate figure on your regular statements but are reflected in your portfolio values.
According to the National Association for Variable Annuities (NAVA), management fees average about 0.77% annually, but the actual charge can vary quite dramatically, based on the size of the fund or the way the portfolio invests. For example, fees on index portfolios tend to be significantly lower than fees on international equity portfolios or those requiring extensive or ongoing research and oversight.
In a fixed account within variable annuities contracts, the expenses are paid by the account’s interest margin. This margin is the difference between the percentage being earned on investments made by the company and the percentage being credited to your account as earnings.
Surrender Fees
Many variable annuities contracts, include a charge, if you withdraw part or all of your contract value during the early years of the contract. These surrender fees are usually calculated as a percentage of the amount of the withdrawal. However, many annuities let you withdraw a certain percentage of your account value each year without a surrender fee.
If you withdraw money from your variable annuity in the first year, your surrender fee might be 7%. This percentage generally declines each year until the fee disappears. With some annuities contracts, the surrender fee period begins with the purchase of the contract. With others, a new surrender fee period begins with each new purchase payment.
Surrender fees serve several purposes. First, they make people think twice before taking their money out, and thereby interrupting the growth opportunity of their long-term retirement account.
The fee also benefits the annuity company, as it has significant upfront expenses in issuing the contracts. These include sales and marketing expenses, insurance underwriting costs, and other such expenses. The insurance company counts on receiving asset-based fees or interest margins over a period of years and the surrender fees cover this loss of income that results when the annuity is ended earlier than projected.
Are Variable Annuities Cost-Effective?
Some critics claim variable annuities are more costly to own than other investments; for example mutual funds, which also involve asset-based fees, have expense ratios for domestic-stock funds averaging 1.52%, in comparison to the 2.07% that’s typical of variable annuities, based on Morningstar’s database as of August 2004. Those costs, for example, mean that an equity portfolio within annuities contracts must turn in a consistently stronger performance in order to provide the same level of return.
Variable annuities can make sense for investors interested in:
- The tax-deferred status of the returns on annuity portfolios.
- The option of receiving guaranteed retirement income for life.
- Insurance features, such as the death benefit
- A guarantee of minimum annuity purchase rates.
- A guarantee that insurance expenses will not increase above specified limits.
Additionally, many investors appreciate the advice they may receive from the financial advisor who sold the annuity. Investors should be aware that the tax treatment of mutual funds varies from that of variable annuities. Mutual funds gains are subject to capital gains tax whereas gains in variable annuities are taxed as ordinary income upon withdrawal. They can often be combined with a 401(h) account.
Expense Ratios
Expense ratios are the total expenses that you pay for the insurance and management of the assets in your annuity, expressed as a percentage of the annuity value.
The average expense ratio, including management and contract fees, according to Morningstar is 2.14%. You can check the expense ratio figures on your own, and you can also ask for that information from the insurance company or your financial advisor.
Even for portfolios offered by a single annuity contract, you’ll notice that the difference in expense ratios can be significant. Those variations are the result of differing management expenses.
Although you probably won’t want to base your choice of your annuity investments on expense ratio alone, it should be one of the factors you consider, particularly when choosing among those with comparable performance records.