An Overview Of Annuities

Most investors share the same goal of long-term wealth accumulation. Some of us have no problem watching our investments bounce up and down from day to day, while riskaverse investors or those nearing retirement generally can't withstand short-term volatility within their portfolios. If you are this type of investor - or one who has a moderate risk tolerance - annuities can be a valuable investment tool. (Learn more, in Designating A Trust As Retirement Beneficiary.) Today's Annuities An annuity is a contract between you - the annuitant - and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides a kind of retirement-income insurance: you contribute funds to the annuity in exchange for the guaranteed income stream of your choosing later in life. Typically, annuities are purchased by investors who wish to guarantee themselves a minimum income stream during their retirement years. Most annuities offer tax sheltering, meaning your contributions reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw an income from them. This feature can be very attractive to young investors, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments. Because they are a long-term, retirement planning instrument, most annuities have provisions that penalize investors if they withdraw funds before accumulating for a minimum number of years. Also, tax rules generally encourage investors to prolong withdrawing annuity funds until a minimum age. However, most annuities have provisions that allow about 10-15% of the account to be withdrawn for emergency purposes without penalty. (NB Delay In Retirement Savings Costs More In The Long Run.)

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How They Work Generally speaking, there are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities. With an immediate annuity, you contribute a lump sum to the annuity account and immediately begin receiving regular payments, which can be a specified, fixed amount or variable depending upon your choice of annuity package and usually last for the rest of your life. Typically, you would choose this type of annuity if you have experienced a one-time payment of a large amount of capital, such as lottery winnings or inheritance. Immediate annuities convert a cash pool into a lifelong income stream, providing you with a guaranteed monthly allowance for your old age. Deferred annuities are structured to meet a different type of investor need - to contribute and accumulate capital over your working life to build a sizable income stream for your retirement. The regular contributions you make to the annuity account grow tax sheltered until you choose to draw an income from the account. This period of regular contributions and tax-sheltered growth is called the accumulation phase. Sometimes, when establishing a deferred annuity, an investor may transfer a large sum of assets from another investment account, such as a pension plan. In this way the investor begins the accumulation phase with a large lump-sum contribution, followed by smaller periodic contributions. (Learn more about retirement, in Guaranteed Retirement Income - In Any Market.) Perks of Tax Deferral It is important to note the benefits of tax sheltering during the accumulation phase of a deferred

annuity. If you contribute funds to the annuity through an IRA or similar type of account, you are usually able to annually defer taxable income equal to the amount of your contributions, giving you tax savings for the year of your contributions. Also, any capital gains you realize in the annuity account over the life of the accumulation phase are not taxable. Over a long period of time, your tax savings can compound and result in substantially boosted returns. It's also worth noting that since you're likely to earn less in retirement than in your working years, you will probably fit into a lower tax bracket once your retire. This means you will pay less taxes on the assets than you would have had you claimed the income when you earned it. In the end, this provides you with even higher after-tax return on your investment. Retirement Income The goal of any annuity is to provide a stable, long-term income supplement for the annuitant. Once you decide to start the distribution phase of your annuity, you inform your insurance company of your desire to do so. The insurer employs actuaries who then determine your periodic payment amount by means of a mathematical model. The primary factors taken into account in the calculation are the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your payments will be), the expected future inflation-adjusted returns from the account's assets and your life expectancy (based on industry-standard life-expectancy tables). Finally, the spousal provisions included in the annuity contract are also factored into the equation. Most annuitants choose to receive monthly payments for the rest of their life and their spouse's life (meaning the insurer stops issuing payments only after both parties are deceased). If you chose this distribution arrangement and you live a long retirement life, the total value you receive from your annuity contract will be significantly more than what you paid into it. However, should you pass away relatively early, you may receive less than what you paid the insurance company. Regardless of how long you live, the primary benefit you receive from your contract is peace of mind: guaranteed income for the rest of your life. Furthermore, your insurance company - while it is impossible for you to predict your lifespan need only be concerned with the average retirement life span of all their clients, which is relatively easy to predict. Thus, the insurer operates on certainty, pricing annuities so that it will marginally retain more funds than its aggregate payout to clients. At the same time, each client receives the certainty of a guaranteed retirement income. Annuities can have other provisions, such as a guaranteed number of payment years. If you (and your spouse, if applicable) die before the guaranteed payment period is over, the insurer pays the remaining funds to the annuitant's estate. Generally, the more guarantees inserted into an annuity contract, the smaller the monthly payments will be. Fixed and Variable Annuities Different investors place different values on a guaranteed retirement income. For some, it is critical to secure a risk-free income for their retirement. Other investors are less concerned about receiving a fixed income from their annuity investment than they are about continuing to enjoy the capital gains of their funds. Which needs and priorities you have will determine whether you choose a fixed or variable annuity. A fixed annuity offers you a very low-risk retirement - you receive a fixed amount of money every month for the rest of their life. However, the price for removing risk is missing out on growth opportunity. Should the financial markets enjoy bull market conditions during your retirement, you forgo additional gains on your annuity funds. Variable annuities allow you to participate in potential further appreciation of your assets while still drawing an income from your annuity. With this type of annuity, the insurance company

