Annuities: Unsuitable Investments For Seniors
The senior citizen population is large, growing, and by some estimates, hold two-thirds of the individual wealth in the United States. By the year 2050, the number of seniors is projected to be nearly twice as large as it was in 2012. Since many seniors have been able to save up a nest egg for their retirement years, they are often targeted with fraud in a way that younger people with no savings are not.
With billions of dollars in sales to be made, insurance companies may offer commissions as high as 10 percent to agents to sell products like long-term deferred annuities to senior citizens. In this environment, consumers should arm themselves with information to protect their interests. The Attorney General provides the following tips to consider before purchasing an annuity:
What You Will Learn In This Post
- 1. How Do Annuities Work?
- 2. Annuities and Your Retirement Plan
- 3. Things You Should Pay Attention to in Annuities
- 4. Are Annuities a Safe Investment?
An annuity is basically a contract between an insurance company and you in which the insurance company agrees to pay you regular payments at some time in the future or right away. When you buy an annuity you can choose between one-time payment or recurring payments.
An annuity can be structured in one of two ways, as a deferred annuity or an immediate annuity. A deferred annuity is when the payment are delayed to the future, usually used as a retirement plan investment whereas an immediate annuity starts paying you monthly payments right away.
The key is when you will start receiving payments, for immediate annuities you pay a one-time premium, and deferred annuities you make premium payments to the insurance company over time and receive payments at some future date.
Annuities are a good option for retirees to turn part of their saved income into a steady income stream. At the time of retirement, retirees need to decide how to take the money they have saved last for the rest of their lives annuities can be used to accomplish this goal.
In the following section we will go into more details on annuities, the two types of annuities fixed or variable, risk factors of each type and annuities liquidity concerns.
Immediate And Deferred Annuities
Annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits. The immediate payment annuity begins paying immediately after the annuitant deposits a lump sum. Deferred income annuities, on the other hand, don’t begin paying out after the initial investment. Instead, the client specifies an age at which they would like to begin receiving payments from the insurance company.
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What Are The Benefits And Risks Of Variable Annuities
Some people look to annuities to insure their retirement and to receive periodic payments once they no longer receive a salary. There are two phases to annuities, the accumulation phase and the payout phase.
- During the accumulation phase, you make payments that may be split among various investment options. In addition, variable annuities often allow you to put some of your money in an account that pays a fixed rate of interest.
- During the payout phase, you get your payments back, along with any investment income and gains. You may take the payout in one lump-sum payment, or you may choose to receive a regular stream of payments, generally monthly.
All investments carry a level of risk. Make sure you consider the financial strength of the insurance company issuing the annuity. You want to be sure the company will still be around, and financially sound, during your payout phase.
Variable annuities have a number of features that you need to understand before you invest. Understand that variable annuities are designed as an investment for long-term goals, such as retirement. They are not suitable for short-term goals because you typically will pay substantial taxes and charges or other penalties if you withdraw your money early. Variable annuities also involve investment risks, just as mutual funds do.
What Is The Best Age To Buy An Annuity
Investing in an income annuity should be considered as part of an overall strategy that includes growth assets that can help offset inflation throughout your lifetime. Most financial advisors will tell you that the best age for starting an income annuity is between 70 and 75, which allows for the maximum payout.
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Fixed Annuities Offer High Rates But Come With Some Catches
A fixed annuity is simple. The amount of income you receive is based on a predetermined rate which usually corresponds with a term. It can provide you with diversification outside of your bond portfolio or if you’re frustrated with the low rates that CDs offer, it will usually pay you a higher rate. If you purchase a 5 year CD, you can expect to earn 1% on average but if you use that same money to buy a fixed annuity, you can earn as much as 3%..
In general, fixed investments don’t keep pace with inflation well. You get comfort in knowing exactly what you can expect but each year but might find yourself struggling with maintaining your cost of living. With fixed products, you’re also locked into your rates and if they rise, you can’t always take advantage of them. Annuities have very little flexibility and if you sell your annuity before your holding period is over, you are assessed with a fee called a surrender charge, which, depending on how much time is left in your term, can be quite large.
If you value predictability over flexibility, a fixed annuity could add value to your portfolio. If, however, you have liquidity needs in the near term, limits on accessing your money would make this type of investment less suitable.
