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Annuities: The Basics
Annuities are one of the most effective yet least-known ways to save for retirement and ensure financial stability in your later years. This article will cover how annuities function, and how you can use them to help yourself in retirement.
What is an annuity?
An annuity is an individualized insurance contract that guarantees its buyer a fixed income or lump-sum payment at some point in the future. Annuities can be bought through a one-time payment or series of payments and serve as a helpful tool for those planning for retirement since buyers can be confident in the guarantee of future income. In essence, through an annuity, insurance companies assume the risk of you outliving your retirement savings, providing you with future income in exchange for current payments.
How does it work?
Although the functional details of annuities differ depending on individual contracts and the type of annuity, a buyer generally pays an upfront premium to an insurance company in exchange for guaranteed future income. As mentioned, premiums can be paid as a lump sum or through a series of payments. Similarly, the payout structure of annuities varies.
An immediate annuity usually begins paying the buyer within a month of the purchase till their death.
A deferred annuity goes through a process of accumulation—allowing your premium to grow tax-deferred through different investments until the payment period begins. This payment period is also known as the annuitization phase, and the length in between these periods depends on the details agreed upon in the insurance contract. In most cases, upon the beginning of the annuitization phase, your income is guaranteed until death unless otherwise specified within the initial contract.
Types of Annuities
One of the most important distinctions between different annuities is the start of the payout period. Annuities can either be deferred or immediate with the difference between the two being the start of the payment period. Annuities also differ in how they pay the buyer. The three main types of annuities are:
Fixed It pays out a predetermined amount based on a pre-set, fixed interest rate. For instance, a $10,000 fixed annuity at 5% would pay out $500 each payment period.
Variable It pays income based on the performance of investments you choose within the annuity. Payouts vary depending on your investment returns, making it a riskier but potentially more rewarding option.
Indexed It serves as a hybrid of the other two types. An indexed annuity’s payouts guarantee a minimum interest rate, but also allow for potential growth by tying the payouts to a given stock index such as an S&P 500 index fund. This choice allows for higher payouts when the stock index is performing well, but also guarantees a minimum income.
Fees are another important factor to consider when choosing an annuity as they vary between each type. Generally, fixed annuities have the least fees; variable, the most.
Benefits of Annuities
One of the largest benefits of annuities is the freedom to shape the contract to your individual needs and desires. Depending on your proximity to retirement and risk tolerance, you can craft an annuity that is designed to address your specific needs. This freedom is achieved through contractual mechanisms are known as riders, or special clauses/addendums that can be inserted on a case-by-case basis. As such, it’s critical to review the riders within your annuity and ensure your full understanding of the details before signing. Another large benefit of annuities is their favorable tax structure. After paying income tax on the money used to purchase an annuity, your investment will be able to grow tax-free until you begin receiving income from it in the future.
Drawbacks
While annuities may be very helpful to certain people, they still have downsides. The fees and commissions associated with annuities are one of their largest drawbacks. Annuities entail fees and commissions due to the risk assumed by the insurance company, and these charges can cut into your investment returns and future income. The fees associated with annuities also underscore another major drawback. Compared to many other investment vehicles, annuities often only earn modest returns, imposing an opportunity cost on the buyer. Before buying, you should consider the potential for gaining greater returns on other investments as tying up your money in an annuity could cost you a great deal in potential lost investments.
Deciding whether an annuity is right for you comes down to your personal circumstances, and you should weigh their various benefits and drawbacks in tandem with your future plans and lifestyle. Either way, it’s important to be aware of this unique option when planning for your later life.