typically guarantees a minimum income stream, through what is called a guaranteed income benefit option, and offers an excess payment amount that fluctuates with the performance of the annuity's investments. You enjoy larger payments when your managed portfolio renders high returns and smaller payments when it does not. Variable annuities may offer a comfortable balance between guaranteed retirement income and continued growth exposure. Conclusion Annuities offer tax-sheltered growth, which can result in significant long-term returns for you if you contribute to the annuity for a long period and wait to withdraw funds until retirement. You get peace of mind from an annuity's guaranteed income stream, and the tax benefits of deferred annuities can amount to substantial savings. Finally, variable annuities allow less risk-averse retirees prolonged exposure to the financial markets. Be sure to consider annuities as part of your overall investment strategy, as they may add value to your retirement in more ways than you think.

Introduction To Annuities: The History Of Annuities

Do you ever lie awake at night, wondering what would happen if you were to outlive your retirement income? The thought of running out of money at a time in your life when you may be totally unable to replace it may be a major source of worry, especially if your nest egg is relatively small. Fortunately, you are not the first person to have this fear. And several decades ago, the life insurance industry decided to create a vehicle that helps to insure against this risk. What Is an Annuity? Conceptually speaking, annuities can be thought of as a reverse form of life insurance. Life insurance pays the insured upon death, while annuities pay annuitants while they are still living. The academic definition of an annuity is a promise by one party to make a series of payments of a specific value to another for a given period of time, or until a certain event occurs (such as the death of the person receiving the payments). As an actual investment, annuities are retirement vehicles by nature. Investopedia defines an annuity as "a financial product sold by financial institutions that is designed to accept and grow funds from an individual and then pay out a stream of payments to the individual at a later point in time." Purpose of Annuities Annuities were originally created by life insurance companies to insure against superannuation, or the risk of outliving one's income stream. Modern annuity products can also help to pay for such things as disability and long-term care, and they can also serve as tax shelters for wealthy individuals whose incomes are too high to allow them to save money in other retirement vehicles such as Individual Retirement Accounts (IRAs). History of Annuities Although annuities have only existed in their present form for a few decades, the idea of paying out a stream of income to an individual or family dates clear back to the Roman Empire. The Latin word "annua" meant annual stipends and during the reign of the emperors the word signified a contract that made annual payments. Individuals would make a single large payment into the annua and then receive an annual payment each year until death, or for a specified period of time. The Roman speculator and jurist Gnaeus Domitius Annius Ulpianis is cited as one of the earliest dealers of these annuities, and he is also credited with creating the very first actuarial life table. Roman soldiers were paid annuities as a form of compensation for military service. During the Middle Ages, annuities were used by feudal lords and kings to help cover the heavy costs of their constant wars and conflicts with each other. At this time, annuities were offered in the form of a tontine, or a large pool of cash from which payments were made to investors. As investors eventually died off, their payments would cease and be redistributed to the remaining investors, with the last investor finally receiving the entire pool. This provided investors the incentive of not only receiving payments, but also the chance to "win" the entire

