Annuities: What Everyone Should Know Before They Invest

Before you go, we thought you'd like these...
Before you go close icon
AM5279 thumbing a thick stack of American paper money $100 dollar bills.  cash; money; rich; wealthy; success; wad; lottery; gai
Annuities are among the most controversial products in the investment world, with proponents and critics fiercely disagreeing about their benefits and limitations. Yet annuities are just another tool that investors have for financial planning. Let's look at five of the most common types of annuities and the features and potential pitfalls they offer to investors.

1. Fixed Annuities

As their name suggests, fixed annuities offer investors a fixed interest rate on their investment for a certain period, making them closely resemble bank certificates of deposit. But as an insurance product, fixed annuities are entitled to tax-deferred treatment for their earnings. In addition, fixed annuities will often offer higher interest rates than bank products, and given the current low-rate environment, that makes annuities an attractive alternative for many conservative investors.

But fixed annuities aren't the same as bank CDs. Unlike CDs, fixed annuities aren't guaranteed by the FDIC, although the individual insurance company that issues the annuity stands behind the annuity with its own corporate guarantee. Moreover, fixed annuities often include limitations on the amount of money you can withdraw over specified time frames, imposing additional fees under certain circumstances.

2. Variable Annuities

Variable annuities give investors exposure to different types of assets, which makes them look a lot like mutual funds. Like fixed annuities, variable annuities offer tax-deferred growth until you start making withdrawals. In addition, most variable annuities offer the option of getting guaranteed benefits, ranging from a minimum benefit at your death to minimum provisions for income and withdrawals throughout your lifetime.

The features that variable annuities offer come at a price, though, with costs that are sometimes much higher than a mutual fund that invests in similar stocks or other investments. Moreover, the same limits on withdrawals often apply to variable annuities, and those under age 59½ will have to pay penalties on earnings if they need their money back before then.

3. Immediate Annuities

Immediate annuities are designed to resemble what most people get from pensions and Social Security. As soon as you buy the annuity, the insurance company starts making monthly payments to you based on your life expectancy and the prevailing interest rates. Unless you choose special provisions to the contrary, after your death, the insurance company will stop making payments, keeping any excess as profit.

Immediate annuities can be quite valuable to reduce longevity risk -- meaning the risk that you'll run out of money before you die. The longer you live, the more you'll profit from having chosen an immediate annuity. Those who die before they reach full life expectancy end up subsidizing the longer payout periods of those who don't. Unfortunately, in the current low-rate environment, the monthly payments you'll get will be smaller for any given up-front payment than in past years.

4. Deferred Income Annuities

Deferred income annuities are much like immediate annuities in that they provide dependable income throughout a lifetime. The difference, though, is that deferred income annuities don't start paying benefits out immediately. Rather, they're designed to wait until you're a certain age before triggering and starting to make payments.

The trade-off with deferred income annuities is that by waiting, your eventual monthly payments from the annuity will be larger. In exchange, though, the risk of dying before you reach the age at which the annuity will start making payments is greater, and so it's more likely that you could lose everything you invest. As with immediate annuities, alternatives are available to leave something for your heirs, but they come at the cost of smaller benefits for you.

5. Equity Indexed Annuities

Equity indexed annuities sound like a simple product, but they're deceptively complex. Their returns depend on movements of an underlying stock index like the Dow Jones industrials (^DJI) or the S&P 500 (^GSPC), but they don't generally track the stock market directly. Instead, most equity indexed annuities offer minimum returns even if the stock market crashes, and in exchange, they offer only a portion of the return of the index and sometimes cap upside gains if the market soars. Most important, most of these annuities don't include the dividends that investors in index funds would receive.

In addition to fees and potential charges for early withdrawal, equity indexed annuities can be very difficult to understand,the watchdog agency Financial Industry Regulatory Authority warned in an Investor Alert in 2010.

Be Smart About Annuities

Annuities can be difficult to understand, with various products offering much different benefits and costs. By knowing the various types of annuities, you'll find it easier to tell if one particular annuity is the best one for you.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google Plus. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.

