Before we jump into explaining annuities, let’s go over why they’re so important.
We’ll start with the fact that Americans are living longer, while simultaneously struggling to save enough for the future. In fact, did you know that according to the Social Security Administrations website, on average:
- men aged 65 today are expected to live until age 84,
- and women aged 65 today are expected to live until the age of 86.5.
Aside from the fact that 1-in-4 Americans have no retirement savings, those who do are on track to outlive their income! Furthermore, many are fully aware of their lack of retirement and general savings, but few are doing anything about it.
For instance, in Northwestern Mutual’s 2019 Planning & Progress Study, on average people expressed a 45% of outliving their savings, yet 41% haven’t taken any preventative action. Certainly a problem that annuities are designed to solve!
So, are you hoping to escape the average and find long-term financial security, retirement income, and principal preservation? If so, an income insurance product called annuities may be just the thing you’re after!
Here’s a fun fact for your next trivia night escapade: What do you call an owner of an annuity? An annuitant.
- An annuity converts an investor’s premiums into a guaranteed fixed income stream.
- The annuity type you purchase will determine the future annuity payments.
- With an annuity you can have guaranteed income all throughout retirement.
- You can have the option to customize your annuity and leave money to your spouse and heirs.
- Annuities come in immediate and deferred forms.
- There exist fixed, indexed, and variable annuities to choose from.
What is an annuity?
Annuities are customizable insurance contracts designed to offer people a hedge against outliving their money, and/or bridge the retirement savings gap by guaranteeing a fixed income for life.
These are legally binding written agreements between you and issuing company, generally a life insurance company. They’re not something you can back out of on a whim, without a penalty. The annuity contract essentially transfers the risk of you outliving your savings to the annuity provider.
In other words the provider promises to pay you a series of guaranteed fixed payments, starting at an agreed upon time in the future. As a result of you paying premiums (or a one-time lump sum) until that time comes, as stipulated by the contract. You pay now for a guaranteed income later.
How do annuities work?
As mentioned above, these insurance products offer a reliable and steady income stream for a specified period of time. Moreover, they’re meant to support you retirement financial needs.
By design, and all else being equal, annuity holders cannot outlive their annuity income stream.
Consider these shocking retirement statistics we’ve compiled, and you’ll begin to see why annuities can be a life-saver! For example, according to the Insured Retirement Institute roughly 42% of baby boomers had no retirement savings (Source: IRI). Yet, 80% of the Baby Boomers surveyed said they believed retirement income sources be guaranteed for life.
And that’s exactly what annuities offer! Here’s how an annuity works in a nutshell.
The two phases of an annuity
This is the period in which you’re still making periodic payments and funding/growing the annuity. The technical insurance terms for these periodic payments you’re making is ‘premiums’ or ‘deposits’. Annuity payments can be made monthly, quarterly, yearly, or at any other regular interval of time.
But keep in mind that annuities can also be structured to accommodate for a lump-sum funding method, known as an immediate annuity. In other words, you trade a lump-sum of money now, for an ongoing and guaranteed stream of income for a set number of years, or for the rest of your life.
For example, consider the ironic fact that most lottery winners eventually go broke. It’s an unfortunate phenomenon, yet had they been advised to construct a lump-sum funded immediate annuity before their wild spending sprees, they would at least have a significant backup plan.
As soon as you start receiving annuity payments, you’ve entered the annuitization phase. As a result of all those years of investing in your annuity, it’s time to reap what you sowed and collect your payment(s)!
Of course the amount you’ll be receiving and for how long will all depend on the type and value of your annuity. But generally speaking, the more money you put in, the more money you’ll receive.
Furthermore, once the annuitization period takes effect, you’ll have the following payout method options:
- Life Option: Typically offers the highest payout, and provides you with an income stream for life. Under the joint-life option, the payments continue to your spouse after your death.
- Period Certain: Your annuity’s value is paid out over a defined period of time you choose. For example, if you choose a 10-year payout period and happen to die at year 6, the contract will guarantee your beneficiary gets paid for the remaining 4 years.
- Systemic Withdrawal: With this method you’re choosing to systematically and eventually withdraw the full balance of your annuity. Essentially risking depletion of funds before death.
- Lump Sum: Undoubtedly a self explanatory option. As a consequence of choosing this option, the amount is typically less than the sum of payments that you would have otherwise received. Because you’re asking the annuity provider to produce much more money upfront than they would have otherwise been required to.
Additionally, annuities also come with something called a surrender period. And its basically a prohibitive period during which you cannot withdraw funds from your annuity without a penalty.
For one thing, depending on the type of annuity, these surrender periods can last anywhere from 2 to over 10 years and the associated penalty could be 10% or more! Thus, tread carefully.
Annuities vs. life insurance
Another question people tend to have is regarding the difference between life insurance and annuities. Are they the same thing? No, but you can think of them as two sides of the same coin.
