Annuities offer retirees one potential way of providing income in their golden years. But the world of annuities can feel confusing because of the vast array of options out there. It’s common for those nearing retirement not to know what annuities are and how they work.
But it’s important to understand the ins and outs of annuities to help you determine if one of these products would be a good addition to your retirement plan. Here’s what you need to know about annuities so you can figure out if they should be part of your retirement income strategy.
What are annuities?
An annuity is a product sold by an insurance company that creates an investment contract between the investor and the insurer. In exchange for a lump sum from the investor, the insurance company provides guaranteed payments to the investor for either a fixed period or for the investor’s lifetime. As for the lump sum, the insurer invests that money and then shares some of the investment growth with you through your guaranteed payments.
You can purchase an annuity through any number of insurance companies. While most annuities are purchased with a lump sum (known as single premium), you can also purchase annuities over a period of time by paying in installments. This is known as a flexible premium.
The timeframe for receiving your payment from the insurer can either be immediate or deferred. Here’s how each one works.
Just like it sounds, immediate annuities offer you regular, guaranteed payments immediately after you make your initial lump sum purchase. Since there is no time for an immediate annuity to grow, these products generally cost more than deferred annuities to get the same monthly payment.
If your payments are deferred, there is time to allow your initial investment to grow, making these kinds of annuities less expensive to purchase. The time between your initial investment and when you begin withdrawing money is called the surrender period. If you try to take money out of your deferred annuity before the end of the surrender period, you will face hefty fees known as surrender charges.
With a deferred annuity, once you have finished the surrender period, there are multiple ways to access the money. You can withdraw the original lump sum (plus any interest you have earned), receive regular payments for a set period or life, or take systematic withdrawals when you need them until you have emptied the fund.
Types of annuities
Within the basic framework outline above, there are different types of annuities with different benefits and drawbacks. Here are three of the most common types.
This type of annuity promises a specific, guaranteed interest rate for your investment. The rate is set by the insurer. While it is possible that your money will earn more than the guaranteed rate, it will never earn less.
The catch with fixed annuities is that the insurer needs to make certain it will earn more interest than it will pay you, which means the guaranteed interest rate is likely to be relatively low. Putting your money in a fixed annuity may guarantee you payment, but it is unlikely to do better than (or even as well as) more traditional investments.
With variable annuities, there is no guaranteed interest rate for the investment. However, variable annuities earn returns based on their underlying investment portfolios. As the investor, you get to choose which investment portfolio (known as a sub-account) you want for your variable annuity. If the investment does well, you receive the bump up in interest that you would miss if you had a fixed annuity. On the other hand, if the investment does poorly, you will also experience the downturn that a fixed annuity would have shielded you from.
Another version of a variable annuity is an indexed annuity, which ties the investment’s performance to a specific index, such as the S&P 500. Since the annuity is tied to an index that theoretically follows the market’s performance as a whole, this product potentially offers investors the upside of a variable annuity with the peace-of-mind of a fixed annuity.
Indexed annuities are not without pitfalls, however. To begin with, insurers place interest caps on their indexed annuities, which state the maximum amount of interest you can earn even if the underlying investment does much better than the cap.
In addition, the insurer may set a “participation rate,” where it decides the percentage of the index’s return that it will credit to the annuity. For instance, if the index goes up 8% and the indexed annuity has an 80% participation rate, your investment will only earn 80% of the 8% gains — or 6.4%.
Why you might choose an annuity
Though annuity products can be quite complex, there are a number of reasons why a savvy investor may choose to make an annuity part of their retirement plan.
- Guaranteed, predictable income for life: If you would like to continue to get what amounts to a paycheck in retirement, an annuity could be a helpful way to structure your retirement income. This is particularly helpful for those who know that they can budget a predictable and regular income, but might struggle if they had access to more than a month’s worth of money at a time. Since annuities can offer lifetime payouts, this kind of predictable income will always be there.
- Protection from stock market fluctuations: Depending on what type of annuity you choose, you can feel confident that your money will not take a hit in a market downturn. If you feel overwhelmed or panicked by market fluctuations, an annuity can offer you a great deal of peace of mind.
- Life insurance benefits without underwriting: If you’re not in perfect health but want to provide a life insurance payout to your spouse, an annuity can be a good option. There is no health underwriting for an annuity and you can designate your spouse as the beneficiary of your annuity, which means the payments transfer to him or her upon your death. There may also be some additional riders that you can add to your annuity to increase the payment at your death. This makes an annuity a reasonable substitute if you are unable to qualify for life insurance.
- Long-term care protection: Purchasing a long-term care rider for your annuity can offer you a financial safety net in case you need long-term care. This can be a more affordable option than long-term care insurance.
Why you might not want an annuity
Despite the benefits, annuities do come with their fair share of pitfalls. Here are some of the reasons why you may not want an annuity to be part of your retirement income plan:
- Illiquid investment: The biggest downside to an annuity is the fact that your money is tied up in it once you have purchased it. There is no way to access your funds without paying a painful fee.
- High fees: The fee structures for annuities can be complex, expensive and less-than-transparent. The fees for variable annuities tend to be significantly higher than fees for similar investments that are not annuities, and the surrender charges you pay for accessing your money early can be prohibitive.
- Commission sales: In many cases, insurance agents selling annuities receive commissions for their sales, incentivizing them to sell you more expensive products than you may need.
- High level of complexity: While the simplest annuities are easy to understand, annuities can get incredibly complex and difficult to understand. While some retirees are happy to do the necessary work to understand the specifics of any one annuity product, others are turned off by the complexity and would prefer to put their money in something that does not require a flowchart to understand.
Annuities are not the right product for everyone. Retirees who need the security of a guaranteed regular payment, protection from long-term care costs or who are unable to get life insurance may want to consider an annuity to cover their needs.
However, anyone considering an annuity needs to be fully aware of the potential costs, complexity and risks of putting their money into an illiquid, complex investment. Make sure you know what you will pay in fees and how your specific annuity would work before you sign on the dotted line.