pool if they could outlive their peers. European countries continued to offer annuity arrangements in later centuries to fund wars, provide for royal families and for other purposes. They were popular investments among the wealthy at that time, due mainly to the security they offered, which most other types of investments did not provide. Up until this point, annuities cost the same for any investor, regardless of their age or gender. However, issuers of these instruments began to see that their annuitants generally had longer life expectancies than the public at large and started to adjust their pricing structures accordingly. Annuities came to America in 1759 in the form of a retirement pool for church pastors in Pennsylvania. These annuities were funded by contributions from both church leaders and their congregations, and provided a lifetime stream of income for both ministers and their families. They also became the forerunners of modern widow and orphan benefits. Benjamin Franklin left the cities of Boston and Philadelphia each an annuity in his will; incredibly, the Boston annuity continued to pay out until the early 1990s, when the city finally decided to stop receiving payments and take a lump-sum distribution of the remaining balance. But the concept of annuities was slow to catch on with the general public in the United States because the majority of the population at that time felt that they could rely on their extended families to support them in their old age. Instead, annuities were used chiefly by attorneys and executors of estates who had to employ a secure means of providing for beneficiaries as specified in the will and testament of their deceased clients. Annuities did not become commercially available to individuals until 1812, when a Pennsylvania life insurance company began marketing ready-made contracts to the public. During the Civil War, the Union government used annuities to provide an alternate form of compensation to soldiers instead of land. President Lincoln supported this plan as a means of helping injured and disabled soldiers and their families, but annuity premiums only accounted for 1.5% of all life insurance premiums collected between 1866 and 1920. Annuity growth began to slowly increase during the early 20th century as the percentage of multigenerational households in America declined. The stock market crash of 1929 marked the beginning of a period of tremendous growth for these vehicles as the investing public sought safe havens for their hard-earned cash. The first variable annuity was unveiled in 1952, and many new features, riders and benefits have been incorporated into both fixed and variable contracts ever since. Indexed annuities first made their appearance in the late 1980s and early 1990s, and these products have grown more diverse and sophisticated as well. In 2011, sales of annuities were estimated to exceed $200 billion annually. Despite their original conceptual simplicity, modern annuities are complex products that have also been among the most misunderstood, misused and abused products in the financial marketplace, and they have had more than their fair share of negative publicity from the media. In the next section we will explore the mechanics of these contracts more thoroughly, along with their basic benefits and the parties involved. In Section 2, we will examine the basic characteristics inherent in all annuity contracts.

Calculating The Present And Future Value Of Annuities

At some point in your life you may have had to make a series of fixed payments over a period of time - such as rent or car payments - or have received a series of payments over a period of time, such as bond coupons. These are called annuities. If you understand the time value of money and have an understanding of future and present value you're ready to learn about annuities and how their present and future values are calculated.

What Are Annuities? Annuities are essentially series of fixed payments required from you or paid to you at a specified frequency over the course of a fixed period of time. The most common payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly (four times a year) and monthly (once a month). There are two basic types of annuities: ordinary annuities and annuities due. Ordinary Annuity: Payments are required at the end of each period. For example, straight bonds usually pay coupon payments at the end of every six months until the bond's maturity date. Annuity Due: Payments are required at the beginning of each period. Rent is an example of annuity due. You are usually required to pay rent when you first move in at the beginning of the month, and then on the first of each month thereafter.

Since the present and future value calculations for ordinary annuities and annuities due are slightly different, we will first discuss the present and future value calculation for ordinary annuities.

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Calculating the Future Value of an Ordinary Annuity If you know how much you can invest per period for a certain time period, the future value of an ordinary annuity formula is useful for finding out how much you would have in the future by investing at your given interest rate. If you are making payments on a loan, the future value is useful for determining the total cost of the loan. Let's now run through Example 1. Consider the following annuity cash flow schedule:

In order to calculate the future value of the annuity, we have to calculate the future value of each cash flow. Let's assume that you are receiving $1,000 every year for the next five years, and you invested each payment at 5%. The following diagram shows how much you would have at the end of the five-year period:

Since we have to add the future value of each payment, you may have noticed that, if you have an ordinary annuity with many cash flows, it would take a long time to calculate all the future values and then add them together. Fortunately, mathematics provides a formula that serves as a short cut for finding the accumulated value of all cash flows received from an ordinary annuity:

C = Cash flow per period i = interest rate n = number of payments

If we were to use the above formula for Example 1 above, this is the result:

