Breaking Down the Basics of Annuities

August 31, 2016
DMD Staff

Annuities can play an important role for some investors. Here's a look at how they work.

There is often an inverse relationship between the perceived complexity of a retirement investment and its adoption in the marketplace. Lifecycle (target-date) funds are at the simpler end of the complexity spectrum. For many, annuities are at the other end of the spectrum. For that reason, and several others, annuities are often ignored by investors.

But the key advantage an annuity offers—guaranteed income in retirement—is too important to completely ignore—complexity or no. Dentists who get used to a certain level of income might find the idea appealing. While the topic of annuities is large enough to fill a textbook, we’ll are tackling it in three parts. Last week, we looked at the different types of annuities. Today we’ll look more broadly at the concept of annuities. In the final part of the series, we’ll look at the different phases of an annuity contract.

What Is an Annuity?

An annuity is essentially a life insurance product that changes over time into a series of payments for the investor. Life insurance pays an insured beneficiary upon death, while annuities pay the insured while they are still living. The idea behind annuities dates back centuries, but recent changes and additions to annuity offerings have made them a more attractive investment vehicle than they once were.

Still, there are several kinds of annuities—fixed and variable—and several stages of investment in an annuity. So even a quick, simplified breakdown of annuities isn’t all that quick or simplified. Ironically, an investment vehicle designed for simplicity is anything but. So, before we lose you, let’s talk about the…

Advantages of Annuities

We’ll summarize the benefits here and probe more in later articles.

Tax deferral: All money invested into annuities of any kind grows tax-deferred until it is withdrawn. A key advantage for high income investors is that, unlike many other investments, you can make unlimited contributions to annuities.

Guaranteed payout: With any annuity, choosing a life payout option means an annuitant will receive some sort of payment until they die.

Protection from creditors and exemption from assets: Annuity contracts are (with some state-level exceptions) exempt from creditors and probate proceedings nationwide.

There are, of course, some …

Disadvantages of Annuities

The cons of investing in annuities often depend on the type of investor you are and the type of annuity you invest in, but they can include:

Costs and fees: Much of annuities’ bad reputation in the marketplace comes from the simple fact that they are one of the most expensive types of investments available in the financial marketplace. This is not a myth.

Taxation: How can we list tax deferral as the key benefit of annuities, and then “taxation” as a disadvantage? Because withdrawals from annuities funded from pre-tax money are taxed as ordinary income, regardless of how long the investment was held.

• Lack of liquidity: You can withdraw money from an annuity, but it will not easy, and it will come with a penalty—in some cases a substantial penalty.

Complexity: Have we mentioned this? Even experienced investors may not understand how annuities work and may misuse them in their investment portfolio. We’ll discuss in future articles how to avoid the missteps. Also, because of fee complexity, many insurance providers have come under fire for charging excessive fees, which consumers often fail to notice. This is one of the many reasons the Department of Labor recently overhauled the kinds of disclosure financial services providers must give their clients.

In future articles, we’ll get into the details of annuities and why they are an important investment option for dentists.