Annuities Offer Tax Deferral But Without Upfront Deductions Or Tax
If you are someone who pays a lot of taxes, you can use an annuity to create a tax-deferred investment and reduce your liability. If you add non-retirement money to an annuity, any contributions you make as well as interest or dividends that pay into your account grow tax-deferred.
While your investment grows tax-deferred, you do pay taxes when you start taking withdrawals. The rate that you pay taxes at if you funded your annuity with after-tax dollars will take into account how much of your withdrawal is from your principal and how much of it is attributed to growth .
The benefit of tax deferral comes at a cost and when you start an annuity you are subject to the same tax penalties that other retirement money is subject to. If you take money from your annuity before reaching the age of 59 1/2, you’ll owe a 10% penalty on any portion of your withdrawals that you owe taxes on plus the taxes. This puts limits on your taxable money that you wouldn’t have in a regular brokerage account and if you’re considering an annuity for this purpose, you should remember this limitation and weigh the benefits carefully.
Annuities have good and bad qualities and they’re not for everyone. Deciding if an annuity is right for you requires that you educate yourself about them and examine your needs. If the pros they provide match your need and outweigh the cons, annuities could make up a very important part of your investment plan.
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Present Value Of An Annuity Table
He or she finds the corresponding interest rate and number of payment periods in the table to find the annuity factor. The person then multiplies the amount of each payment by the annuity factor to find the present value of the annuity. The present value annuity factor is used for simplifying the process of calculating the present value of an annuity. A table is used to find the present value per dollar of cash flows based on the number of periods and rate per period.
After that, the examples provide a more efficient way to do the calculations by working with concepts and calculations we have already explored in Sections 6.2 and 6.3. Payment size is represented as p, pmt, or A interest rate by i or r and number of periods by n or t. The PV of a perpetuity can be found by dividing the size of the payments by the interest rate. Provided you know m, r, n, and t, therefore, you can find the future value of an annuity. We give you a realistic view on exactly where youre at financially so when you retire you know how much money youll get each month. While this is a simple and effective way to find the present value of an annuity, its not as effective as manual calculations or calculators. We create short videos, and clear examples of formulas, functions, pivot tables, conditional formatting, and charts.Read more.
Your Contributions Can Grow Tax
The money that you contribute to an annuity is tax-deferred. That means you can contribute money before you pay taxes. In fact, you wont owe taxes on the money until you start receiving payments. During the time between when you contribute funds and when you withdraw them, its possible that your money could grow significantly. This type of growth is similar to how 401 contributions grow.
When Are Annuities A Good Investment And When Are They Not
The question, Are annuities a good investment? depends largely on your long-term personal goals, especially as they relate to retirement.
Annuities can offer a set amount of income during retirement. Some investors want this. It’s possible to use an annuity to at least meet your basic needs. And then you can use other types of investments to help you meet other goals. You don’t need to base your entire retirement income on an annuity.
As long as you understand the fees and terms of the annuity, an annuity can be a good investment. Just make sure it fits into your overall financial plan.
On the other hand, an annuity investment may not be a good choice if, for example, if it has many fees or complicated restrictions. Some annuities are designed to be straightforward. But others are so convoluted you’re not sure what you’re getting into.
Additionally, don’t buy an annuity from someone who isn’t looking at your finances holistically. Be sure they can clearly explain where and how an annuity fits in with your goals.
As with most investments, it’s usually not a good idea to put all of your eggs in one basket. An annuity investment is the same. While an annuity could make a reasonable addition to your financial plan, it shouldn’t be your entire plan. Want to create a good financial plan? can match you up with 5-star financial advisors who will help you achieve your goals.
Are Annuities Only For Retirees
Annuities can be part of your financial picture in your working years as well as during retirement.
Because deferred annuities offer tax-deferral1, you have more time to grow your money without paying income taxes on earnings. In that scenario, if you choose a variable annuity, you may have the option to invest in the stock market for growth and to protect your principal for beneficiaries.
Two additional reasons you might purchase an annuity before retirement: 1) to roll over a workplace retirement account when you change jobs and 2) to continue saving after you reach 401 or IRA annual contribution limits.
