You may have heard about annuities, but do you understand what they are and the role they could play in your retirement strategy? According to a recent study, only 19% of American adults correctly identified the definition of an annuity. Gain a better understanding of how annuities may factor into your plan for retirement.
How annuities work
An annuity is a contract between you and an insurance company. You make an investment in the annuity, and in return the insurance company agrees to make a series of payments (or a lump-sum payment) beginning on a future date. The income you receive from an annuity can be paid out for a specified period or even for the rest of your life.
What is a retirement annuity?
Annuities differ from other types of retirement accounts like 401(k)s and IRAs in that they are designed to offer a guaranteed stream of income during the payout period. In the case of fixed annuities, the insurance company assumes the risk of market volatility, agreeing to pay a set rate of interest for the duration of the contract. While variable annuities may be subject to market performance, they still offer a guaranteed stream of income. A retirement annuity can work alongside your other retirement savings such as Social Security, a 401(k) and/or an IRA to provide a base level of income that can be supplemented by additional retirement savings.
How do annuities work in retirement?
Annuities are often used as a retirement strategy tool primarily because they can allow you to turn a lump sum of money into a steady income stream for a set number of years, or even the rest of your life. Common uses for annuities in retirement strategy may include, among other things, accumulating assets, supplementing Social Security or a pension, and receiving income for life.
Consider an example. Helen and Tom are in their late 50s and have set aside $900,000 in retirement savings. They estimate that their monthly expenses will total $6,000. Together, they will draw $4,500 per month in Social Security. To fill the gap, they invest $250,000 from their retirement account in a fixed annuity, which provides an income stream of $1,500/month to fill the monthly expense gap. They invest the remainder of their retirement savings in a mutual fund in hopes of achieving some growth so that if expenses increase with inflation, unexpected medical bills or other challenges present themselves, they will still have some additional retirement funds.
Retirement advantages of annuities
There are different kinds of annuities to meet your particular goals. Fixed annuities offer a guaranteed income stream over time, insulating that income stream from market volatility which may apply to other retirement savings accounts. Indexed annuities offer some potential for growth, but limit risk. Variable annuities offer greater potential for growth, but are subject to volatility.
One of the greatest advantages of using annuities for retirement strategy is that you can put away larger sums of cash and defer paying taxes on growth. Just like your 401(k) or IRA, as long as you leave your earnings alone, the growth on annuities is tax-free until funds are withdrawn. However, unlike other tax-deferred retirement accounts, there are no annual contribution limits. Not only does this allow you to save more, but it’s useful for individuals who are nearing retirement and need to catch up.
Is a retirement annuity right for you?
There are many different financial tools available to help you achieve your retirement goals. The decision of whether or not to invest in an annuity depends on your own retirement strategy, your financial situation and personal goals. Consider some of the pros and cons of annuities compared with other retirement strategies.
Pros of retirement annuities:
- Annuities, specifically fixed and indexed annuities, are less risky than 401(k)s and IRAs because your money is not subject to extreme market volatility. With a fixed annuity, the risk is assumed by the insurance company so you receive a guaranteed stream of income regardless of market performance.
- There is no contribution limit to an annuity, so you can contribute as much as you’d like. This is in contrast with other types of retirement accounts, which place a cap on contribution limits.
- Unlike savings in your 401(k) or IRA, annuities may provide a guaranteed stream of income throughout your retirement years.* If you’re concerned about outliving your retirement savings, an annuity may be a good option for you.
- Contributions to annuities grow tax deferred and you pay income taxes on the distributions only once payout begins. In many cases, your effective tax rate may be lower when you retire than it is during your prime earning years, so this tax-deferred investment can save you money.
Cons of retirement annuities:
- Annuities often offer less risk, but also less growth potential than other financial vehicles. In times of strong market performance, your investments made in a 401(k) or IRA could experience more growth than an annuity.
- Due to the risk assumed by the life insurance company offering annuities, there are administrative, investment and other fees associated with them. Early withdrawals are also penalized.
- Annuities may offer less flexibility than other types of retirement strategies. Riders that add flexibility, such as return of premium, living benefit riders or others may be expensive.
Types of retirement annuities
When it comes to retirement annuities, there are several options available. Carefully consider the differences so you can choose the option that works best for you.
Fixed annuity
A fixed annuity gives you the promise of fixed interest payments over a specified period of time. You agree to deposit a lump sum of money or series of payments and the insurance company agrees to pay you a guaranteed rate of interest that compounds on a tax-deferred basis.
Variable annuity
A variable annuity (VA) puts your money in investments that you select from a list made available by the issuing insurance company. Most often, those investments are a variety of portfolios providing you with options that may include both stocks and bonds. It's these investments that will determine how your variable annuity will perform. Like all market investments, they can create gains or losses to your investment. As an additional benefit, some VAs offer an enhanced death benefit that guarantees your beneficiary won't receive less than your original investment (minus withdrawals) should you pass away during the accumulation phase - no matter how the funds perform. However, all guarantees are dependent upon the claims-paying ability of the issuing insurance company.
Indexed annuity
The indexed annuity is a type of fixed annuity that calculates interest payments based on upward and downward movements in common indexes such as the S&P 500 Index. You are provided the opportunity to enjoy the benefits of positive upturns in the index (subject to a cap) with a limit to your downside risk. However, you would not be directly invested in the stock market or index.
