Ian Cuddy Financial Advisor

Life Insurance and Annuities have a few similarities but the objectives of the two products are the exact opposite. A life insurance policy is to insurance that if you die prematurely that your lost income will be replaced for your dependents and heirs. An annuity is a contract with an insurance company that guarantees that you will not out live your retirement income. In other words, one is to insure your income if you die too soon, the other is to insure your income if you live too long.

Who Should Buy Life Insurance?

Many people wonder if they even need life insurance. If you are single with no dependents, why should you worry about life insurance? Well if before you die you become very ill and need 24 hour care maybe in a hospital, you will rack up some hefty medical expenses. Will you parents or you siblings want to be strapped with these bills? Probably not.

What about funeral expenses? Who will be strapped with those? If you have credit card debt or any other kind of debt, you may want to consider covering that with life insurance. So even if you are single, you need to have some life insurance to cover the mess you will leave.

If you are married and have a family it goes without question that you need life insurance. If you die prematurely your family will still have rent or a mortgage and bills to pay. You may also leave a mess that needs to be cleaned up also, plus incur funeral expenses.

So, to answer the question of who should buy life insurance, everyone should have some life insurance benefits. It is just to help with extra expenses that a death can cause a family and in some instances it is to replace your financial contribution to the welfare of your family. If you are a stay at home mother, you need life insurance also. If you die prematurely, your family will have additional expenses for child care and other help.

Who Should Buy an Annuity?

Annuities are typically purchased by people who are beginning to think about retirement. You don’t have to be ready to retire soon in order to consider an annuity, but most annuity buyers have pretty finished raising their children and have some extra money set aside for a rainy day.

Many annuity buyers will be in their late 40’s or early 50’s. They are not ready just yet to retire but are beginning to focus on this phase of their lives a bit more. If you have done all the pre-tax saving you can do with IRAs and 401K contributions, you may want to start looking at other ways to tax-defer investment income. An annuity is a good want to add to your retirement nest egg.

You can contribute after tax dollars but any returns you make will be tax deferred until you start to take withdrawals from the annuity. You can use an annuity for 401K rollovers into IRA accounts if you want to start adding guaranteed living benefits to your retirement vehicles.

The annuities available in today’s marketplace are especially designed to give you living guarantees. Years ago people looked at annuities as a way to tax-defer investment returns and then annuitize the contract at retirement so that they had a life long income. The living benefits on some of the newer annuity contracts give fabulous benefits beyond tax deferral and annuitization. In fact, most annuities are not annuitized anymore. The contract owners can take lifetime income from them while still maintaining control of the money in them.

For more information, see Annuities Explained.

What are the Differences between Life Insurance and Annuity Contracts?

The obvious differences between a life insurance contract and an annuity contract is that one provides a death benefit as the primary benefit, and the other provides an investment vehicle that will provide a future income to the owner. Many people confuse these two vehicles. It is important to distinguish the differences though.

If you primary concern right now is to make sure you have enough retirement income that you cannot out live, then an annuity is the vehicle to use to fill this need. There is a secondary benefit of a death benefit to your dependents and heirs, but that is only a secondary benefit. You need to use the right product to meet your primary needs first.

If your primary concern is to replace your lost income to your family in the event of your premature death then you need to purchase life insurance. This is the most cost effective way to fulfill this need. If you live a long life there are long term benefits in the way of cash value accumulation that you can eventually use as a source of retirement income.

This is however, a secondary benefit of a life insurance policy. You should use life insurance only to fulfill your primary need of replacing your income to your family and if you are lucky enough not to need it for this purpose you can take advantage of the secondary benefit.

Conclusion

In conclusion, when trying to decide whether you are better off buying a life insurance policy that builds great cash value or buying an annuity that has a death benefit, you should stop to consider your primary objective. As mentioned earlier, every person needs some life insurance just to clean up their debts and expenses from a premature death. Some people need life insurance to replace their current income for dependents. After you have these things and probably quite a few other things covered, then you can start thinking about annuities for retirement income.

Both of these contracts are good ideas for most people at some point during there life, just determine what you most immediate needs are and use the correct product for that need. Life insurance insures the replacement of your income to your to those who survive you and an annuity insures your income if you live too long.