= $1000*[5.53] = $5525.63
Note that the one cent difference between $5,525.64 and $5,525.63 is due to a rounding error in the first calculation. Each of the values of the first calculation must be rounded to the nearest penny - the more you have to round numbers in a calculation the more likely rounding errors will occur. So, the above formula not only provides a short-cut to finding FV of an ordinary annuity but also gives a more accurate result. (Now that you know how to do these on your own, check out our Future Value of an Annuity Calculator for the easy method.)
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Calculating the Present Value of an Ordinary Annuity If you would like to determine today's value of a series of future payments, you need to use the formula that calculates the present value of an ordinary annuity. This is the formula you would use as part of a bond pricing calculation. The PV of ordinary annuity calculates the present value of the coupon payments that you will receive in the future. For Example 2, we'll use the same annuity cash flow schedule as we did in Example 1. To obtain the total discounted value, we need to take the present value of each future payment and, as we did in Example 1, add the cash flows together.

Again, calculating and adding all these values will take a considerable amount of time, especially if we expect many future payments. As such, there is a mathematical shortcut we can use for PV of ordinary annuity.

C = Cash flow per period i = interest rate n = number of payments

The formula provides us with the PV in a few easy steps. Here is the calculation of the annuity represented in the diagram for Example 2:

= $1000*[4.33] = $4329.48
Not that you'd want to use it now that you know the long way to get present value of an annuity, but just in case, you can check out our Present Value of an Annuity Calculator. Calculating the Future Value of an Annuity Due When you are receiving or paying cash flows for an annuity due, your cash flow schedule would appear as follows:

Since each payment in the series is made one period sooner, we need to discount the formula one period back. A slight modification to the FV-of-an-ordinary-annuity formula accounts for payments occurring at the beginning of each period. In Example 3, let's illustrate why this modification is needed when each $1,000 payment is made at the beginning of the period rather than the end (interest rate is still 5%):

Notice that when payments are made at the beginning of the period, each amount is held for

longer at the end of the period. For example, if the $1,000 was invested on January 1st rather than December 31st of each year, the last payment before we value our investment at the end of five years (on December 31st) would have been made a year prior (January 1st) rather than the same day on which it is valued. The future value of annuity formula would then read:
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Therefore,

= $1000*5.53*1.05 = $5801.91
Check out our Future Value Annuity Due Calculator to save some time. Calculating the Present Value of an Annuity Due For the present value of an annuity due formula, we need to discount the formula one period forward as the payments are held for a lesser amount of time. When calculating the present value, we assume that the first payment was made today. We could use this formula for calculating the present value of your future rent payments as specified in a lease you sign with your landlord. Let's say for Example 4 that you make your first rent payment at the beginning of the month and are evaluating the present value of your fivemonth lease on that same day. Your present value calculation would work as follows:

Of course, we can use a formula shortcut to calculate the present value of an annuity due:

Therefore,

= $1000*4.33*1.05 = $4545.95

Recall that the present value of an ordinary annuity returned a value of $4,329.48. The present value of an ordinary annuity is less than that of an annuity due because the further back we discount a future payment, the lower its present value: each payment or cash flow in ordinary annuity occurs one period further into future. Check out our Present Value Annuity Due Calculator. Conclusion Now you can see how annuity affects how you calculate the present and future value of any amount of money. Remember that the payment frequencies, or number of payments, and the time at which these payments are made (whether at the beginning or end of each payment period) are all variables you need to account for in your calculations.

