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Are Annuities a Safe Retirement Investment?

written by: ShawnTe•edited by: Donna Cosmato•updated: 5/17/2010

Part one of the Understanding Annuities series discussed the differences of annuities and bank CDs. Part two will explore how safe this retirement investment is by discussing the different types of annuities and their governing bodies. "Are annuities a safe investment?", read on and decide yourself.

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    Alissaarp 2009 wikimedia commons Saving for retirement requires developing a retirement plan. An ideal plan will have a mix of investments that have little or no risk (safe) to a few with high risk that yield high returns. Annuities are a retirement investment many consider. However, the question remains, "Are annuities safe investments?"

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    Types of Annuities

    There are three basic types of annuities: fixed, variable and indexed, or equity-indexed. At least two entities, typically the National Association of Insurance Commissioners (NAIC), and each state’s insurance department monitor annuities. However, indexed annuities, up until January 12, 2011, are monitored by four entities: each state's insurance department, the NAIC, Securities and Exchange Commission (SEC), and the National Association of Securities Dealers. Even with governing bodies monitoring their activities, each type of annuity comes with a certain level of risk that determine the safety of annuities.

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    Fixed Annuities

    Fixed annuities function similarly to fixed rate CDs, as they both pay out a fixed or guaranteed interest rate. However, fixed annuity rates are often higher. This type of annuity can be either immediate or deferred.

    Immediate fixed annuities are for contracts paid in one lump sum. Since the contract is already paid for, payments can be issued to the investor in as little as one month. Deferred fixed annuities payout after a set number of years and accumulate interest during this time. Taxes are also deferred until payouts commence.

    Many consider fixed annuities the safest kind of annuity investment because you are guaranteed a fixed payout over the years. However, other factors to consider are:

    • How long is the term? - Is the term longer than your life expectancy?
    • Does the contract make provisions for your spouse to collect upon your death?
    • What additional fees or costs are associated that may eat away at your investment?

    Scouring the contract before finalizing and asking these questions helps mitigate your risk.

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    Variable Annuities

    Variable annuities perform similar to mutual funds, where the investor chooses from a selection of investments creating a managed portfolio. The investor can pick from a mixture of stock and bond portfolios called subaccounts. The performance of this type of annuity is directly linked to the performance of the investments within the managed portfolio.

    Your profit depends on the volatility of the market. When the market is doing well, higher returns are expected. When the market is performing poorly, expect low returns. Variable annuities have the potential to increase your savings via long-term capital growth if you retain the annuity for a number of years. According to Money Magazine's "Ultimate Guide to Retirement", variable annuities are more likely to survive or outpace inflation than a fixed annuity. This aspect may cause certain investors to deem variable annuities a safer retirement investment.

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    Page one discussed Fixed and Variable annuities as retirement investment vehicles. Page two the discussion featuring indexed annuities. Are annuities safe investments? If so which annuity is the safer investment? You decide.
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    Indexed/Equity-Indexed Annuities

    Investors get the best of both worlds (fixed and variable annuities) with an equity-indexed annuity. At least, that is the sales pitch many retirees receive and in part, it is true. Equity-indexed annuities offer a guaranteed minimum return around two to three percent and the principal investment remains protected. However, you also can experience high gains when the stock market is doing well, because the annuity's return is based upon the performance of such indices as Standard & Poor's 500.

    Index annuities come with significant disadvantages that affect its safety as a retirement investment such as:

    • They don't always give you the entire return of the indices they are tied to. - some give a portion of what the index is worth or set an annual cap.
    • Higher fees - specifically surrender charges that surge as high as 20 percent.
    • They exist in a governing loophole - index annuities are not quite a security or an insurance product since it behaves like both. In 2011, this issue will change when the SEC will take over regulation of these annuities.
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    Each type of annuity has its advantages and risks. No single one is entirely safe. However, if you like the comfort of knowing what to expect each month, fixed annuities are safest for you. If you are willing to wait to achieve capital gain and hope to beat inflation, then you may consider variable annuities the safer option. However, the wild dog of the bunch is index annuities. Whichever annuity you decide on, make sure to read the contract thoroughly and ask questions before signing.

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    Sources

    MCNAMARA AND BANJO. (2010, February 10). Look Before You Leap Into Fixed Annuities. Retrieved May 13, 2010, from Wall Street Journal: http://online.wsj.com/article/SB123421518890265071.html

    Money Magazine. (2010). Ultimate Guide to Retirement: What is a fixed annuity? Retrieved May 13, 2010, from CNNMoney: http://money.cnn.com/retirement/guide/annuities_fixed.moneymag/index.htm

    Money Magazine. (2010). Ultimate Guide to Retirement: What is a variable annuity? Retrieved May 13, 2010, from CNNMoney: http://money.cnn.com/retirement/guide/annuities_variable.moneymag/index.htm

    Pierce, S. (2009). How Do Annuities Work? Retrieved May 13, 2010, from Life123: http://www.life123.com/career-money/investing/annuity/how-annuities-work.shtml

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    Image Credits

    Image, Wikimedia Commons/Alissaarp, 2009