With the retirement playing field cluttered with crumpled investments and dreams, the security of assured income streams seems more desirable each day. Some annuities can offer such a guarantee.
If you ask an insurance company to describe annuities, the marketing phrase the insurer will most likely use is: “Annuities can generate an income stream you can’t outlive.” That can be real. Annuity income can last for as long as you live – or even longer – because the payments depend on your life expectancy.
On the exterior, this looks great, but annuities are among the most frequently misinterpreted and misused financial products.
The problem is annuities are often sold and not bought. Consumers are shoved into ill-fitting products because that’s what the broker is selling that month. It’s crucial to be an educated consumer when you look for an annuity, so let’s look at what annuities are, how income annuity works, types of annuities, and more.
An annuity income is an insurance product that gives out income and can be utilized as a part of a retirement strategy. Annuities are a common choice for investors who want to obtain a stable income stream in retirement.
While annuities can be valuable retirement planning tools, they can also be a terrible investment choice for particular people because of their extremely high expenses. Financial planners and insurance salesmen will often try to turn seniors or other people in a variety of stages toward retirement into annuities. Anyone who is looking to buy an annuity should study it carefully first, before determining whether it’s a suitable investment for someone in their position.
You purchase an annuity because it does what no other investment can do: Give guaranteed income for the rest of your life no matter how long you live.
This makes annuities popular retirement planning schemes. Annuities can offer more tax-sheltered methods to save for retirement if you’ve already maxed out your 401(k) and IRA. Because annuities have no contribution thresholds, you can save as much as your heart desires.
And since your annuity will provide guaranteed income, later on, you may possibly be able to take a more assertive investing strategy with your other assets.
An annuity works by shifting risk from the owner, labeled as an annuitant, to the insurance company. Like other kinds of insurance, you pay the annuity company premiums to carry this risk. Premiums can be a single lump sum or a series of payments, based on the type of annuity. The premium-paying period is called the accumulation phase.
Contrasting to other types of insurance, you don’t pay annuity premiums forever. Sooner or later, you cease paying the annuity and the annuity begins paying you. When this occurs, your contract is believed to enter the payout phase.
There’s great flexibility in how annuity incomes are managed. Annuities can be designed to initiate payments for a fixed number of years to you or your heirs, for your lifetime, until you and your spouse have passed away, or a mixture of both lifetime income with a guaranteed “period certain” payout. A “life with period certain annuity” pays you income for life, but if you die during a particular time frame (the period certain years), the annuity will pay your beneficiary the rest of your payments for the contractual period you opted at the time of application.
As with Social Security, annuity lifetime income streams depend on the recipient’s life expectancy, with smaller payments collected over longer periods. So, the younger you are when you start receiving annuity income, the longer your life expectancy is, or the longer the period certain term is, the smaller your payments will be.
Payments can be monthly, quarterly, annual, or even a lump sum. They can start instantly, or they can be postponed for years, even decades.
Annuities are extremely customizable. Finding an annuity to fulfill your needs comes down to two questions, What do you want the money to contractually do? And second, when do you want those contractual guarantees to begin?
A fixed annuity pays you a guaranteed annual minimum, making sure you receive a baseline of annuity income from the contract each year. Based on the details of the annuity contract, a fixed annuity could pay you more in years when the annuity company’s investments earn higher returns.But during less rewarding years, you get at least the guaranteed minimum amount of annuity income.
To put it another way, the guaranteed annual minimum income from a fixed annuity does not depend directly on market performance. Fixed annuities are the securest option because you know the exact minimum you will earn over time, assisting you to calculate your annuity income when you start taking distributions.
With a variable annuity, your annuity incomes are based on market performance. You choose a variety of investments, typically mutual funds that hold stocks, bonds, and money market instruments. The amount of money paid out to you is decided by the performance of these investments, after expenses.
Risk is more with a variable annuity, but you also get more benefit from the investments. If your
investments do well, your annuity balance will increase more rapidly and your future payments will be larger. But, if your investments do badly, your balance will grow less quickly and could even drop value, reducing your future payments.
The amount you earn from an index annuity is decided by the performance of a market index, like the S&P 500. Your annual return is computed over the course of a specific period, usually one year. When the index gains value, the value of your index annuity increases, but it also loses value when the index declines.
This potential for volatility is the key feature of an indexed annuity. Though, your gains and losses are normally covered by the annuity contract. The participation rate restricts how much you can gain when the index rises and stock dividends are usually excluded from your index gain. On the downside, a floor is usually included, which limits your annual loss no matter how far the index falls.
