What is an Annuity? A Guide to Stable Retirement Income

Preparing for a comfortable retirement requires you to understand the different options available for sustaining yourself after you’re done working. One of those options is to use an annuity as a source of income during retirement.

Annuities can be a divisive topic in the financial world with some people having very strong opinions on either side of the argument. Like any other type of investment, annuities are not right for everyone. However, they offer significant advantages in the right situation, so it’s best to familiarize yourself with how annuities work so you can determine if it’s the choice that’s right for you.

What Is an Annuity?

Annuities are an investment vehicle that can provide guaranteed income. They come in many different forms with many different features, but they all have one thing in common: they allow investors to make a lump-sum payment or series of payments and then receive monthly or yearly payments for the rest of their lives, or for a set number of years.

If you're approaching retirement and you're concerned about the possibility of outliving your money, an annuity may provide peace of mind through a stable and predictable income.

Essentially, annuities are contracts between you and and insurance company. You'll pay a specific amount of money upfront in exchange for regular payments in the future.

Types of Annuities

There are a few specific types of annuities. It's essential to understand the details because the differences can be significant in the long run.

Fixed Annuities

A fixed annuity pays you a guaranteed amount of money, based on the terms of the contract. It's the most straightforward type of annuity since your payments are not based on financial market performance. The contract will state a fixed rate or payment amount, so you'll know exactly what to expect.

Fixed annuities can be either immediate or deferred. With an immediate annuity, you'll start receiving payments right away. With a deferred annuity, you'll start getting payments at a future date that’s specified in the contract. This allows the investment to grow and accumulate interest before the payments begin.

Variable Annuities

With variable annuities, returns are tied to how well an investment portfolio performs. If markets do well during the term written into the contract, your payouts will be higher. But if markets don't deliver strong gains over time, your payouts will be lower. Obviously, variable annuities come with more risk than a fixed annuity, but also with the potential for higher payouts.

Index Annuities

With index annuities, you’re guaranteed to receive a minimum return, with the chance for a better return. This is because the insurance company will set your account balance based on their projection of how well an underlying stock market index performs during the time period written into your contract.

Index annuities provide some downside protection in case the market is bad, but the upside is also capped or limited. As a result, this type is somewhat of a combination of fixed and variable annuities.

The Benefits of Annuities

There are several specific reasons why you might want to consider an annuity.

Annuities Provide an Income Stream in Retirement

The most obvious benefit is that you'll get an income stream to help cover your living costs in retirement. Social Security checks aren't enough for most retirees to live on, and so you'll need some other source of income for a comfortable retirement. Annuities can be the solution.

Tax-Deferred Growth

Annuities are tax-deferred, so you won't be responsible for taxes on the money while it’s invested in the annuity. The payments you receive from the annuity will be taxed. If you choose a deferred annuity, your investment will grow during the accumulation phase with no tax being due.

In Addition to Other Retirement Savings

Some people choose an annuity because they've maxed out their IRA or 401(k) contributions. Generally, contributions to an annuity are not capped or limited, so it's another way to get more money into retirement savings.

The Downside of Annuities

Of course, annuities also come with some drawbacks.

Fees and Commissions

One of the most significant concerns with annuities relates to the fees and commissions that you'll pay. The specific fees will vary and simpler annuities typically have smaller fees. In some cases, it can be challenging to understand exactly how the fees and commissions work. Be sure to get clarity on the fees you'll be paying before investing in an annuity.

You Might Get Better Returns With Other Investments

Another drawback of annuities is that they don't typically earn the highest possible returns. If you're looking for maximum return potential, an annuity may not be your best option. Annuities are a relatively safe source of income during retirement, but if you're willing to accept a little more risk, you're likely to earn a better return with another type of investment.

Lack of Liquidity

The money you invest into an annuity is illiquid and cannot be taken out early without significant penalties. This is not the best type of investment for anyone who is young or for those who may need the money for other purposes.

Complexity

Annuities are complex, and there is some risk that you'll be sold an inappropriate product or have trouble understanding all the terms. With several different types of annuities, it's critical that you understand what you're investing in.

Are Annuities Safe?

Overall, annuities are considered to be safe, but different types of annuities offer varying levels of security from investment risk. Fixed annuities offer the highest level of safety since the payments you receive will be set in the contract and not based on the performance of a portfolio or the financial markets as a whole.

Variable annuities come with a higher degree of risk since the payouts will depend on the performance of the investment.

Index annuities are safer than variable annuities since they guarantee a certain minimum payout, with a chance for a better payout based on the investment's performance.

Consider the Financial Strength of the Insurer

Just like a life insurance policy, the strength and security of your annuity is only as good as the company behind it. Be sure to choose a company that’s likely to be around for the rest of your lifetime. Research ratings with A.M. Best, Standard & Poors, and others to be sure that you're going with a strong company.

How Are Annuities Taxed?

Annuities can have complicated tax implications, so it's best to speak with a tax professional before making an investment decision.

Your annuity can be funded with pre-tax or after-tax dollars. If it's funded with pre-tax dollars, it is considered a qualified annuity, and the entire payment you receive will be taxed as regular income. If the annuity is funded with after-tax dollars, it is considered a non-qualified annuity and only your earnings will be taxed (so you're not double taxed on your contributions).

Who Should Invest in Annuities?

The bottom line on whether an annuity is right for your situation depends on your personal preferences and financial goals. Whether or not you decide to go ahead with one will depend partly on how much flexibility you want in managing your money during retirement compared to having guaranteed income coverage without worrying about outliving your savings.

The income provided through an annuity could provide a strong sense of security (especially if it's a fixed annuity and you know exactly what to expect). If you have significant concerns about outliving your money, an annuity could be part of the solution.

However, it's equally important to understand when an annuity would not be a good fit. If you're looking to maximize the returns from your portfolio and you're willing to accept some degree of risk, an annuity might not be the most appropriate investment. If you enjoy managing your finances and making your own investment choices, you'd probably prefer other types of investments over an annuity.

If you're not sure whether an annuity is right for you, speak to a financial professional (not one who sells annuities) to get personalized advice.

Annuities vs. Life Insurance

Life insurance is purchased to prevent the financial impact of premature death. It provides benefits to your loved ones after your death. An annuity provides you with benefits while you're living. It protects you from the risk of outliving your savings.

Final Thoughts

An annuity is not right for everyone. If you want to manage your own investments, enjoy the freedom of making those choices, and pursue the best returns possible, an annuity may not be a good fit for you.

If you're looking for more security in retirement by having income generated through savings that will last as long as you do, an annuity could be ideal for your needs.

Be sure to consider your own unique situation and also take as much time as needed to research and understand the details before investing.