What Is An Annuity?

It’s a simple question, isn’t it? Unfortunately, annuities are complicated, so the answers we get aren’t always straight forward. There’s a lot of press around these products – some good, some bad, some scathingly bad. Regardless of your opinion on annuities, we can all agree that they are some of the most misunderstood products in the financial market place.

To understand what an annuity is, let’s start by understanding what an annuity was. Before insurance companies got creative, annuities were designed to do one thing: provide lifetime income to the recipient in exchange for a lump sum of money. For example: I hand the insurance company $100,000, and they promise me $500 per month, no matter how long I live. Pretty straight forward, right?

Although this type of annuity (known as an immediate annuity) still exists, but it’s no longer alone. In the 90s, we could all go to McDonald’s an order French fries. Are our options on the side were ketchup, and ketchup. But humans are fickle creatures, and not all of us like ketchup. Restaurants want our money, so they put out packets of ranch dressing, bbq sauce, honey, mustard, honey mustard, and so on. All of these fall into the category of “condiments,” yet all of them are slightly different and gears towards consumers’ unique tastes. This is not unlike annuities today.

Let’s return to the above example. I hand the insurance company $100,000, and they promise me $500 per month, no matter how long I live. But what happens after I die? Are you saying the insurance company just gets to keep my money, that I worked hard for and earned? Just like ranch dressing doesn’t sit well in some people’s stomachs, that concept of losing one’s hard earned money didn’t sit well with retirees. So insurance companies came up with death benefits that are also guaranteed. I die early, my wife keeps getting paid. We both die early, our kids get a refund.

Okay, great, insurance companies are to fast food conglomerates as annuities are to condiments. What else do I need to know? Well, there’s a catch. You want more benefits, you pay for them. (It drives me nuts when I have to pay extra for a side of ranch!) In our running example, the insurance company just might offer you $400 per month instead of $500 if you want death benefits.

Fast food wouldn’t exist without preservatives. Sure, they’re often terrible for you, but they keep products from spoiling, and profits from falling. Because we as fickle consumers, want things when want them, and not when they’re available, preservatives have found their way into our whopper jrs and chicken nuggets to make their ingredients last longer. This is not unlike deferred annuities, which are designed for people who want money later, but not right now. If I use retirement money to buy an annuity, but plan to work for two more years, why do I want to take income right now and pay tax on it? I’m already earning money through my job.

You might be thinking: who needs an annuity if they don’t need income now? It’s another great question, and the simple answer is that not everyone is comfortable leaving their nest egg parked in other investments that are exposed to market risk. Enter deferred annuities, many of which are fixed, and earn a set interest rate, or at the very least cannot lose money. For someone who has gone through major recessions like 2001 and 2008, the peace of mind that comes with guaranteed growth might be worth the opportunity cost that comes with risky investing – especially if they are only a few years out from retirement.

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