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Today, Certificates of Deposit are at an all-time low, causing people to take a closer look at annuities.

Annuities FAQ

The main reason is the guarantee. Annuities provide:

  • Guaranteed interest rates. No matter what happens to the stock market. The insurance company you buy the annuity from assumes the risk, not you. Sometimes annuity interest rates are higher than rates on Certificates of Deposit (CD’s).
  • Guaranteed payments. Collect as long as you live. If you live longer than your normal life expectancy, the insurance company must continue to pay.

A simple way to understand how annuities work is to compare them to life insurance. With a life insurance policy, you pay a relatively small amount of money (the premium) to an insurance company. When you die, your beneficiary receives the full face amount of the insurance you purchased. Annuities work the opposite way in that you pay the insurance company a relatively large amount of money, and they in turn pay you a set monthly amount for as long as you live. Think of an annuity as something that continues to pay until you die (known as an Immediate Annuity).

Similar to a CD, annuities can be purchased with a guaranteed rate of interest for a specific period of time. The term could be for 3, 5, or 7 years, or longer. But instead of collecting monthly payments right away (annuitizing), you can defer the payments. You’d simply let the money grow and accumulate before taking it out at the end of the term. These are known as Deferred Annuities.

At the end of the term you can withdraw the money without any penalty or charge, keeping all the interest earned. You may take the money out sooner but there will be a stiff penalty. Some annuities allow you to take out the interest earned free of charge each year, while others allow up to 10% to be taken each year without penalty.

That depends on the type you purchase. There are three types:

  • Fixed annuities – They pay a guaranteed rate of interest. The insurance company determines what interest rate is offered and guarantees the payment (for example, 3.5% for a 5-year period). The principal and interest are both guaranteed. This is the safest type of annuity.
  • Variable annuities – The rate of return varies depending on the performance of the underlying investment. For example, you may have a choice of mutual funds to invest in. If they perform well, you may earn more. On the other hand, if those mutual funds do poorly, you could lose money.
  • Equity indexed annuities – The rate of return is tied to how well an index performs (ie. The S&P 500). These annuities combine aspects of the first two explained above. They typically guarantee a minimum rate of return (1%-2%), yet offer the potential to earn more than the minimum rate based on investment performance.

Typically there are surrender charges if you decide to cash in an annuity before the term of the contract expires. For example, if you purchased a 5-year annuity and cashed it in before the five years were up, you would be charged a penalty. Penalties range from 1% to 10%, depending on how long you have kept the annuity. Also, unlike bank CD’s which are backed by an agency of the U.S. government, annuities are backed by the full faith and credit of the insurance company.

Since everyone has different circumstances, the guidance of a trusted advisor is recommended before making a decision on annuities.

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