Indeed, from a life insurance company’s perspective with one product they’re offering protection from dying prematurely, and with the other they’re offering protection from outliving your savings.
With a life insurance product the company can incur a loss if the policyholder dies prematurely, below the average set by the actuaries and supported by data science. Whereas with annuities, the risk to the insurance company is that the policyholder will survive well above the industry average.
We mention life insurance companies because they are the most common type of institution to issue annuities. But also because life insurance is something you should seriously consider.
Did you know that 40% of Americans leave their families with financial burdens when they pass away? Take a look at these life insurance statistics that will make you consider getting a policy!
Example of an annuity
Here’s a very basic overview of how an annuity works at a very fundamental level.
- You buy an annuity for $60,000 and in return you get $1,200 per month for 5 years.
But are you getting a good deal? Let’s do the math.
- $1,200 per month for 5 years = $1,200 x 12 x 5 = $72,000.
Since the math checks out, you’re probably wondering why you’d get out more than you deposited? Because to a risk juggling annuity provider money now is better than money later.
In the finance world this is a concept known as the present value of money. Generally speaking, they can take your initial $60,000 and invest it, earn interest, and do other financial Kung-Fu with it.
But also to further offset their risk, annuity providers charge fees and other administrative expenses. In addition to the mentioned surrender period, during which you’ll face a penalty for withdrawals.
Real life example: One common type of annuity that you’ve most likely heard of are pension payments.
Who regulates annuities?
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Accordingly, those selling annuities must hold a state-issued life insurance license to be compliant. As well as a securities license, for those selling variable annuities.
Cash now vs. cash later
Annuities come in two basic forms: immediate and deferred.
Which you choose will depend primarily on your financial goals. In the case of immediate annuities, you’ll start receiving payments right away. Alternately, a deferred annuity allows you to push the specified start date of the annuity payments as far out into the future as you see fit.
We are about to go over the differences between immediate and deferred annuities, but keep in mind that combining the two is also an option, through something called a split-funded annuity.
Cash now (immediate annuities)
Representing a small portion (roughly 10%) of annuities sold each year are immediate annuities.
Also known as Single Premium Immediate Annuities (SPIAs), immediate payment annuities, or income annuities, they’re constructed for income purposes only. Popular among those reaching retirement age and looking to supplement their Social Security income and pension plans.
As a result they skip the accumulation phase and jump right into the payout period. Thus, they typically begin paying out either immediately or within a year after you’ve purchased one with a single, lump-sump payment.
Some key characteristics of immediate annuities:
- funded through a single lump-sum payment (aka premium)
- guaranteed and immediate monthly payouts
- can be funded with pre-tax and after-tax dollars
- no account or management fees
- helps supplement retirement savings
Because you’re dishing out a large sum of money, be sure to sit down with your financial advisor and really think the decision through. Receiving a guaranteed and immediate cash flow is certainly a pro, but what if you need a large sum in the near future that significantly exceeds them?
Cash later (deferred annuities)
Unlike the cash now approach, deferred annuities are all about receiving cash later. In fact, the two phases we mentioned, accumulation and payout phases, apply to this type of annuity. Whereas immediate annuities skip the accumulation phase and start paying out within a year, deferred annuities can take years of accumulation to reach the payout phase.
But the good news is, as you’re making payments into your deferred annuity, the earnings on your premiums can grow tax-deferred until it’s time to withdraw the money. Subsequently, the interest rate at which your earnings may grow depends on your deferred annuity type. Mainly whether it’s a fixed rate, variable rate, or an index rate.
Some key characteristics of immediate annuities:
- tax-deferred investment
- most guarantee against loss
- lifetime benefits if you annuitize your contract (for you or your spouse)
- death benefit component (surviving heirs receive remaining benefits)
- no contribution limits
Paying into a deferred annuity:
- Single Premium Deferred Annuities: You can purchase a deferred annuity with a single premium payment as well. However, unlike immediate annuities for which you must pay in one installment, you can spread the deferred annuity’s single premium into a series of payments.
- Flexible Premium Deferred Annuities: This is the most common approach, you pay a series of payments for a set amount of time. In fact you can schedule these payments to be fixed or to vary over time, adjusting to your financial goals or ability to contribute.
Receiving payouts from a deferred annuity:
- Lump sum: You’re withdrawing the full balance, minus the tax you owe on it.
- Systemic Withdraw: Money withdrawn from annuity through periodic taxable payments. But the remaining money in the annuity account continues to earn interest, until full depletion.
- Annuitization: With this distribution plan, the annuitant gets paid out monthly, quarterly, or yearly for a set amount of time. Until the annuity owner dies or until their spouse dies.
An interesting and appealing thing about deferred annuities is that IRS has no limits in place on the principal amount you can contribute. In fact, some Americans with 401(k)’s even choose to roll their 401(k) into an annuity for guaranteed retirement income; a move that comes with certain tradeoffs.