For instance, an index annuity contract might say the most you can earn in a good year is 7%—no matter how much the underlying index gains in one year—but during market slumps the annuity company guarantees you would not lose money, so in the most terrible case you just have a return of 0%.
An immediate annuity starts paying income (almost) instantly. Though it’s annuitized immediately, an immediate annuity doesn’t begin paying income right away. You make a single lump-sum payment to the insurance company, and it begins paying you income one annuity period after purchase, which can be 30 days to one year later.
The period depends on how frequently you choose to receive income payments. For example,
if you select monthly payments, your first immediate annuity income will come one month after you purchase it. Because payments start so soon, immediate annuities are popular among retirees.
A deferred product, by contrast, is more of a long-term tool. After paying in, you don’t collect until a specified date. Before you get to that date, your money has the opportunity to either accrue interest (fixed annuities) or benefit from market gains (variable annuities).
A life insurance policy is an example of a fixed annuity in which an individual pays a fixed amount each month for a pre-defined time period (typically 59.5 years) and receives a fixed income stream during her retirement years.
An example of an immediate annuity is when an individual pays a single premium, suppose
$200,000, to an insurance company and receives monthly payments, say $5,000, for a fixed time period afterward. The payout amount for immediate annuities is based on market conditions and interest rates.
The annuity fund is the part of your annuity contract where returns are received. How your annuity fund works is based on the type of annuity you have.
With a fixed annuity, for instance, the annuity fund may be part of the company’s larger investment portfolio. An asset manager manages how investments are made and where funds are allocated to generate returns. Keep in mind, fixed annuities have a tendency to be more conservative compared to variable annuities, so your annuity fund may hold things like government securities or bonds as well as stock-based mutual funds.
With a variable annuity, the investment method is a little different. For example, you may have a heavier weighting of stocks to bonds or have the choice of investing in a wider range of mutual funds, including index funds, target-date funds, or exchange-traded funds. Based on how the annuity fund is set up, you may have more of a direct say in which funds you would like to invest where.
For instance, apart from increasing your exposure to stocks and bonds you may have the alternative of allotting part of your annuity fund to safer investments. You might decide to put some of your money into a money market fund, for example, or CDs and bonds that earn a guaranteed rate of return. Combining things up this way increases diversification, which can assist you better in controlling risk.
Once you know what an annuity fund is, you can contemplate which type of investment is best based on your goals. That goes back to deciding whether you’re more comfortable with a fixed, variable, or indexed annuity.
For instance, all three types of annuities can provide guaranteed income for life. You could
also shape your annuity to give income payments to your spouse for their lifetime if you’re married. A fixed annuity would offer more downside protection against market losses compared to a variable annuity. A variable annuity, nevertheless, could offer better growth.
Getting to know which one to select means knowing your risk tolerance and risk capacity. Risk tolerance implies how much risk you’re comfortable taking on. This is completely a personal preference but usually, investing experts say that the younger you are, the more risk you can endure since you’d have longer to recoup from a market recession.
Risk capacity is the degree of risk you need to take to attain your investment goals. Risk capacity may not constantly align just with risk tolerance so it’s critical to measure both to decide how wide the gap may be. Between a fixed and variable annuity, the variable annuity would mean taking on more risk.
To keep things in viewpoint, study what type of returns you’re seeking on your money. If you have other retirement investments, such as a 401(k), individual retirement account, or a pension, then you may not need your money to rack up huge returns. But, if you’re feeling that you are not fully prepared for retirement, you may need to see a little more growth from your annuity to attain your income goals.
Yes, it’s likely to lose money with some kinds of annuities. All else equal, if
Nevertheless, these are edge cases. Of the annuities discussed here, only the variable annuity without an income rider characterizes a similar risk of loss as owning a mutual fund or ETF of equities.
If you’re seeking a simple annuity where you know what you’ll get in guaranteed return or guaranteed monthly income at the time you purchase, you’re best off going with a traditional fixed annuity (for a CD-like guaranteed return) or income annuity with a cash refund (for monthly income) from a highly-rated insurer.
Annuities can be a useful part of a retirement plan, but annuities are complicated financial vehicles. Because of their complexity, many employers don’t offer them as part of an employee’s retirement portfolio.
Nevertheless, the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law by President Donald Trump in late December 2019, relaxes the rules on how employers can choose annuity providers and include annuity options within 401(k) or 403(b) investment plans. The relaxation of these rules may cause more annuity options to open to eligible employees in the near future.
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