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Oct 18

Annuities: What They Are and What You Need to Know Before Buying One

Annuities What They Are and What You Need to Know Before Buying One

Annuities have a mixed reputation among both investors and financial professionals. Some people are quick to offer reasons why purchasing an annuity is a bad way to spend your money, while others insist that they’re the ideal investment vehicle for a variety of different scenarios.

This mixed messaging can make it difficult to decide if an annuity is the right financial tool for your situation, but a bit of knowledge on the subject should help clarify what you need to know to make a wise financial decision.

Let’s take a look at how annuities function and what you need to know before buying one.

What Exactly Is an Annuity?

An annuity is an insurance product that you buy into as an investment, often touted by those who sell them as a part of an overall retirement strategy. Annuities are issued and purchased from an insurance company for a lump sum. Terms vary, but in return the insurance company agrees to make payments on a specified date or set of dates.

The total size of the payments an investor receives from an annuity is influenced by several different factors, but the length of the payment period is typically the most important. Payments can be received monthly, quarterly, or yearly, as well as in a lump sum.

Money paid into an annuity is then invested by the insurance company. Depending on the type of annuity purchased, the yield on the “underlying investments” can increase or decrease the amount an investor eventually receives. And there are two different types of annuities that are available — fixed and variable.

Fixed Vs. Variable Annuities

A fixed annuity offers a guaranteed rate of interest. The returns are fixed and tax-deferred, meaning they are not subject to market or interest rate fluctuations, and you won’t pay taxes on any gains until money is withdrawn. Also, a fixed annuity guarantees the principal investment.

A variable annuity differs from the fixed variety in that while it is also a tax-deferred investment vehicle, the returns depend on the performance of the annuity’s underlying investments. In other words, a variable annuity behaves similar to the investments it holds of stocks, bonds, and money market funds.

What You Need to Know Before Buying One

So, what is the catch? Is there a catch? On paper, annuities sound like they could be a financial tool worth considering. Maybe. But annuities don’t tend to live up to the hype and, as with any investment, you will want to weigh the risk vs. reward of adding such a financial tool to your retirement belt.

Here are some characteristics of annuities that you should fully understand before buying one:

  • They’re expensive. In general, annuities tend to be a more expensive financial tool that isn’t necessary for a comprehensive financial strategy. The fees associated with a variable annuity often outweigh the potential for long-term gains, which make them less promising than how they may be presented to you.
  • They’re complex. Complicated investments don’t always mean better. In fact, making the right financial choices for your situation often occurs at the intersection of simple and smart. The nature of an annuity is to be complex. They are based on an annuity contract with the issuing insurance company, which can contain numerous provisions that you as the the investor need to have a thorough understanding of.
  • They’re NOT FDIC-insured. This is not an FDIC-insured financial product. Therefore, if the issuing insurance company closes its doors, the money invested with them may go with it.
  • Those who sell annuities earn a commission. Because this is a financial product sold by insurance companies, know that whoever is trying to sell one to you is earning a commission on the sale. Regardless of whether or not the professional believes an annuity product is a good option for your situation, there is an inherent conflict of interest any investor should be fully aware of beforehand.

Conclusion

A sound investment strategy is never a one size fits all scenario. Every investor’s situation is different and therefore requires its own personalized approach to management. As with any investment, we strongly encourage you to fully understand any financial vehicle you use before incorporating it into your financial strategy. This is for your own protection and financial well-being.

Choosing the best financial tools to help you reach your financial goals can (and probably should) raise questions. When you are actively working to secure your financial future, you can never be too thorough. You can always reach out to us at The Money Guy Show with your financial questions by writing to us directly brian@moneyguy.com and bo@moneyguy.com. And we also recommend that you speak with your financial advisor to determine which financial tools are best-suited for you and your needs.