Annuities: How To Find The Right One For You

Annuities are an excellent way to generate a lifetime income, save for retirement without the worry of market risk and leave something to your family or a favorite charity after you die. However, like many financial products, what was once a simple idea has become very complicated. In this article, we outline the three main types of annuities - fixed, variable and indexed - and tell you what to look for in each, as well as what questions to ask before you invest. Annuity 101 An annuity is a financial product sold by insurance companies or other financial institutions to hold and grow funds. When you annuitize, you accept a payout stream that can begin immediately or in the future. The payouts can be for life or a certain number of years. Annuities are mainly used to provide a steady income during retirement. (For a general overview of annuities, see An Overview Of Annuities.) Fixed Annuities A fixed annuity is a written contract offered by an insurance company. It guarantees that you'll make a stated interest rate on your money. This type of investment is risk-free - the insurance company assumes all the risk and guarantees that you'll make the stated interest rate. Fixed annuities are not tied to the stock market in any way. The following are two subcategories of fixed annuities: Immediate annuities: An immediate annuity, also called a single premium annuity, is when you make a lump sum, or one-time, payment and then a short time later you start receiving monthly, quarterly or yearly annuity payments. These payments can be for life or for a specified number of years. Generally, you buy this type of annuity when you are about to retire or are retired and want to generate a safe, consistent income no matter what. Deferred annuities: You purchase a deferred annuity when you want to build up money on a tax-deferred basis and, at some point in the future, use the money that is invested for your ultimate goals. Some people use deferred annuities as a way to build up for retirement knowing that they will be receiving a guaranteed return no matter what. When you take the money out in the future, you'll owe taxes on the earnings that you made in the annuity.

Generally, you can withdraw up to 10% a year from a fixed annuity without having to pay an early withdrawal penalty. You can easily convert money from a deferred annuity to an

immediate annuity. You also can leave the money to a loved one or favorite charity free of estate taxes. Plus, annuities have a 30-day free-look period - if you don't like what the annuity contract says or you simply change your mind, you can return the annuity to the insurance company and receive a full refund.

Watch: What is An Annuity

Variable Annuities A variable annuity is a contract between you and an insurance company. In this contract, you can make either a lump sum (single) payment or a series of payments. The insurance company agrees to make consistent payments to you immediately or at some date in the future. Variable annuities combine the elements of mutual funds, life insurance and tax deferred retirement savings plans. When you invest in a variable annuity, you can select a variety of mutual funds to invest in. A variable annuity has two phases: The accumulation phase: During the accumulation phase, you are paying money into the annuity and you have a variety of investment options, ranging from a balanced fund - a type of mutual fund that holds preferred stocks, bonds and common stock to obtain income and growth - to money markets andinternational funds. The money that you put in the investment options will increase or decrease depending on the funds' performance. The best information you can get about the variable annuity's investment options is the prospectus. This will describe the risks, volatility and whether the fund contributes to the diversification of the investments in the annuity. The payout phase: During the payout phase, you start to receive payments. These payments can be lump sum, or you can have payments sent out to you on a regular basis (monthly, quarterly or annually) for a certain number of years or a lifetime. These payments are guaranteed by the insurance company.

Variable annuities generally provide guarantees that you can't get with other investments. For example, for a fee, you can add a death benefit feature to the variable annuity. Let's say that you invest $125,000 into a variable annuity. A while later, the value of the mutual funds held in the annuity declines to $95,000. Had you put this money into an ordinary mutual fund, you would be down $30,000. With a variable annuity, your beneficiaries will still get $125,000 if you die. In some, if the market value rises to $150,000, your beneficiaries could get a "stepped up" death benefit of $150,000 if you die. Indexed Annuities An indexed annuity is a contract between you and an insurance company. With this type of annuity, you can make a one-time payment or a series of payments. The insurance company will credit you the return that is calculated by the changes on a certain index, such as the S&P 500. The insurance company will also guarantee you a minimum return; these minimums can vary from one insurance company to the next. Here are some of the benefits of an indexed annuity: You can use the funds to build up money on a tax deferred basis (where you pay the taxes once you take the money out). You can take up to 10% a year of the original amount you invested without having a penalty. You can add a death benefit where, if you die early, the annuity will go to your beneficiary and avoid probate altogether. You can also pull out up to 100% of the annuity without penalty if you are forced to go into a nursing home.

Before You Purchase an Annuity There are several questions that you should ask yourself and an insurance agent to gain a greater understanding of any annuity you are considering. Ask yourself: What am I going to use this annuity for? If you are retired or nearing retirement and need a consistent income, you may want to consider using a fixed annuity. If you are building up for retirement, you may want to consider a fixed annuity, variable annuity or indexed annuity. If you are going to be leaving your annuity to your children or grandchildren, you may want to take a look at a variable annuity with a death benefit. Am I going to need the money right away? What you really need to know is whether you will need the money in the next two to five years. This is an important factor to consider when you have surrender fees that can affect the principal amount if you take the funds out early.

