Life Insurance & Annuities: The Dynamic Duo of Financial Protection
While life insurance and annuities are both products of life insurance companies, they serve two very distinct purposes. Life insurance policies offer protection against dying too soon, while annuities provide protection against living too long. However, when utilized in the context of a complete financial plan built on a solid foundation of family and financial security, the two work hand-in-hand to protect the complete circle of life.
Life Insurance as a Capital Creator
The basic premise of life insurance is that most people, throughout their financial lives, have obligations and expenses that need to be paid, both now and in the future. In the earlier stages of life, these are funded through cash flow and accumulated savings. But, when a person dies too soon, these obligations and expenses are usually left unpaid because not enough time has passed to be able to accumulate the capital needed. For instance, an outstanding debt is being paid down through monthly payments. When the debt holder dies, the outstanding balance is left unpaid.
Or, if a family is saving for college, and has only accumulated a portion of the required funds when one of the primary breadwinners dies, the future obligation is unfunded, and the likelihood of continued savings towards the goal is diminished.
Life insurance becomes the source of the much needed capital to fulfill these obligations and pay down debt. Essentially, it replaces the income earning capacity of a breadwinner and ensures that the family can continue to maintain the lifestyle to which it is accustomed, which is why it is important to accurately assess the financial needs of the family in order to have enough protection.
Life insurance can be used as a capital creator in any instance where an untimely death could leave a family, a business or an estate in a precarious financial position. If a fledgling business were to lose a key person or partner, it could suffer a devastating financial loss. Life insurance can provide the capital a business needs to maintain continuity while searching for a replacement or rebuilding client goodwill. When a person dies and leaves a sizable estate, life insurance provides the liquidity the heirs need to pay estate settlement costs and taxes so that assets don’t have to be forced into liquidation.
Certain types of life insurance can also be used as a source of financial stability, cash flow for taking control of the financing mechanism for large purchases, capital preservation, or even a source of tax-advantaged retirement income.
Annuities as a Capital Protector
In the later stages of life, after savings and assets have been accumulated, annuities serve to protect this capital so that it can be preserved for future use. The unique characteristics of annuities combine to create a shield of protection that allows the capital to accumulate while guaranteeing its full return to its holders. Additionally, annuities can protect the distribution of the capital to ensure that it will fully fund a lifetime income stream without interruption or loss of value.
Annuities are also issued by life insurance companies as a contract much like life insurance policies, except that they insure individuals against the possibility of living too long and outliving their income sources. When a person transfers a portion of his assets to an annuity, it can be left to accumulate, or it can be converted to income (annuitized). In either case, the principal balance is guaranteed as is the minimum rate of interest.* Annuities provide an extra measure of capital preservation by allowing the earnings inside to accumulate on a tax-deferred basis, although they will be taxed when they are eventually received.
Once an annuity begins to make periodic payments, the principal balance is committed, irrevocably, to the life insurer who then commits to making the payments until all of the principal and interest earnings have been fully distributed – over a specific time period, or for the life of the individual.
The payments, which are fixed (except in the case of variable annuities in which payment amounts can fluctuate based on market fluctuations), are based on the amount of the original principal balance, the projected earnings from interest, and the number of payment periods. Individuals who rely upon their assets for income often use annuity income to inject stability and predictability into their overall income portfolio that may also include more risk-oriented assets.
Businesses may also use annuities when they need to fund installment payments or an income stream as part of a compensation arrangement with a key person, or as a funding vehicle in a buy-out situation.
Life Insurers as Circle of Life Protectors
Life insurance and annuities are both issued by life insurance companies. Both provide a form of protection that entails the risk of mortality for which the cost is actuarially calculated by the life insurer. In both cases, those costs are borne by the individual policy holder in the form of a premium. In both cases, the life insurer must calculate the amount of reserves it needs to have on hand to be able to pay all future obligations, either as death benefit proceeds or as annuity income payments (or surrenders).
Therefore, the financial strength and stability of life insurers is paramount to the ultimate security of life insurance and annuity policyholders. The safety track record of life insurance companies in the U.S. dates back over two hundred years (although life insurance as a concept began in ancient Rome).1 While there have been a few cases of life insurer insolvency, the number is very small as compared to the banking industry which has recorded hundreds of failures in just the past few years. In most of the few life insurer insolvencies, the assets and obligations of the insurers were assumed by a larger or financially stronger life insurance company.2
The need to create and preserve capital is essential to meeting important obligations and providing the financial security that families and businesses need. We know of no other financial instrument that can create capital protection for a family as quickly or as inexpensively as life insurance, and there is currently no other financial product that can preserve capital and guarantee its complete distribution over a lifetime like annuities. We believe that a complete financial plan should include both if a client's current and future financial security is a priority.
Do you have the protection you need? Reach out to our office for a free initial strategy session where our financial professionals can help you make sure you and your family are protected against both dying too soon, and living too long!
*In some variable annuity contracts the principal and minimum rate guarantees are options that require additional premiums.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2023 Advisor Websites.