Individuals planning for their retirement have many options to choose from. These options help to secure a stable financial future, providing the funds necessary for expenses once retirement age is reached. From Individual Retirement Accounts (IRAs) to employer-sponsored pension or 401(k) plans, stock and bond investments, or real estate purchases, one can take charge of his or her retirement savings and prepare for an uncertain future. Another potential option is that of the annuity – a specialized type of account that provides guaranteed income after retirement. In this guide, we’ll explore the types of annuities and their particulars, helping you to determine if this option is right for your retirement needs.
What is an Annuity?
The term “annuity” is often discovered when one is starting the retirement planning process. Some confusion surrounds this option, especially in terms of what an annuity is and how it can benefit the diversified retirement savings portfolio. In very simple terms, an annuity is a type of insurance policy issued by an insurance company. In exchange for premium payments, the policy pays out a guaranteed minimum income to the account holder. Because the issuing insurance company shoulders much of the risk, it represents a valuable strategy for securing a stable financial future after retirement.
How Does an Annuity Work?
When establishing an annuity policy, the individual first selects the annuity product, then invests into it via premium payments – much like a traditional insurance policy. Premium payments may be monthly, annually, or in a lump sum. After a specified period of time, depending on the specific language of the annuity policy, the insurance company begins to pay out an income. The income payment may also be paid out on a monthly, quarterly, or annual basis, and can even be received as a lump sum in some cases. There are two major types of annuity: deferred and immediate.
A deferred annuity is that which is invested in over a period of time – typically until the account holder reaches retirement. Once retirement is taken, the account holder begins to receive income payments. Money (the premium payments) grows in value until retirement.
An immediate annuity functions differently; in this type, the account holder makes an initial premium payment, and the income payments begin almost immediately. This type is very popular with those nearing retirement age, and can help cover retirement savings shortfalls.
Variable Vs. Fixed Annuities
In the world of annuities, there are two common ways that insurance companies use to help funds invested in the accounts grow over time:
Fixed annuities provide a set or “fixed” income payment amount, regardless of the performance of investment markets the premium payments are invested in. This choice is perfect for those who are concerned about investment risks; the insurance company guarantees a minimum and maximum income payment, and the initial investment cannot be lost.
A variable annuity does not have a set income payment amount; the amount fluctuates with the performance of investments made by the insurer. This option is better for those with a higher tolerance for risk, and can outperform other annuity types in terms of growth if the market is favorable. If the market should experience a downturn, however, the account holder may not receive much or any income.
An Indexed annuity is the new kid on the block; they are only about 20 years old. They are an interesting hybrid of the two ideas above where they offer 100% guarantee of principal and no chance of a negative return or investment loss – while at the same time giving you the opportunity to participate in a rising stock market. The latest news on these is the Un-Capped crediting options that literally have no upside limit on your accounts ability to benefit from a Bull equities market. We have recently had clients get credits of 37.4%, 24.6% and 30.4% on a 24 month cycle.
Choosing between these types and categories of annuity can be challenging. To best prepare for one’s financial future, it is always a good practice to seek the help of a qualified retirement planning professional. Retirement planners can help you select the right type of annuity for your current and future financial needs, giving you the information needed to make smart investment choices.
Annuities: Pros and Cons
As with any investment strategy, there are advantages and disadvantages to the annuity as a retirement income method. A retirement planning professional can help you understand these pros and cons, but in general, annuities are viable retirement option for many people.
Pros of annuities include:
- Diversification – investing in different retirement accounts is the key to long-term financial stability, and annuities help to diversify the retirement portfolio.
- Reaching retirement goals – many retirement accounts like IRAs, government benefits, and 401(k) plans may be limited in the amount able to be invested and their payouts after retirement. Annuities, on the other hand, offer a guaranteed income, and can serve to supplement or even replace income sources from other retirement savings plans.
- Ensuring lifetime income – once retirement is reached, retirement accounts such as IRAs and 401(k) plans may become exhausted as the retiree pulls funds out of the accounts. Eventually, the retiree is left with little or nothing for expenses, especially if that person were to live long after retirement is reached. Annuities pay continuous and guaranteed income for the lifetime of the policy holder, and will continue to do so regardless of how long that is.
Drawbacks to annuities are few, but bear consideration. These cons include:
- Potential for fees and penalties – some annuities require annual maintenance fees of as much as 3-4%. Surrender charges or penalties for early withdrawal from certain annuity accounts may also impact the value of the account.
- Money tied up – deferred annuities pay income at a specified point after retirement is reached – sometimes years into the future. What happens, then, if you retire and need money now? This option may hamper one’s ability to have liquid assets for unforeseen expenses. To avoid potential problems, individuals should consider portfolio diversification to ensure that money is available whenever it is needed.
Speak to a retirement planner today to see if annuities are right for your current and future retirement goals. Annuities represent guaranteed income and significant advantages for a long and prosperous retirement.
Greg W. Anderson 