Ask your insurance agent: What is the minimum guaranteed return? A guaranteed minimum return is a stated return that you will make no matter what. In the case of fixed annuities, they will state the minimum guaranteed return. This will allow you to see what you will make yearly in a worst-case scenario. What are the initial and annual fees paid to the insurance company? In some cases, there are fees paid yearly to the insurance company and there could also be upfront fees that the insurance company will charge. This information is usually found in the prospectus. What are the surrender fees if I get out early? The surrender fee is a cost to you that is paid if you withdraw your funds early. These fees vary from insurance company to insurance company. As a general rule, the longer you hold the annuity the less the surrender fees are. In some cases, these fees disappear completely after a certain number of years. What different types of death benefits are available to me? A death benefit is provided to beneficiaries if you die. This is a stated amount. In some variable annuities, you can use a "stepped up" death benefit (an increase in the benefits). This increase is the result of a rise in the overall portfolio. This will allow you to adjust the death benefit available to your beneficiaries upward. What waivers are available if I need the money right away? A waiver is used when you may need the money for an emergency, such as a medical condition or if you have to go into a nursing home. Many annuities will waive the surrender fee if you need the money for a situation such as this. Before you buy the annuity you need to find out what types of waivers are available.

Conclusion As you can see, there are several different types of annuities, all with their own benefits. One of the major benefits of an annuity is that it allows you to build up money for retirement, so that when you do retire, you can take a lump sum payment or you can create a consistent income that can last for a certain number of years or for life. You are also able to build up money on a tax-deferred basis.

Some of the drawbacks of investing in annuities include surrender fees that you may have to pay if you need the money early and up-front, and annual fees that may apply. However, you should examine and determine which annuity will work for your situation. This can be done through research and by posing some basic questions, both to yourself and to your insurance advisor.

Selecting The Payout On Your Annuity

For some investors, an annuity can be an appropriate part of a sound financial plan. However, one feature of annuities that is commonly misunderstood is payout options. Here we define these options, how they are calculated and how they are taxed. Phases of an Annuity The two phases in the life of an annuity are the accumulation phase and the annuitization phase (or payout phase). During the accumulation phase, you can add funds to your annuity contract by depositing cash, converting life insurance cash values or doing a 1035 exchange from another annuity (to name a few ways of contributing). If you follow the annuity rules, your annuity will accumulate earnings on a tax-deferred basis until you make withdrawals. Once you reach age 59.5, you can begin to withdraw funds from the annuity without penalty charges. Annuity Payout Options There are a few different methods for taking annuity payouts. Generally speaking, the two most common methods to receive cash payouts are the annuitization method and the systematic withdrawal schedule. The other is taking a lump-sum payment. The annuitization method gives you some guarantee of monthly income for a determined period. Under the systematic withdrawal schedule, you have complete control over the timing of distributions but no protection against outliving annuity assets. Annuitization Methods Let's look at some different options you have with the annuitization method. Life Option The life option typically provides the highest payout because the monthly payment is calculated only on the life of the annuitant. This option provides an income stream for life, which is an effective hedge against outliving your retirement income. Joint-Life Option This common option allows you to continue the retirement income to your spouse upon your death. The monthly payment is lower than that of the life option because the calculation is based on the life expectancy of both the husband and wife. Period Certain With this option the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15 or 20 years. Should you elect a 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years. Life with Guaranteed Term Many people like the idea of income for life (which they get with the life option), but they are afraid to choose that option in case they die in the near future. The life-withguaranteed-term option gives you an income stream for life (like the life option), so it pays you for as long as you live. But with this option, you can select a guaranteed period, such as a 10-year guaranteed term, for which your annuity is obligated to pay to your estate or beneficiaries even if you die before that guaranteed period is over.

