When you plan to start receiving your income.
Everything You Need to Know About Annuities
Table of Contents
What are annuities?
The first thing you need to know is that there is no simple definition of annuity. “Annuities” is a broad category of financial products that are offered by insurance companies. Within that category, there are numerous kinds of annuities. Even annuities that are called the same thing can behave very differently depending on the specific contract and terms attached to it.
An annuity is a contract between you and an insurance company in which you agree to invest a certain amount of money in the insurance company’s annuity. In turn, the annuity will make payments to you, either for a fixed number of years, for the rest of your life or even in a lump sum. Because most annuities offer a guarantee of some kind of income, many people who are concerned about having enough income in retirement find them appealing.
How do annuities work?
The nuts and bolts of an annuity work like this:
Step 1.
You agree to give the insurance a set amount of money, either in a series of payments or a lump sum.
Step 2.
The insurance company now hangs on to your money and invests it. This makes money for both the insurance company (of course) and you.
Step 3.
The insurance company pays you an income stream, as promised in your contract, in the form of regular payments, which might be weekly, monthly, annually or a lump sum.
There Are Many Different Types of Annuities.
There are many different types of annuities available, including variable, fixed rate, fixed indexed, etc., each having different features. Some of them are popular, including indexed annuities and fixed-rate deferred annuities. After the challenges faced during the height of the pandemic, the indexed annuity market rebounded with 2021 sales increasing 15%, according to LIMRA Secure Retirement Institute.
However, not all annuities are necessarily a good fit, or a good deal. It is very important to work with a trusted financial advisor who can compare pros and cons, fees and costs for you to help you assess suitability based on your unique situation.
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“The indexed annuity market rebounded with 2021 sales increasing 15%.”
-LIMRA Secure Retirement Institute
Types of Annuities.
The different types of annuities can be broken into a couple of different categories based on two characteristics:
How your annuity earns interest.
“Your goals are the only ones that matter when planning your financial blueprint, and any plan you make, with or without a financial professional, has to start with you: your needs, your goals, your circumstances.”
– Jeff B. Junior | Trajan Wealth Founder & CEO
When you plan to start receiving your income is more officially known as the annuity’s “distribution phase.” If you’re looking at an immediate annuity, that’s the kind that begins paying you income right away. No big surprise there, right?
If an annuity is not immediate, then it is a deferred annuity, which means that you are investing now but deferring the income you will be receiving. This is a longer-term investment solution that allows you to put your money away today and let it grow tax-deferred (we’ll discuss the tax benefits of annuities soon) until you need the income. So how does your money grow? That’s the next part of how your annuity is defined, but the variance in growth is also defined by the contract terms and type of annuity it is.
Annuities are further broken down into a few different categories based on how they earn interest.
Immediate annuities
You make one lump-sum contribution. It’s converted into an ongoing, guaranteed stream of income for a specified period of time (as few as five years) or for a lifetime.
FIXED ANNUITIES
Fixed annuities allow you to lock in a rate of earning that, even over long periods of time, remains unaffected by market ups and downs.
VARIABLE ANNUITIES
Unlike the others, variable annuities are securities products, typically mutual funds invested in stocks, bonds, money market instruments, or some combination of the three.
FIXED INDEX
ANNUITIES (FIAS)
We briefly discussed this type of annuity earlier. Each FIA is tied to a stock market index, and it earns interest by participating in a set percentage of that index’s growth.
“Keep in mind that you and your needs are the most important factor in choosing whether annuity is right for your retirement plan, and if so which one?”
“Keep in mind that you and your needs are the most important factor in choosing whether annuity is right for your retirement plan, and if so which one?”
Who Are They For?
FACTORS THAT MEAN YOU MIGHT WANT TO CONSIDER AN ANNUITY
You are healthy and have a family history of longevity. Remember, annuities can offer you a lifetime income that will not run out no matter how long you live, so if Grandma and Grandpa lived into their 90s, this might be something to take into account.
You aren’t in the best of health. Alternatively, if you already know that you have a family history or tendency toward health conditions that might require long-term care, an annuity can help you plan for those costs without risking your income.
You worry about money. If just thinking about your hard-earned savings sitting in the roller coaster stockmarket is something that keeps you up at night, an annuity could be a good option for you.
You aren’t sure if you have enough to retire. If you’re working with limited assets and taking a loss would impact your retirement quality of life, an annuity might help offer some protection for the assets you’ve amassed.
Budgets aren’t your thing. An annuity will provide you a set income (or part of your income), which can be a good thing if you know that you’d spend your way through a chunk of money quickly.