If you are considering the purchase of an annuity, you may be thinking that you either do a variable annuity or a fixed annuity. A variable annuity allows you to benefit from investing in the stock market which can have its ups and downs. No pun intended. You may want the chance to make gains when the stock market goes up but you may also have a high degree of fear that you will lose money when it drops.

You may think that the only other alternative to the stock market and a variable annuity is a fixed rate annuity that will not fluctuate but which currently pays very low fixed interest rate returns. What if you could have a bit of both of these types of annuities? That is what an Equity Indexed Annuity offers.

You can have the assurance that you will not lose money if the market goes down but you have the chance to benefit to a limited degree if it goes up. There is a price to pay for this benefit. Not only are there fees included inside your contract for this benefit but you will give up some of the yield you would get on a traditional fixed annuity. If you can get a fixed rate 7 year annuity paying you a guaranteed 2.5%, you may only get 1.75% guaranteed on an equity indexed annuity. Why? Because you are giving up a bit or your guarantee for more potential upside gain.

How does an Equity Indexed Annuity Work?

When you purchase your equity indexed annuity you will be given a rate of participation percentage. You may be able to participate in the upside of the market with a 70% participation ratio. That means that if the Index that your annuity is tracking, which is typically the S & P 500, goes up 10% for the year, you will receive an interest credit of 7% for that year. Most contracts have a limit to the interest rate you can be credited.

An example of an equity indexed annuity may be one where you invest $200,000 initially. You are guaranteed to get no less than a 1.5% annual interest credit. However, you can participate at an 80% ratio up to a maximum of 8% per year. Suppose in your first year the S & P index moved up 12%. That means that you would receive an 8% interest rate that year. Why not 9.6%? Because you are capped at 8%.

Suppose that the next year the market goes up only 7%. You would get an interest credit of 5.6% for the year. (80% of the 7%) However, say in the third year the market goes down 30%. Your principal would not go down but you would only get credited a 1.5% interest rate. This is a simple example but you get the idea. This type of annuity gives up potential for greater gain but not so much of a guaranteed rate of return.

Who Should Consider an Equity Indexed Annuity?

The type of person who should consider an Equity Indexed Annuity is someone who has a few years until they retire. This gives them some time to try and get a larger return with stock market gains. In the current economic environment though where fixed rates of return are so incredibly low, it may be the best way to go for people in close to retirement.

Current fixed rate annuities may pay 3% if you are willing to lock in that rate for 10 years. At this rate the cost of trying to get a higher return by investing in an Equity Indexed annuity is minimal. If you can handle potentially getting 1.5% lower return each year, you may find that over time you do much better with an indexed annuity than with a fixed rate annuity.

If interest rates were higher currently on fixed annuities it may be a bit more tempting to just lock in a fixed rate and forget it. However, at a cost of 1% or 2%, what’s the big deal? Right? As recent as 3 years ago, a person could lock in a rate of 4.5% on fixed annuities for 5 years, but those days are gone now.

Important Issues to Consider When Shopping for an Equity Indexed Annuity

Unlike variable annuities, equity indexed annuities do not invest in mutual funds. They invest in fixed income instruments. Their security is directly tied to the credit strength of the insurance company that is offering them. If the insurance company goes into bankruptcy, your annuity will be paid back according to bankruptcy court rulings. That means you can lose your money if the insurance company goes under.

It is a rare event to see an insurance company go bankrupt, but it has happened. With the current world economic instability, it is very important that you select an insurance company with a rock solid financial standing. John Hancock is one of the top ranked insurance companies in the industry. New York Life in another top ranked company. Pacific Life, American National and Prudential are a few other names that are in pretty good financial standing.

You should do some research and make sure that the company you are dealing with has one of the top financial ratings available. Moody’s and Standard and Poor’s as well as Best’s all put out credit ratings for insurance companies. Don’t invest until you do your homework.

Conclusion

As mentioned earlier, in the current low interest rate environment we are in, it may be worth looking at an Equity Indexed annuity for your retirement. We can’t say for sure what will happen with the stock market over time, but the cost of trying for higher returns is very low right now.

You should compare the internal costs of the annuities offered by the top ranked insurance companies on these types of contracts. Also compare the minimum rates of return and then make your selection.