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How To Calculate Annuity On Financial Calculator
A time-value-of-money calculation can be used to determine the current or future value of an annuity amount. There are three ways to do this. An annuitys present value can be calculated using a formula and either a conventional or financial calculator. A spreadsheet program like Excel, with its built-in financial calculations, is another option.
Calculating The Present Value Of An Ordinary Annuity
In contrast to the future value calculation, a present value calculation tells you how much money would be required now to produce a series of payments in the future, again assuming a set interest rate.
Using the same example of five $1,000 payments made over a period of five years, here is how a present value calculation would look. It shows that $4,329.58, invested at 5% interest, would be sufficient to produce those five $1,000 payments.
This is the applicable formula:
4 8 \begin \text_} & = \$1,000 \times \left \\ & =\$1,000 \times 4.33 \\ & =\$4,329.48 \\ \end PVOrdinary Annuity=$1,000×=$1,000×4.33=$4,329.48
Calculating The Present Value Of An Annuity Due
Similarly, the formula for calculating the present value of an annuity due takes into account the fact that payments are made at the beginning rather than the end of each period.
For example, you could use this formula to calculate the present value of your future rent payments as specified in your lease. Let’s say you pay $1,000 a month in rent. Below, we can see what the next five months would cost you, in terms of present value, assuming you kept your money in an account earning 5% interest.
This is the formula for calculating the present value of an annuity due:
9 5 \begin \text_} & = \$1,000 \times \left \times \\ & = \$1,000 \times 4.33 \times1.05 \\ & = \$4,545.95 \\ \end PVAnnuity Due=$1,000××=$1,000×4.33×1.05=$4,545.95
Present Value of an Annuity
Annuities And Your Retirement Plan
Now that we have an understanding of how annuities work the question is whether you should make part of your retirement income plan.
Here are some things you need to know about annuities before you decide to use them as retirement income:
Furthermore, many of the other retirement investment vehicles run the risk of running out of money if you live longer than anticipated. Annuities on the hand allow you to create your own pension plan, eliminating the risks associated with the stocks market and concerns about you outliving your money. Yes, fees are high, they are not very liquid and can be complex to understand, but they do give you peace of mind. Additionally, it has been shown that adding annuities to your portfolio can add longevity to your portfolio.
Additionally, annuities have some other cool benefits that can boost your retirement investments, such as tax-sheltering. Many annuities reduce your taxable income for that year and it grows tax-free until you start drawing income from them.
So the question is when should you buy an annuity? This part is easy, experts agree that if you are close to your requirement age you should max out your 401s and IRAs before buying an annuity. But if you are a few months from retiring then an immediate annuity may be a good option to start receiving monthly payouts right away.
Here are a few questions you can ask yourself to decide whether you want to buy an annuity for your requirement income plan:
First Distinguish Between An Ordinary Annuity And An Annuity Due
Most of us have had the experience of making a series of fixed payments over a period of timesuch as rent or car paymentsor receiving a series of payments for a period of time, such as interest from a bond or certificate of deposit . These recurring or ongoing payments are technically referred to as “annuities” .
Use Of Insurance Charges
Formally known as “mortality and expense” charges, insurance charges are a way for an insurance company to recoup the costs of providing an annuity, with additional profit built in. The average mortality and expense charge will run about 1.25 percent per year.
In addition to paying for the selling and administrative charges of an annuity contract, these charges also cover the cost of providing the guarantees inherent in most annuity contracts. Typical guarantees offered by annuities include a death benefit to policy holders or the guaranteed safety of an investor’s principal, depending on the type of annuity.
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Two Types Of Annuities
Annuities, in this sense of the word, break down into two basic types: ordinary annuities and annuities due.
- Ordinary annuities: An ordinary annuity makes payments at the end of each period. For example, bonds generally pay interest at the end of every six months.
- Annuities due: With an annuity due, by contrast, payments come at the beginning of each period. Rent, which landlords typically require at the beginning of each month, is a common example.
You can calculate the present or future value for an ordinary annuity or an annuity due using the following formulas.
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What Are Disadvantages Of Annuities
Annuities tie money up in a long-term investment plan that has poor liquidity and does not allow you to take advantage of better investment opportunities if interest rates increase or if the markets are on the rise. The opportunity cost of putting most of a retirement nest egg into an annuity is just too great.