Watch: What is An Annuity

Systematic Withdrawal Schedule Under this method, you can select the amount of payment that you wish to receive each month and how many you want to receive. However, the insurance company will not guarantee that you will not outlive your income payments. How much you receive and how many months you receive payments depends on how much you have in the account. The burden of life-expectancy risk is on your shoulders. Lump-Sum Payment Taking out the assets in your annuity in one lump sum is usually not recommended because, in the year you take the lump sum, ordinary income taxes will be due on the entire investmentgain portion of your annuity. Clearly, this is a very inefficient payout option from a tax minimization perspective. Electing Not to Take Payments Some individuals have no need for income from the funds that have accumulated in their annuity. If the same is true for you, be sure to check your beneficiary designation is correct since the annuity can be transferred to your beneficiary at your death. How Does the Insurance Company Compute your Monthly Payment? There are several factors that insurance companies use to compute your monthly payment amount; two of the most common are gender and age - both of which affect your life expectancy. Since women have longer life expectancies than men, women won't receive as high of a payment as their male counterparts. And, of course, the older you are, the lower your life expectancy. A 75-year-old man with the life option will receive a higher monthly payout than a 65-year-old man because the older man's life expectancy is shorter. Another major factor that affects the size of your monthly payout is the payout option that you select - which affects how long the payments will last. For example, if you select the joint-life option, your monthly payout most likely will be lower as the payment continues to your spouse after your death. Finally, the size of your monthly payout depends also on the insurance company that you use, and its expected investment returns on your money. If the company can make a 5% instead of a 3% return with your money, your payment will be higher. However, the increase in your payment when returns are higher depends on whether you select a fixed monthly payout or a variable monthly payout from your annuity. If you select the fixed amount, your payout will not change, and the insurance company assumes all investment risk. Under the variable payout, the size of the monthly payout fluctuates based on market conditions, so you assume the market risk. Tax Treatment of Annuity Payouts Once your contract is annuitized, part of each payment (from a fixed annuity) is considered a partial return of the basis (your contribution) and part is taxable income using an exclusion ratio. Once you select your payout method with your insurance company, you should ask for your exclusion ratio, which tells you how much is excluded from being taxed. If your exclusion ratio is 80% on a $1,000 monthly payout, then $800 is excluded from income tax and $200 is subject to ordinary income tax. Premature distributions (those occurring before you reach age 59.5) are subject to a 10% penalty, and for annuities purchased before Aug 14, 1982, the FIFO (first-in, first-out) method is used for withdrawals. For annuities purchased after Aug 13, 1982, the withdrawal rule is LIFO (last-in, first-out), meaning that earnings will come out first. You have to pay not only a 10% penalty on the withdrawal, but also income tax on any portion of the withdrawal attributable as investment gain. It is not a wise decision to pull funds prior to age 59.5, so try to

avoid it at all costs. Credit Quality Concerns A final factor to consider is the credit quality of the insurance company. Remember that just because you have accumulated your annuity at one insurance company over the past 20 years, you don't necessarily need to start your payouts with them. If another insurer with a high rating has offered you a higher monthly payout, it might be worth your time to look into doing a taxfree 1035 exchange to the new insurer, but make sure to check the surrender charges on your current contract before you initiate any transfer! The insurance companies have well-paid employees in specialized departments that will provide you with an estimated payout for each option. Make them earn that extra 1.5% in fees that they charge annually to your contract have multiple quality insurance companies give you a quote on the current value of your annuity with multiple payout options. Conclusion Deciding on the best annuitization payout method to choose for your annuity is not an easy decision. Consider your priorities, the amount you need each month and how long you think you will need these payments.

Build Your Own Annuity

Life insurance companies have been offering investors in America the promise of lifetime income from annuity contracts. The first annuity contracts were relatively simple instruments that paid a fixed rate of interest, and then paid out a guaranteed stream of income that the beneficiary could not outlive. Variable annuities made their appearance in the late 1980s with the promise of higher returns from mutual fund subaccounts. Indexed annuities were introduced in the following decade as a way of providing a safe method of market participation for conservative investors. All types of annuity contracts provide several key benefits, such as: Unconditional exemption from probate. Protection from creditors (at least in most cases). Unlimited tax-deferral with no contribution limits (for non-IRA or qualified contracts). Protection from superannuation, or outliving one's income (the contract must be annuitized to do this).

