WHAT ARE ANNUITIES?
Today, with pension plans becoming less common, many people are looking toward annuities to replace income streams. About 6 in 10 American workers are worried they might outlive their retirement savings. That might explain why nearly half of them plan to buy an annuity by the time they retire or already have one.
In general, annuities are insurance products that can provide you with a future lump-sum payment or income stream. You buy an annuity with a single upfront payment or make a series of payments to the insurance company. Then, the insurance company sends you either one lump sum or multiple payments during retirement.
An annuity can be a very confusing thing. While the basic concept is simple, the details of how they work are often complicated. If you're not careful, it will make your head spin. So, let’s take a closer look at what annuities are, the types, how they work, and why you should consider them.
WHAT IS AN ANNUITY?
An annuity is a contract between you and an insurance company designed to cover specific goals, such as principal protection, lifetime income, legacy planning, or long-term care costs. You make a payment (or payments) to an insurance company and in return, they promise to grow that money and send you payments during retirement.
Even though annuities may be marketed as investments, they are not. They are insurance products since you pay the insurance company to take on your risk of outliving your retirement savings.
HOW DOES AN ANNUITY WORK?
Annuities work by giving you limited access to your funds annually just like how income is received from Social Security. An annuity transfers risk from the owner, called the annuitant, to the insurance company. Like other types of insurance, you pay the annuity company premiums to bear this risk. Premiums can be a single lump sum or a series of payments, depending on the type of annuity. The premium-paying period is known as the accumulation phase.
Unlike other types of insurance, you don't pay annuity premiums indefinitely. Eventually, you stop paying the annuity. Then the annuity starts paying you. When this happens, your contract is said to enter the payout phase.
TYPES OF ANNUITIES
1. Fixed Annuities
A fixed annuity is fairly straightforward. It is a savings account with an insurance company. They are similar to a certificate of deposit (CD) you can find at most banks. With it, the insurance company promises you a set rate of interest, around 5%, that is locked in rather than being tied to market rates. They work by providing periodic payments in the amounts specified in the contract. If your contract says the payout rate is 5 percent on a $100,000 annuity, for example, then you will receive $5,000 worth of payments every year covered by the contract. Fixed annuities might not be worth your time though. If you're saving up for retirement, the rate of return that fixed annuities offer just won't cut it. You can do much better than that with good growth stock mutual funds.
Here are two types of fixed annuities:
· Immediate fixed-income annuities: They usually require you to pay a lump sum to receive a guaranteed stream of income for a set period, which could extend for life, depending on what your contract states. It begins paying out right away.
· Deferred income annuities: Instead of beginning immediately, your income stream is deferred and can start anywhere from months to years from when you buy your annuity. You may get bigger payouts this way because your money has more time to accumulate interest and increase your future income.
2. Variable Annuities
Variable annuities aren’t as straightforward as fixed annuities. They’re more of an investment product. And you’ll have to decide which investment options you want to direct your annuity payments to. Variable annuities have payout rates that vary, depending on the performance of an investment portfolio, that is, how much money the portfolio gains or loses. They're mutual funds stuffed inside an annuity. So unlike fixed annuities, your payments in retirement will depend on how well the mutual funds you choose perform. That's why they are variable. With a variable annuity, you put in money already taxed, and then the account grows tax-deferred. That means you'll have to pay income taxes on whatever growth the annuity makes when you start taking money out in retirement.
So like we said, the amount of your future income stream will be based on the number of your payments and the return of the investments you choose within your annuity, as well as any fees or other expenses the annuity charges. This is risky, but also has the potential of paying you more. Because while a variable annuity may give you a chance for better returns and a higher payout, it could just as well result in a lower-than-anticipated income in retirement.
3. Indexed Annuities
Indexed annuities are somewhat of a mix between a fixed and variable annuity. Essentially, indexed annuities can offer protection from drops in the market, but you also won’t benefit as much if the market does well.
With an indexed annuity, you could have higher earnings but also more risk. You get a base amount of guaranteed income. But another part of your income stream will depend on the performance of an index, such as the S&P 500, which gives you the chance for investment growth.
WHY SHOULD I CONSIDER AN ANNUITY?
An annuity can provide you with a stream of income in retirement that you can rely on in addition to any pensions or Social Security benefits you might receive. That brings a bit of peace of mind or what do you think? If you choose an annuity that provides payments for the remainder of your life, you might not have to worry about running out of money in retirement, as long as the annuity can cover your expenses. And you can leave a beneficiary on the annuity so that the payments you were getting can go to a loved one when you die.
Some variable annuities even offer a guarantee on your principal investment. So basically, if you put $200,000 into an annuity and the value of the investment drops below that, you’ll still get your $200,000 when you take your money out. And unlike a 401(k) or an IRA, annuities don't have yearly contribution limits, so you can put as much money into it as you'd like.
A lot of the benefits of buying an annuity sound pretty appealing at first. But the decision about whether to buy is up to you and potentially a financial adviser. Annuities can be complicated, and they may not be for everyone or every situation. You'll need to factor in your specific situation, preferences, and risk tolerance to decide if an annuity (and what kind of annuity) could be worth it for you.
If you want to have the retirement of your dreams, you need to use an investment strategy that works and stick to it. If you decide to get an annuity, make sure you understand the annuity you buy beforehand and its associated fees. This includes understanding the fine print and asking for help from a qualified professional if you need it. Finally, don't forget to shop around to find an annuity that fits your situation, as contracts can vary from company to company.