Having a regular source of income is always a good thing, whether you’re retired or not. One way to accomplish this is through an annuity. Sold by insurance companies and financial institutions, annuities can be useful when you want to have an income stream you can count on in the future. This article explores types of annuities, who uses them, their advantages and drawbacks, and factors to consider when selecting the right annuity for your needs.
What is an annuity?
An annuity is a financial product sold by insurance companies or financial institutions. Annuities provide an individual or entity with a steady source of income over a specified period of time.
The annuity buyer pays either a lump sum or a series of payments to the provider who invests those funds. Then, the provider makes regular payments back to the buyer either immediately or in the future.
There are many types of annuities to consider depending on your goals. Buyers can appreciate the reliable retirement income, but there are many factors to weigh (including fees and charges).
Types of annuities
Investors can choose from many types of annuities. You might buy an annuity on your own or with the help of your employer. This section compares common annuity offerings.
Fixed period annuities
This annuity type pays you a fixed amount at regular intervals for a pre-established amount of time. Also known as a term-certain annuity, this product makes monthly, quarterly, or annual payments for the specified annuity term, ranging from a few years to several decades.
You’ll typically purchase a fixed-period annuity with a lump sum payment. An advantage is the guaranteed income stream, regardless of market or interest rate changes. Your payments are determined upfront by the amount you invest, the term length, and the interest rate when you buy the annuity.
On the other hand, you only get paid for the duration of the fixed period. Plus, you don’t have inflation protection, so the purchasing power of your guaranteed income may decrease over time.
Variable annuities
Your payments vary in amount, depending on the underlying investments’ performance, for a definite length of time or life. This type of annuity bases your regular income stream on the value of the mutual funds, stocks, bonds, and other securities the annuity invests in. This can generate higher returns than a fixed annuity, but there is also a greater risk as annuity value can fluctuate.
Variable annuities typically come with higher fees, which can impact your returns. As an added feature, variable annuities often offer optional riders to provide additional protections or benefits for the buyer.
Indexed annuities
Also known as fixed-indexed annuities, this annuity provides a guaranteed minimum interest rate combined with the opportunity to earn additional interest based on the performance of a specific stock market index.
With the minimum interest rate, and the potential to earn more based on the performance of the linked index, this investment can perform well. In fact, the potential for additional interest is often capped or limited, which means you may not be able to fully participate in the upside potential of the linked index.
Meanwhile, you typically have some protection against the S&P 500 or Dow Jones Industrial Average performing poorly via a guaranteed participation rate, cap rate, or floor rate. These annuities often come with high fees and expenses.
Single-life annuities
A single-life annuity pays out regularly during your life. You can count on steady payments for as long as you live, although this type of annuity often has lower payments.
You’ll typically make a lump sum payment for this annuity. The initial investment amount as well as your age, gender, and life expectancy, will determine your annuity income payments.
If you expect to live longer than average, this annuity may suit you. However, the income ends when you die with no payout for your survivors. That means you may not get the full return on your investment.
Joint and survivor annuities
This annuity type provides guaranteed income for the lives of two people, typically a married couple. The annuity pays a fixed amount to you or your partner at regular intervals until you or they die. After that, the surviving partner continues to receive a fixed amount at regular intervals.
The amount paid to the survivor may be the same or different depending on the terms of the annuity. This product is attractive to couples wanting to provide for both parties and when there is an age disparity between the partners. Still, as the product is covering two people, you may pay higher fees. Plus, the payments are fixed at purchase, so your purchasing power with the payments may erode due to inflation.
Qualified employee annuities
Your employer may offer a qualified employee annuity. This retirement annuity provides another tax-deferred way to save for retirement. Your contributions are made with pre-tax dollars. You pay taxes only when the funds are withdrawn. This can help reduce your current tax liability.
Qualified employee annuities include plans such as 401(k), 403(b), and 457 plans. Some employers offer matching contributions to the plan, which can increase the value of the account over time.
Tax-sheltered annuities
Also known as a 403(b) plan or a tax-deferred annuity, this type of annuity is only available to employees of certain nonprofits, public schools, or tax-exempt organizations.
You make pre-tax contributions, which grow tax-free until you withdraw the funds. The idea is to defer the taxes until retirement age when your tax rate may be lower.
