Annuities are financial products that can offer you flexible investment strategies to reach your financial goals, both retirement and non-retirement. Although annuities aren’t solely for retirees, they’re a powerful asset when setting up predictable income streams later in life. Buying one today may guarantee you’ll receive monthly payouts down the road.
Read on to learn what an annuity is and how it works to determine whether it’s worthy of investment.
Annuities are contracts between you and an insurance company. You pay them either a lump sum or multiple payments, and in return the insurance company pays out a fixed or variable income stream to the purchaser beginning right away or at some time in the future in exchange for premiums you've paid.
When you buy an annuity, you’ll either send one deposit or regular annuity payments (known as premiums) until you reach the total amount you agreed to invest. The insurance provider uses your funds to grow your money over time and you generally receive tax-deferral earnings and depending on the type of annuity you may receive the benefit of market like returns.
An annuity’s accumulation phase is when you make regular payments and wait as the contract matures. During the accumulation period, your contributions have time to grow, and you can take advantage of tax-deferred growth. The longer you stay in the accumulation period, the more you can earn. The annuitization period, also known as the annuity payout period, is the time when an annuity owner, or annuitant, receives payments from their annuity. The length and size of the payments, as well as the payout period itself, depends on the type of annuity and its value and there may be extra benefits such as access to emergency medical funds, adjustments for inflation, and death benefit payments to beneficiaries.
The structure of an annuity is typically consistent: Deposit money in the annuity, wait, and receive payouts at some set point in the future. That said, there are five distinct kinds of annuities, each with unique implications for your risk profile, payout schedule, and expected returns.
These contracts are similar to certificates of deposits, except you’re working with an insurance company rather than a bank. In both cases, you lock a set amount of money in the financial instrument and receive a guaranteed interest rate over the set term.
The promise of a guaranteed fixed rate over a fixed annuity’s term may make it appealing to anyone who wants a predictable, passive approach to grow their savings.
When you see variable, think volatility. A variable annuity has the highest risk profile because it generally has zero downside protection. Instead of a guaranteed rate of return, variable annuities give you access to subaccounts, each consisting of assets like stocks, bonds, or mutual funds.
The direct exposure to market prices is a double-edged sword for investors. You stand to gain the most during favorable market conditions. But if your subaccounts performance slides, there’s a chance your annuity dips below your principal investment.
The fastest way to activate annuitization is to open an immediate annuity. These annuities instantly transform a lump sum of cash into regular payouts. Although growth potential is low, immediate annuities are simple to implement, predictable, and carry low fees.
If you’re a proactive retirement planner, deferred annuities provide the most time to let compounding earnings work in your favor. These long-duration contracts involve years of accumulation and may allow you flexibility to contribute steady payments rather than one lump sum at the start.
A deferred annuity is also tax-deferred, so you don’t have to pay the IRS for earnings until you start withdrawing.
Fixed indexed annuities merge the security of fixed annuities with the growth prospects of variable ones. These contracts provide exposure to an index like the S&P 500, this allows your account value to earn interest credits that are linked to the performance of a financial index. If the index goes up, so will the interest credited to your account value. Simliarly if the index you are tracking goes down, you may not earn any interest, but your principal is protected.
To compensate for their protection, fixed indexed annuities often have a max cap on the upside to limit potential gains. So, if the S&P 500 grows 25% in the first year, your account value takes advantage of 20% of growth.
Here are the benefits and drawbacks of annuities so you can decide if they align with your financial goals.
If you’re serious about adding an annuity to your retirement strategy, consider the following to ensure you take advantage of their customizability.
There’s nothing wrong with keeping your annuity as simple as possible, but there are a few techniques to enhance your retirement account’s potential. Consider these strategies when building an annuity income stream:
Understanding annuities is easier when you can look at real-world scenarios. Put yourself in each hypothetical annuitant’s shoes and imagine how their plan affects retirement income streams:
By examining these scenarios, you can see how annuities can provide tailored solutions for different financial needs and goals in retirement.