Annuity types explained
As is the case with most things in life, people have different needs and circumstances, and thus different annuity products exist to meet the diverse needs of the market. Hence, your own financial goals and personal objectives will determine the best type of annuity for you.
Fixed annuities (guaranteed income)
Firstly, the simplest type of annuity, offering the most predictable and reliable cash flow. Can be immediate or deferred, and usually has low fees. In this case, you pay into the annuity and the provider is contractually obligated to guarantee your principal and a minimum interest rate.
Fixed indexed annuities (growth potential)
Second, an annuity whose income payments are tied to a stock index. Naturally, these do well when the stock market is doing well and you stand to make more than with traditional fixed annuities.
But the real good news is that they carry a guaranteed minimum return as well. So, if (when!) things go south you won’t lose all your money. Typically you’ll receive at least 87.5 percent of your principal back plus 1-to-3 percent interest. People often refer to these as hybrid annuities.
Variable annuities (flexible income)
Lastly, an annuity that carries a potential for high returns but offers no guaranteed payout. In this case, the money you contribute is put into an investment portfolio. Some providers allow annuitants to select a portfolio that matches their time horizons, investment objectives, and risk tolerance.
Because a variable annuity is tied to the performance of an investment portfolio, their payments can fluctuate in accordance with the portfolio’s performance. Typically the annuity provider may guarantee the return of money you put in (premium) but should the investments not do well, you risk not earning any growth. Conversely, if it does really well, your potential gains are increased.
Reasons to buy an annuity
That depends on your financial goals, and whether you’ve just won the lottery or not. All jokes aside, annuities can be a good investment for individuals of all ages who seek stable, long-term, guaranteed retirement income. But the type of annuity and conditions depend on your situation.
For example, if you’re relatively young and have a lot of money saved up, paying for an annuity with a lump-sum can tie up your money for a long time and subject you to hefty early withdrawal fines. Similarly, no matter your age, you absolutely must consider future liquidity needs beforehand.
On the other hand, if you’re someone whose maxed out your 401(k) and IRA accounts, and have additional funds to set aside for retirement, an annuity’s tax-free growth may make sense. Especially if your salary puts you in a high-income bracket today and you’re looking to decrease taxes now.
Overall, though mostly thought of as a way for imminent retirees to supplement their retirement income and hedge against outliving their savings, annuities can actually benefit investors of all ages with a variety of financial goals.
All in all, your personal reason for choosing an annuity should take into consideration your current and future lifestyle, financial needs, and familial obligations. After which we can look to the general benefits of this financial vehicle, that offers to fill a retirement savings gap in this post-pension age.
Some annuity benefits to consider:
- Tax deferred growth (only taxed on earnings during payout phase)
- Boost your retirement savings with no contribution limits (unlike 401k and IRAs)
- Predictable guaranteed income streams for life
- Allows you to provide for your family after death (death benefit riders)
- Market-linked growth potential (indexed annuities)
- Investment options (variable annuities)
- Minimum guaranteed interest rate (fixed and indexed annuities)
- Flexible features of distribution and accumulation
- Protection from creditors
These days there are seemingly countless traditional and alternative investments to choose from. But as you can see from the benefits listed above, the predictable nature of annuities is perhaps what attracts people to them so much; and maybe why they’ve been used since the Roman Empire.
You didn’t think it was all rainbows and butterflies, did you? Though we’re dealing with pretty safe, valuable, and viable instruments here, annuities do come with certain disadvantages as well.
Some annuity disadvantages to consider:
- Sacrificing liquidity (very big deal for some people)
- Conservative returns (as compared to other investments)
- Commissions and fees (high sales and admin costs)
- Opportunity cost (loss of potential returns from other investments )
- Surrender charges and tax penalties (for early withdrawals)
- Investment earnings are taxed at owner’s ordinary income tax rate
- May lack loan features
Many young people shy away from annuities due to their illiquid nature. Because they feel like they could achieve higher returns by going after more aggressive investment options. And this is fair, as young investors by default have the luxury of higher risk tolerance and longer time horizons.
On the other hand, retirees and older investors tend to be more conservative in their approach.
Annuities can play a crucial role in your retirement planning, primarily by helping you hedge against outliving your savings. But they can also help provide income to your heirs after you’re gone, as well as offer certain tax advantages and investment options of their own.
However, these instruments can come with a healthy dose of complexity. Hence, before you sign your name on the dotted line, make sure you are:
- working with a reputable company,
- asking questions so you understand precisely how the annuity works,
- aware of all the fees and expenses tied to the annuity.
The last thing you want is to spend your life after 65 worrying about your financial situation, so take the time to sit down with a financial advisor now and formulate a custom-tailored strategy for you.
Insured Retirement Institute (IRI) | Social Security Administration | Northwestern Mutual Planning & Progress Study 2019
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