Americans are increasingly turning to annuities for retirement planning, as this form of investment vehicle tends to benefit from high interest rates. An annuity is a contract between a buyer and an insurance company that agrees to provide the buyer with a regular income stream, typically in retirement. Annuities require steady payments for over a year and can be purchased by the investor directly on their own or with their employer's help.
The person who takes out the contract is referred to as the "annuitant." They can buy annuities or invest in them via a single lump-sum payment or by making monthly premium payments over a period of time.
How annuities work
The insurance company that holds the annuity establishes a steady stream of payments to be made to the buyer over a set time period. In most cases, annuities are used as guaranteed regular payments in retirement and are designed to help people avoid outliving their retirement savings.
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Annuities aren't recommended for people before they reach their retirement years or for those who need access to their cash, because invested cash is, by its very nature, illiquid — and take time to convert into cash quickly without incurring significant expense. Annuities may also be subject to withdrawal penalties.
Rules and regulations
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FIRA) regulate annuities. To be able to sell annuities, brokers must hold a life insurance license issued by their state. To sell variable annuities, they must also hold a securities license. These brokers usually earn a commission based on the contract's notional value.
What are the phases of an annuity?
Annuities go through two basic phases. The first is the accumulation phase, which is the time period during which the annuity is being funded before the payouts begin. All the money that's invested in the annuity during this accumulation phase grows on a tax-deferred basis.
The second phase is the annuitization phase, which is when the payouts are occurring. Most annuities also have a surrender period, during which the annuitant can't withdraw any money without paying a fee. Most insurance companies allow annuitants to withdraw up to 10% of the value of the account without having to pay a surrender fee. However, withdrawing more than that may trigger a penalty, even after the surrender period is over.
What are the main types of annuities?
Annuities can be either immediate or deferred, depending on when you begin to receive payments. Types of annuities include fixed, variable, and indexed.
Immediate annuities: People who receive a large sum of money all at once, such as from a settlement on a lawsuit, may choose to exchange the funds in order to receive steady, guaranteed income stretching into the future. Payouts may be made monthly, quarterly, semiannually or annually.
Deferred annuities: This type of annuity is designed to grow on a tax-deferred basis, providing guaranteed income to the annuitant starting on a particular date they choose. The savings period for deferred annuities can last from a few years to decades, and the money grows over time.
Fixed annuities: Fixed annuities have guaranteed interest rates that are fixed, and the money grows on a tax-deferred basis over time. Technically, fixed annuities are also deferred annuities because they don't start paying immediately. However, they are also slightly different from a deferred annuity because the annuitant can decide when the payments will begin.
Variable annuities: These also grow on a tax-deferred basis, although they offer additional choices. The amounts of the regular payouts in retirement are based on how your selected investments perform, resulting in variable payouts over time rather than fixed guaranteed payments.
Secondary annuities: Aside from the four main types of annuities, there are three other secondary kinds.
- Equity-indexed annuities mix the features of variable and fixed annuities, providing a guaranteed minimum payment that could increase if the annuitant's investments outperform.
- A longevity annuity requires the annuitant to wait until around age 80 before payouts begin. At that point, the payouts are guaranteed to last until the end of the person's life. However, if they die before the payouts begin, the heirs don't get the remaining money.
- A retirement annuity accumulates retirement funds while the annuitant is still working. Upon retirement, two-thirds of the money saved is used to buy an annuity.
What are the advantages and disadvantages of annuities?
Annuities have several advantages over some other forms of retirement savings as well as disadvantages to keep in mind.
Advantages
- Guaranteed income. An annuity can provide income, which can supplement a retiree’s income from an individual retirement account (IRA) or Social Security.
- Regular payments. Depending on the type of annuity, annuitants can receive a lump-sum income payment, or income payments on a monthly, quarterly or annual basis.
- Fixed interest rate. Annuitants can lock in an interest rate to easily budget how much income is coming in monthly, quarterly or annually.
- Tax-deferred contributions. Most annuities let buyers make tax-deferred contributions so the money added isn’t taxed until retirement. Taxes aren’t due until the start of annuity payouts.
- No contribution limits. Different from an IRA or 401(k), an annuity doesn’t require annual contribution limits.
- Death benefits. Sometimes for an additional cost, some annuities can be set up to pay a death benefit to beneficiaries, either as a lump-sum payment or a percentage of regular income payments.
Disadvantages
- Tied-up money. Most annuities let an owner take out a designated portion of their money without paying a surrender charge during the surrender period. However if there is a withdrawal before age 59½, the owner could be slapped with a tax on “ordinary” income and potentially a 10% federal income tax penalty.
- Fees and commissions. Some annuities may charge fees, such as surrender charges, mortality and expense risk fees, sales and commissions and administration fees.
- Pricey riders. In some cases, coupled with fees and commissions, a rider could further dilute your investment.
- Variable returns. If the owner has a variable annuity, the cash value goes up or down based on the performance of the market. This can lend to an uncertain income stream during retirement.
Bottom line
Annuities are best suited for anyone who wants predictable retirement income. But because you will be giving up a substantial amount of cash in return for quarantined income, it is best to consider each of them prior to making a decision. It’s also best to look at any fees a provider may charge, which can dilute the value of your investment.
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