Common Uses for Annuities
Anyone can take advantage of an annuity. You might use an annuity to:
- Save for your child’s college education or a down payment
- Supplement your income during your working years
- Boost your retirement income
- Provide income in the event of a disability or other unforeseen circumstances.
- Plan to transfer assets to your heirs
- Protect against the risk of outliving your retirement savings
Advantages and drawbacks of annuities
Annuities offer several key advantages, yet there are drawbacks to consider as well. Consulting with a financial advisor can help you determine if this is a good option for you.
Advantages
Key benefits of annuities include:
- Guaranteed income for a specified period of time or your lifetime (depending on annuity type)
- Financial security and peace of mind
- Tax-deferred growth on your investment
- No contribution limits (unlike traditional retirement accounts like 401(k)s and IRAs)
- Protection against market volatility with fixed or indexed annuities
Drawbacks
While there are many advantages, the drawbacks include:
- Limited liquidity (annuities typically come with surrender charges or other fees for withdrawing early)
- High fees and expenses
- Complexity, which can make it difficult to compare products
- Inflation risk (your payments may reduce in value over time)
- Counterparty risk (You’re banking on that financial institution or insurance company to remain stable and able to pay out in the long term)
Factors to consider when choosing annuities
Each annuity has its own features, which translate to different advantages and drawbacks for your financial situation and goals. To determine the best product for your situation, you’ll want to consider:
- Payment structure: You can receive payment immediately (income annuity) or at a set time in the future (deferred annuity), typically after retirement. You can also choose how long you want to receive payments. You might select a fixed period of time, for your lifetime, or for the lifetime of your beneficiary.
- Interest rates: The interest rate for your annuity will impact your overall return on investment.
- Fees: There are many types of fees and charges, which we cover in greater detail next.
- Financial stability of the annuity issuer: You’ll likely want to buy from a provider with a strong financial rating and a history of financial stability.
- Your liquidity needs: Annuities are typically built for long-term investment. You will have to pay a surrender fee to withdraw money early.
- Tax implications: The different types of annuity come with varied tax implications. It’s a good idea to speak with a tax professional before making your choice.
You’ll also need to weigh all of these in the context of your overall financial situation. Working with a financial advisor to understand the complexity of this product, you can consider your age, goals, other income sources, and risk tolerance to decide on the appropriate option.
Annuity fees & charges
Fixed and variable annuities are the two main types, but there are many other types to consider. You can look at when you expect a payout (e.g., deferred versus immediate) or the duration of the payments (e.g., fixed versus lifetime), and that’s just the beginning. Knowing more about the common types of fees and charges with annuities can help you identify the best product for your needs.
When investing in annuities expect to encounter:
- Commission fees are collected either upfront or over time-based on the annuity’s value.
- Administrative fees cover record keeping and account maintenance; these can be assessed monthly or yearly depending on the issuer.
- Surrender fees. If you withdraw your funds before the pre-determined surrender period you pay a fee (can be as much as 10%).
- Mortality and expense fees. These cover the costs of providing the annuity and address the risk of paying you longer than anticipated due to your lifespan.
- Investment expense ratio. This management fee is charged as a percentage of your account balance.
- Riders. You can pay extra for added features to further customize your annuity. Examples include riders:
- Providing a guaranteed minimum income stream even if the annuity’s value decreases.
- Providing a guaranteed minimum annual withdrawal amount regardless of the account value.
- Allowing you to access a portion of the annuity’s value to cover long-term care expenses.
- Guaranteeing a minimum payout to your beneficiaries at your death.
- Adjusting the annuity’s payments to account for inflation
Who should not buy an annuity?
Annuities are not for everyone. If you are looking for capital gains, this is not the investment for you. Annuities convert your investment today into an income in the future. If you already have guaranteed income sources, you may not need the additional income an annuity offers.
When you have limited funds available to invest, an annuity may not be a good choice. They often require a large upfront investment and do not offer the liquidity and flexibility of other investment products.
Also, if you have a short-term investment horizon, this is not your best choice as these are structured for long-term investments.
Next steps
As you can see, the many types of annuities make for a difficult decision. You’ll want to consider all potential benefits and risks before making this type of investment. Working with a financial advisor and conducting thorough research can help you determine if this is an appropriate investment option for your financial circumstances and goals.