You need a tax-deferred strategy to add to your retirement plan. If you’re looking for some strategies to reduce your tax burden (and who isn’t?), an annuity might offer one option.
You have specific legacy goals. Annuities can offer a number of options for people who want to leave something behind for their families or for causes they find important, even if they don’t have an excess of savings to set aside for that legacy.
Annuity Advantages
SECURITY
Perhaps one of the most prevalent reasons to consider an annuity is security. Many people close to retirement are simply not comfortable with the risk of volatility in the stock market, and they prefer to place at least a portion of their savings in a more secure investment.
TAX BENEFITS
Many people consider the tax benefits of annuities one of their greatest attributes: specifically, the interest on annuities grows tax-deferred, which allows the overall value of annuities to grow faster than if tax had to be paid monthly, quarterly or annually on earnings. Annuities can also be purchased with post-tax money, which means that the annuity owner will owe taxes on earnings only upon withdrawal (retirement, typically).
ESTATE PLANNING
As insurance products, annuities must have listed beneficiaries. This creates a framework and structure for estate planning, but it also, if structured properly, allows that money to pass to beneficiaries without the money being subject to probate.
INTEREST RATES
There are several variations of annuities. A fixed annuity provides a guaranteed minimum return by the issuing insurance company. A common guarantee on a fixed annuity may range between 2% and 6%. An indexed annuity credits interest based on the performance of a particular index such as the S&P 500.
Structured PAYMENTS
Annuities can be structured to pay-out for the life of the owner for a fixed term such as five or ten years; this spreads out your tax burden as well as provides enhanced income security. Annuities are long-term savings vehicles and may require a 10% federal tax penalty for withdrawal of funds that exceeds those discussed above prior to age 59 ½.
In 2023, total U.S. annuity sales could increase to a range of….
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-LIMRA Secure Retirement Institute
In 2023, total U.S. annuity sales could increase to a range of….
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to
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Up from the estimated 2022 U.S. individual annuity sales totaled range of…
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-LIMRA Secure Retirement Institute
Where Can You Get Them?
Annuities are insurance products, which means, of course, that they are sold by insurance companies. In some cases, however, there are also third-party companies, brokerage-type companies, that will sell annuities on behalf of insurance companies, much like life insurance brokers who sell policies from various life insurance companies.
Insurance Companies
Third-party Companies
Are There Any Risks to Annuities?
We’ve spent a lot of time covering how annuities work and, more specifically, how they can work for your retirement plan, but now it’s time to shine a light on the dark side: the risks of annuities. Some of these we’ve mentioned, but this is your retirement we’re talking about: the risks cannot be ignored.
Every financial product has benefits and risks. To create a retirement plan that will ensure your comfort and security, you need to
- Understand all of the risks and benefits of the strategies in your plan
- Know that, for you, the benefits outweigh the risks.
THE INSURANCE COMPANY
If you choose to buy an annuity, you’ll be buying it from an insurance company. Even if you use a third-party broker to make the deal, the issuing insurance company is responsible for the annuity itself and all the things you bought it for—managing the investments and paying your income. There’s no FDIC insurance on insurance products, so doing your research on every insurance company you do business with is a don’t-ever-skip step. Check all of the insurance company rating services (some to check include A.M. Best, oody’s, Standard & Poor’s, Fitch and COMDEX, which combines rankings of the previous four agencies). Also know that insurance is regulated state-by-state, not nationally, so check with your state insurance commission or regulators about any specific insurance company you’re considering buying from.
INFLATION RISKS
Anytime you commit to a set income, you have to keep in mind that inflation is going to erode the spending power of that income, no matter what you do. That’s why any income strategy needs to include a plan for inflation. Social Security generally gives a Cost of Living Adjustment (COLA), but annuities do not often include this kind of adjustment automatically. Annuities can come with inflation protection, but this comes at an additional cost and often reduces your income initially.
SURRENDER PERIODS AND PENALTIES
We all know that insurance companies are in the money-making business. They make long-term investments like annuities because they offer a way to bring in a foreseeable cash flow, providing them with predictable flows of money. In order to achieve these reliable flows of incoming (and outgoing) cash, they need to encourage investors not just to invest their money, but also to leave it there. That’s where surrender periods and penalties come in. Typically annuities allow for a 10% per year penalty free withdrawal. If however, you were to take out more than the free amount before the surrender period, you may pay a steep penalty. Liquidity needs to be given serious consideration.
It’s important to remember that an annuity doesn’t operate like a demand deposit account, such as a savings or checking account. You choose an annuity for the potential of higher returns, and those returns depend on your being able to leave your money in the annuity for a certain length of time. Surrender charges are one of reasons you may not want to invest all of your savings into an annuity. By working with your trusted financial professional, you can determine the appropriate asset mix that is right for you.
