What Is an Annuity?
Annuities are financial products that provide tax-deferred income designed to mitigate the risk of outliving savings during retirement. They can be purchased from an insurance company with either a single lump sum or a series of payments.
How Do Annuities Work?
Annuities are popular financial products for retirement because they offer tax-deferred growth and a guaranteed income stream.
You can purchase an annuity in a single payment, called a principal, or with multiple payments.
- Accumulation: The savings phase.
- Distribution: The payout phase.
Annuities offer flexibility and hedge against longevity risk — the threat of running out of money in retirement.
Payout options for annuities include a lump sum, a series of payments distributed over a specific time period or guaranteed payments for life.
Annuities vs. Life Insurance
Annuities and life insurance share similarities. Both offer protection against risk and take the form of a written contract between you and an insurance company.
However, these products serve very different purposes.
Life insurance is protection in case you die too soon. An annuity is protection in case you live too long.
In other words, life insurance protects your beneficiaries if you pass away prematurely while an annuity protects your income if you live longer than expected. Both are common components of retirement planning.
Types of Annuities
Annuities come in all shapes and sizes. The right type of annuity for you depends on many factors, including your income, risk tolerance and when you want to begin receiving payments.
A fixed annuity guarantees a return of your premium plus a minimum interest rate. The interest rate may be guaranteed or may fluctuate from year to year, depending on your contract.
Fixed annuities are considered predictable ways to ensure income after exiting the workforce. Payouts are not affected by fluctuations in the market, so they can provide peace of mind for those nearing retirement.
- Earns a guaranteed rate of interest for a specific period of time.
- Backed by the insurance company that issues it.
- The simplest type of annuity.
- Payments typically do not have cost-of-living adjustments to keep pace with inflation.
- Money grows on a tax-deferred basis.
Fixed Index Annuities
According to the U.S. Securities and Exchange Commission, interest rates for indexed annuities are tied to an equity index, such as the Nasdaq. Indexed annuities carry more risk than fixed annuities, but less risk than variable annuities.
- Earns interest based on a market index, such as the S&P 500.
- Money grows tax deferred.
- Preserves your premium.
- Guaranteed minimum rate of return.
- You don’t lose money if the stock market underperforms.
With a variable annuity, the money you pay is allocated to an investment portfolio. These underlying investments, or subaccounts, may include stocks, mutual funds, bonds, money market funds or other options.
The amount of money you receive will vary depending on how much money you put in and the performance of your underlying investments.
You may be able to purchase a rider for an extra fee that offers a guaranteed minimum withdrawal or income benefit, even when market performance is poor.
- Earns interest through investments you select within the annuity.
- Does not guarantee a return but offers more growth potential.
- Money grows tax deferred.
How to Buy an Annuity
Annuities are sold by insurance companies as well as some banks, brokerage firms and mutual fund companies.
Three Ways to Purchase an Annuity
- You can transfer funds from an existing annuity or retirement account.
- You may purchase an annuity within a 401(k) plan offered to you by your employer.
- You can fund an annuity using cash from your bank account.
- Assess your current and future financial needs.
- Select your provider. Do your homework. Select a company with a reliable reputation and sound financial history. Annuities are usually regulated by state insurance commissioners. Be sure to check with them to confirm that your broker is registered to sell insurance in your state.
- Choose an annuity that meets your needs, and carefully review contract terms. High expenses and fees can erode an annuity’s value. It’s critical to shop carefully to ensure you get the best deal. All fees should be clearly detailed in your contract.
- Complete the application.
- Transfer funds.
The Role of Annuities in Retirement
One of the greatest benefits of an annuity is a guaranteed income stream that gives people peace of mind by ensuring their needs will be met during retirement.
Annuities provide what the industry calls “longevity insurance,” or protection against outliving your savings.
Pensions are increasingly rare in the United States and Social Security may not cover all your living expenses. A retirement savings account, such as a 401(k), can help bridge this gap, but these plans don’t offer the same income guarantee as annuities.
Annuities are also beneficial for retirees because they offer a death benefit to loved ones. If you die before you start receiving annuity payments, your designated beneficiary will receive payment instead.
7 Cited Research Articles
- Chorpenning, A. (2020, January 2). Annuities vs. Life Insurance: Key Differences. Retrieved from https://finance.yahoo.com/news/annuities-vs-life-insurance-key-161944046.html
- U.S. Securities and Exchange Commission. (2019, August 13). Investor Bulletin: Indexed Annuities. Retrieved from https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletin-indexed
- CNN Money. (n.d.). What are the advantages of annuities? Retrieved from https://money.cnn.com/retirement/guide/annuities_basics.moneymag/index4.htm
- Financial Industry Regulatory Authority. (n.d.). Fixed Annuities. Retrieved from https://www.finra.org/investors/learn-to-invest/types-investments/annuities/fixed-annuities
- U.S. Securities and Exchange Commission. (n.d.). Annuities. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities
- U.S. Securities and Exchange Commission. (n.d.). Guide to Variable Annuities. Retrieved from https://www.sec.gov/investor/pubs/sec-guide-to-variable-annuities.pdf
- Wall Street Journal. (n.d.). How to Select and Shop for an Annuity. Retrieved from https://guides.wsj.com/personal-finance/retirement/how-to-select-and-shop-for-an-annuity/