If you’ve started planning for retirement you may have heard of annuities. Doing a quick online search will result in a lot of information, as well as some misinformation. The reason for this is because there are a wide variety of annuities, each with their own specialized options. While this can seem overwhelming and complicated at first glance, it's what allows annuities to be customizable.
So what exactly is an annuity? Basically, an annuity is a retirement income contract offered by insurance companies. They are a long-term agreement that allows you to accumulate funds on a tax-deferred basis, which are then paid out in regular instalments, guaranteeing income during your retirement years. Annuities are structured to give your retirement plan a reliable foundation to build on. Because of this, annuities are not primarily an investment, rather they are a disbursement vehicle. In this way, they work much like corporate pension or Social Security. The payments you receive may last for a predetermined length of time, such as 20 years, or they can be ongoing for your lifetime, and/or the lifetime of your spouse.
So why would you want to consider an annuity?
The main reason people look at annuities is because they provide guaranteed income that you may not outlive. Annuities generate a consistent income stream. Some other benefits are:
You may get back the money you put into it; you won't lose the money you started with.
Annuities aren’t subject to an annual contribution limit, if you have more to contribute to your retirement after you’ve reached your 401(k) and IRA limits you can put it into an annuity.
You can design annuities to fit your needs and lifestyle. You can manage how much income and how much risk, and using riders, you can add on, and customize your annuity to meet your specific needs.
They can also provide for your loved ones when you are gone.
As mentioned before, there are different types of annuities. This is where people tend to get confused. There are fixed, variable, and indexed annuities. Each of these come with their own level of risk and payout potential. You can also choose between immediate or deferred annuities.
A fixed annuity guarantees a set interest rate for a length of time, which may be adjusted on the annuity’s anniversary. The distributions may also be a fixed amount for the term established. With this option you are guaranteed your initial investment and it earns interest at a fixed rate.
A variable annuity fluctuates depending on the returns of the subaccount(s) (similar to a mutual fund(s)) you have selected, making its value go up or down, which in turn could affect the payment amount you receive.
An indexed annuity is a type of fixed annuity that has features from both the fixed and variable annuities. With indexed annuities your investment is protected when the market is down, but still has the possibility of growing your investment more when the market is up.
An immediate annuity begins issuing payments after a lump-sum has been deposited. Once you give the insurance company a lump sum of money you start receiving payments. This option is great if you have acquired a large amount of money like an inheritance.
A deferred annuity starts payments on a future date determined by the owner. You can purchase a deferred annuity with a lump sum, a series of periodic contributions, or a combination of the two.
Think about making a salad- Salads start with a base of leafy greens, but there are a few different choices out there, you’ll pick the one you like best. Once you’ve picked your base you can start adding on the toppings and extra things.
There are some downsides to going with an annuity. Some annuities have fees (generally variable annuities) associated with annuities, which may reduce the value of your annuity. And, like many retirement accounts, if you withdraw money before age 59 ½ you are subject to a 10% penalty penalty tax. You could also get hit with a surrender fee. However, depending on how your annuity is structured,you may be allowed to take out a certain percentage each year without paying a surrender fee, which decreases each year.
While annuities provide a lot of flexibility and options, you pay for all those extras. Those riders mentioned earlier, they can add up quickly. The more riders you add, the more expensive your annuity will be. You will have to weigh the advantages against the costs, and decide if those are really worth it.
Often an annuity works well to fill the gap between desired income, and what Social Security, and/or what a pension is paying. For example: if your planned retirement income is $6,000 per month and you are receiving $2,400 from a pension, and $1,800 from Social Security, totalling $4,200, then you can use an annuity to fill in the gap that would provide a guaranteed income of $1,800.
The word annuity comes from an ancient Roman term annaus - meaning payment, which was a gift to soldiers and their families.
“If you take care of the pennies, the dollars will take care of themselves.”
~ Russell Sage, The Maxims of Wall Street, p. 62