11 Ideas for Your Retirement Travel Bucket List
See Gallery
Annuities: What Everyone Should Know Before They Invest
The Earth has 370,000 miles of coastline with some amazing spots to walk along the beach, listen to the waves crash and relax -- or even party. In the U.S., you can choose among hundreds of Atlantic coast towns: the quiet of Cape Cod; the wide expanses and soft white sand along the Jersey shore, the dunes in North Carolina, or the high energy of Miami Beach. On the West coast, there are the hipster cool California beaches of Newport and Venice Beach, and the serenity of Oregon's Cannon Beach, which holds a sand-castle contest every June. And if the thousands of beaches on the continent aren't enough, you can hop over and take surfing lesson on Waikiki Beach in Hawaii or go windsurfing in Maui.
Providenciales in the Turks and Caicos won the 2014 Travelers' Choice award from for its diving and snorkeling along the miles of accessible coral reefs. Other popular Caribbean destinations include the U.S. Virgin Islands, Barbados and the Cayman Islands. These are all year-round destinations, although many experts say the spring is the best time.
Is there anything more romantic than a relaxing week, watching the sun set from your private hut in the French Polynesian island of Bora Bora? Been there? Done that? How about the honeymoon hotspots of Tahiti or Fiji or the 115 islands of the Seychelles in the Indian Ocean? Check out Australia's Dunk Island rainforest, or get to the Maldives while you still can. Some climate experts warn that it could be the first nation to disappear due to climate change.
There are far more than seven natural wonders in our world, but that list is not a bad place to start. You can see the Grand Canyon, the Great Barrier Reef off the coast of Australia and Mount Everest. There's also the dramatic natural scenery along the Swiss Alps as well as 59 U.S. national parks, including the classic (Yosemite, Yellowstone), the most-visited (Great Smoky Mountains), the wet (the Everglades) to the dry (Death Valley, where the temperature once hit 134 degrees).
If you want everything taken care of for you, a cruise might be your ticket. It's a floating home with tons of food (of varying quality), entertainment and multiple destinations. It also may give you the most bang for the buck, with budget packages available as well as upscale voyages. You can cruise through the Caribbean, up to Alaska (in-season, of course), through the Mediterranean, through the fjords of Norway or down the rivers of Europe. A cruise can also offer something for you, your children and the grandkids, too. The biggest cruise companies are Carnival (CCL) (which also includes Princess and Holland American), Royal Caribbean (RCL), and Star Cruises (based in Malaysia).
After endless meetings, computer time and paperwork, this is the time to get moving. The Grand Canyon is not only grand to look at but it offers some high-adrenaline hiking and white water rafting. Yosemite, Yellowstone and other national parks also offer top-notch hiking trails. Overseas, you can take a four-day, 30-mile trek along the Inca trail to Machu Picchu in Peru; explore the rugged beauty and wildlife of Australia's Outback, or cycle through the rolling hills and villages of France's Provence and Bordeaux regions. While these are active vacations, you don't have to all of the work yourself. Tour companies will make the (sometimes-luxurious) arrangements, and you don't have to rough it.
This might be the ultimate getaway: book a seat on Richard Branson's Virgin Galactic flight into space. The first one is set to launch in the spring of 2015 from the company's Spaceport in New Mexico. Obviously, it's not for everyone. The cost for a seat is more than $400,000. If you want to keep your feet firmly planted on earth, revisit Darwin's trip to the Galapagos Islands or interact with the penguins in the Falkland Islands. Or learn the local culture by trekking through Thailand or Costa Rica.
You can take a safari through more than 100 countries in every continent, but safaris are most associated with Africa. The best times are usually January through March and June through December. A trip into the wild is a chance to get in harmony with nature, experience local cultures and traditions and maybe capture it with one-of-a-kind photos.
I'm not sure which is better: a Michelin-rated restaurant in Paris or a sidewalk cafe with fresh baguettes and pastries. (I do know which is more affordable.) Europe is full of foodie destinations, such as Rome or a tapas crawl in Barcelona. In Asia, you'll want to sample the wonderfully fresh sushi in Tokyo and food in Huangzhou or dozens of other Chinese cities.

In the U.S., go coast-to-coast with lobster rolls in Maine, the famous restaurants and food trucks in New York, Chicago's burgers and pizza, Creole specialties in New Orleans and the coffee bars and fresh oysters in San Francisco. There are many local favorites. Travel+Leisure magazine names the pizza in Providence, Rhode Island (check out the movie "Mystic Pizza" for the Connecticut version); the cheesesteaks of Philadelphia; the small cafes in Savannah, Georgia; the Tex-Mex chili sauces in San Antonio; and the barbecue in Kansas City. When you've consumed everything there is to eat in the U.S., go north of the border to Montreal and Quebec for French cuisine.
Just because you're old enough to retire doesn't mean you too old to learn. In fact, this may be the best stage of life to expand your mind. Road Scholar is a nonprofit that offers 5,500 educational tours in all 50 states and 150 countries. Popular programs include Christmas in New York City and photography of the four corners region of Colorado, Utah, New Mexico and Arizona. In volunteer vacation, participants maintain trails in the U.S. Virgin Islands, work with orphaned or abandoned children in Peru or do other meaningful things with your time, brain and energy.
It's more than a Fleetwood Mac hit of the 1970s. The opportunities to travel are endless. You can go by yourself, as a couple, in small groups. You can go for a long weekend to Boston or settle in for a two-month stay at a villa in the hills of Italy. You can go on a limited budget (AARP offers travel discounts) or live in the lap of luxury. You'll meet new people. You can start to cross items off of your bucket list -- and add new ones to it.
Read Full Story

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

People are Reading