But annuities are also one of the most expensive types of investments on the market today and often contain a plethora of fees, charges and other costs that can substantially reduce the amount of income and principal within the contract. The high expense ratios of many of these contracts have drawn widespread criticism from many industry experts and regulators over the years, and their appropriate use is still a major focus of debate in the financial industry. Do It Yourself Those who are financially sophisticated enough to understand how annuities are designed, can build their own portfolios with individual securities that conceptually duplicate the contracts that are offered by commercial carriers, at least in many respects. First, it is necessary to examine how most annuity carriers manage their own investment portfolios. Most life insurance carriers invest their cash reserves in a relatively conservative combination of stocks, bonds and cash that will grow at a rate that allows the company to meet its financial requirements and still make a profit. Of course, these reserves come from the premiums paid by its customers and the fees and charges that it assesses to insure and administrate these policies. But those who design their own annuity simulation portfolios do not have to pay these costs or meet cash reserve requirements, thus allowing them to retain a much larger portion of the profits from their strategy.

Fixed Annuities Duplicating the interest paid from a fixed annuity is relatively simple. You can create a portfolio of fixed-income securities of a risk level that you are comfortable with. If you are very conservative, then you can use treasury securities or certificate of deposits, while those with a higher risk tolerance could choose from corporate bonds,preferred stock offerings or other similar instruments that pay a higher rate of interest with relative price stability. (As stated previously, most fixed annuity carriers do this and then pass on a lesser rate of interest to the contract owner and keep the spread in return for guaranteeing the principal and interest in the contract.) (To learn more, check out Explaining Types Of Fixed Annuities.) Indexed Annuities Creating a portfolio that duplicates the returns offered by indexed annuity contracts is a bit more complex than duplicating a fixed contract payout. Indexed annuities are funded by a combination of guaranteed investments such as treasury securities, guaranteed investment contracts and index options. For example, for every $100,000 of indexed annuity premium that is received, an insurance carrier may invest, perhaps, $85,000 in guaranteed instruments that will grow back to the original amount of principal (and perhaps a bit more) by the time the contract matures. Another $10,000 will be used to buy call options on the underlying benchmark index that the contract uses, such as the S&P 500 Index. If the index rises, then the calls will rise proportionately (but at a rate much greater than that of the index itself due to their speculative nature). The remaining $5,000 may be used to cover contract expenses or other costs (such as the commission to the broker). But all that the investor sees is that the contract value will grow if the index rises, but will not drop if the index falls. Of course, most indexed contracts have several limitations on how much profit investors can take; most contracts now have caps over a certain time period, such as 8% per year. This means that if the index rises by more than that amount, then the carrier will keep any excess growth above the cap level. However, any investor can divide up a given amount of money and buy one or more fixed-income securities that will grow back to the original amount of principal by a set date in the future. Zero-coupon bonds can be good for this, but any type of guaranteed security can serve this purpose. (For that matter, riskier fixed-income offerings could be mixed in here to beef up the rate of return, depending upon the investor's risk tolerance and time horizon.) The remainder of the money could then be used to buy calls on the index of your choosing (in most cases this should probably be a stock index). Of course, a basic knowledge of how options work is required to do this successfully. Those without experience in this area, who would like to try this strategy, will need to hire a stockbroker or investment advisor to do this for them. But this strategy is still relatively simple and can ultimately yield the same results as a commercial contract - except without the caps and many of the other fees and costs that come with these contracts. Those who are willing to practice this strategy can therefore count on moderate to substantial gains over time with little or no risk to principal. (For more help, check out our tutorial on Options Basics.) Strategy Limitations Admittedly, these portfolios will not be able to provide the insurance protection found in commercial contracts, such as a guaranteed income stream that cannot be outlived. However, in order to receive this kind of protection, the investor must annuitize the contract, which surrenders control of the contract to the insurer in return for an irrevocable payout of income for life. For this reason, the majority of annuity owners choose other forms of payout, such as systematic withdrawal or a required minimum distribution payout at age 70.5. This portfolio

also will not grow tax-deferred like its commercial counterpart unless it is done inside a traditional or Roth IRA, and many IRA custodians do not permit the use of options in their accounts. Those who wish to employ this strategy inside an IRA must therefore find a selfdirected IRA custodian that can facilitate options trading. The Bottom Line Duplicating the interest payments offered by fixed and indexed annuities does have some limitations, but can also be more efficient and thus offer higher returns than commercial contracts will pay. For more information on how annuities work and how you can reap similar investment returns, consult your stockbroker or financial advisor. (For related reading, see An Overview Of Annuities.)