The ABCs of annuities: 6 questions to ask

(MoneyWatch) Guaranteed income for life, especially in the aftermath of a deep recession and financial crisis, sounds wonderful. That must be why insurance companies are ramping up their marketing of annuities. Due to the complexity of annuities, I'll cover the basics in this post, and then set forth the pros and cons in the following one.

An annuity is a financial contract issued by a life insurance company that offers tax-deferred savings and a choice of payout options (income for life, income for a certain period of time or lump sum) to meet your needs in retirement. Because the contract enjoys tax-deferred treatment, the IRS may impose a 10 percent early withdrawal penalty for some distributions if they are taken before age 59 1/2.

The concept of trading a lump sum of money for a stream of income is easy to understand, but annuities come in lots of flavors, which can make them confusing. The two big categories of annuities are "immediate" and "deferred."

In an immediate annuity, payments begin immediately or within one year of the policy's issue. These contracts are also referred to as "single premium immediate annuities" or SPIAs because they are usually purchased with a single deposit. SPIAs can help you manage the risk of outliving your money, which is known as "longevity risk."

A deferred annuity has two phases: the accumulation phase, during which your money grows on a tax-deferred basis; and the payout phase, during which you begin to receive scheduled payments. There are several types of deferred annuities to consider:

-- Fixed annuity: Insurance companies guarantee a fixed interest rate for a certain period of time. At the end of this period, the company will declare a renewal interest rate and another guarantee period. Most guarantee a minimum interest rate for the life of the contract.

-- Variable annuity: For investors who want access to more investment options, variable annuities offer "sub-accounts," which look like mutual funds inside of an insurance policy.

-- Equity index annuity: A blend between a fixed and a variable, where the insurance company invests in a mix of bonds and stocks designed to return a targeted percentage of a particular index (e.g., S&P 500). The owner does not control the investment selection but can participate to a degree in stock market gains during a rising market. Conversely, if markets fall, the contract guarantees a minimum return, typically three percent.

When an insurance salesman, a financial adviser or a broker broaches the topic of annuities with you, here are six questions that you should immediately ask:

1. What type of annuity is this, and why do you recommend it for me?

2. Exactly how much will I pay in the first year of the contract, and then how much in subsequent years?

3. What will be your first-year commission on the contract, and what will you earn in subsequent years? Annuities are notoriously expensive (more on the fees in next week's column), so you will want to understand the total costs, which include mortality and expense charges ("M&E"), administrative fees, underlying fund expenses, charges for special features and the salesperson's commission.

4. Have I already maxed out other tax-deferred vehicles? One of the big selling points of annuities is that they offer tax deferral. That's great, but make sure that you are maximizing your 401(k) or IRA accounts first before investing in an annuity, because chances are, those are cheaper tax-deferred vehicles.

5. Should I tie up my money with this contract? Once you sign up for an annuity, it's hard to get your hands on that money, and it can be expensive to do so. Make sure you have ample liquidity outside of the annuity before taking the plunge.

6. "How is this insurer rated by AM Best, S&P, Moody's and Fitch?" Before the financial crisis, this question seemed silly, but now we know that insurance companies can go broke. Since the success of an annuity is predicated on the survival of the insurance company, it's important that the company be highly rated.

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