LIQUIDITY
We’ve mentioned this before, but your retirement plan—and all of the strategies in it—must work with your goals and your personality. You might be a person who cannot sleep at night unless you have a certain mount of money in the bank, or at least accessible, in case of emergency. Maybe you only need a basic emergency fund, and that’s it. Either way, liquidity is an important consideration in your retirement plan. As we’ve mentioned, most annuities do allow some liquidity. Plus, many contracts allow you to remove the earned interest on a monthly basis. What’s more, if you need total access to your premium (known as a return of premium clause), that is also possible with some annuity contracts, though this comes at a steeper cost. There are also riders to give you access to your premium or additional funds if you are hospitalized, undergoing a life-threatening illness, subjected to a permanent or extended stay in a nursing home, or other major calamities that affect you economically.
COMMISSIONS AND FEES
This is a risk with virtually every financial product, and that is another reason you always want to get a clear, transparent answer when you ask exactly what you’re paying for. If you are working with a financial professional who is making a commission, that doesn’t necessarily mean you are getting bad advice. But wouldn’t you be more comfortable if you knew up front that the professional is getting a commission? That way, perhaps you could weigh your decision accordingly (with, perhaps, a second opinion).
Fees can be another challenging issue with annuities, as some certainly do charge more than others. No fees should ever be hidden. You should be able to see exactly how much you’re paying for the management of your annuity and how often, as well as be aware of any additional fees you’re paying for riders or other services.
All of the risks exist and should not be ignored, but that doesn’t mean you shouldn’t consider an annuity as a potential strategy for your retirement portfolio. As mentioned earlier, there are risks with virtually every financial product on the market. What matters most is that you are aware of and comfortable with all the risks and benefits and, with the help of a financial professional you trust, you’ve accounted for those risks in a well-balanced portfolio that meets your unique needs.
PROTECT YOURSELF
It’s pretty easy to see that annuities offer almost limitless options for addressing the challenges of retirement income planning, but they also come with some pretty vast complexities. In order to protect yourself, be sure that before you buy anything, you’ve covered all of these key steps:
Work with a financial professional who is independent and experienced. Not only is it critical that you work with someone who can explain all of the various terms of any annuity clearly, but also, you want an expert who can help you shop around.
Comparing as many options as possible is one of the best strategies you can use to ensure that you get the right annuity for your goals.
Focus on the end result. The actual amount of income you will receive (or spousal income, or death benefit, etc., depending on your reasons for buying the annuity) is the important thing. That number, based on actual contractual terms, is the number to focus on. You might be surprised to learn that it’s considered ethical (by some annuity agents) to talk to potential annuity buyers about hypothetical returns, rather than to explain the exact contract and hard numbers. Don’t allow that. You deserve to know exactly what you can depend on.
Buy from a company that you can trust. Unlike bank products, annuities are not FDIC insured, so just like you want to do your research about the actual annuities you are considering, you also want to do your research about the insurance companies you’re considering buying them from. Talk to your financial professional about each insurance company’s ratings before making any final decisions.
FAQ
The two main types of annuities are deferred and immediate annuities. Deferred annuities gain funding for a while before they begin to pay out. Immediate annuities begin to send you payments soon after you begin to pay into the account.
Within these categories there are fixed and variable. Fixed annuities include a preset amount of income. Variable annuity payments are based on how well your account investments do, so they can change.
Most investment accounts, such as IRAs and 401(k)s, have annual contribution limits. Annuities, on the other hand, do not have a contribution limit. This makes them extremely beneficial if your annual contribution to your retirement fund exceeds the limits for other types of accounts.
The tax process on annuities can be a bit complex. One of the benefits of annuity is that they are taxed as regular income when you begin to withdraw from them, which is fairly familiar to most people. Where it gets complicated is when you fall below the total premium sum that you contributed, the amount is usually not taxed at all. Having a financial adviser to oversee your annuity tax process is always a good idea.
Unfortunately, early annuity withdrawal comes with a 10% penalty. This can be a significant amount of money, especially since you have likely been contributing to this account for most of your life. It is best to contribute money that you know you will not need until you reach 59.5 years of age.
When explaining annuities versus other retirement accounts, the main difference is how you withdraw the money. With other accounts, you can take out the money as you would like to. With an annuity, you are receiving the money in payments that are similar to an income structure. This means that it’s more difficult to spend large amounts of your annuity account at once.
Take A Deeper Dive
This comprehensive eBook is a straight-forward guide to understanding how annuities work, the various types of annuities, and the questions to ask before purchasing one. Yours for free!
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