One barely discussed aspect of President Bush’s proposed overhaul of Social Security has to do with annuities that many personal account holders would be required to purchase when they reach retirement age.
Americans hold about $1 trillion worth of annuity contracts, but they are not well-understood, particularly among younger workers. On average, owners of so-called non-qualified annuity contracts are 65, and only 20 percent of owners are under 54, according to the National Association for Variable Annuities. Non-qualified annuities are generally purchased with after-tax dollars outside of retirement funds.
Here is a brief explanation of these financial planning instruments.
What is an annuity?
Annuities are contracts sold by insurance companies that provide for regular payments for a specified period of time, often the lifetime of the purchaser. The word comes from the Latin “annua,” referring to an annual stipend.
What are the main types of annuities?
Immediate annuities provide an immediate stream of income in exchange for a one-time, up-front payment. Under President Bush’s proposed personal accounts, some workers could be required to purchase this type of annuity at retirement.
Deferred annuities, which can be offered as part of a tax-sheltered retirement program, allow investors to accumulate assets during their working lives and then receive an income stream during retirement. They can be purchased with a single payment or with a series of payments over time.
Regardless of whether annuities are immediate or deferred, they generally offer two primary options for the payout period:
Fixed annuities offer a guaranteed minimum rate of return during the accumulation phase and a fixed regular payout phase. These contracts are less risky but offer no hedge against inflation.
Variable annuities offer a wide range of investment options during the accrual phase and then fixed or variable payments – or a combination of both – during the payout phase. These contracts are riskeier but offer the potential of greater capital appreciation.
How much do annuities cost?
According to a report from the National Academy of Social Insurance, a 65-year-old with $100,000 could buy a fixed annuity worth about $9,700 a year, or $808 a month, for life. But the purchasing power of that income stream would decline steadily due to inflation.
The same $100,000 could buy an inflation-indexed annuity worth $7,450 a year or $621 a month, which would increase steadily to keep up with the cost of living.
Adding a spousal death benefit would lower the inflation-indexed payment to $500 a month, which would continue until both husband and wife were deceased.