Basic Overview, Types, and Benefits of Annuities

If you’re considering purchasing an annuity to provide income during your retirement, it is crucial to understand the types of annuities and how they work. Here is an in-depth analysis of annuities, how they work, and what to consider before making an investment decision.

annuities and Golden nest egg concept for retirement savings

What’s An Annuity?

An annuity is an insurance contract that provides a steady income for a specified period. It is a contract between the annuitant (the contract holder) and an insurance company. In return for the annuitant’s contributions, the insurance company promises to pay a specific amount of money for a certain period.

Most people purchase annuities as investment income insurance because it guarantees steady income after retirement and sometimes for the rest of their lives.

Many annuities are also linked to tax benefits. The investment earnings often grow tax-free until the investor starts to withdraw income. This tax advantage is attractive to many people planning to save for their retirement and can successfully contribute to deferred annuities for many years. Such an investment model makes it possible to take advantage of tax-free investment compounding with guaranteed cash flow that will be paid out in the future.

Keep in mind that annuities have specific provisions that penalize investors, particularly if they withdraw earnings early. Besides, tax rules encourage investors to postpone income withdrawals until they reach the recommended period. But most of them allow investors to withdraw their income for qualified purposes without getting penalized. Indeed, some have provisions for income withdrawals of up to 10 percent to 15 percent per year (without penalty).

Generally, annuities have been around for many centuries. In ancient Rome, investors would make a payment in return for yearly lifetime payments. That means retirement planning was still a concern for workers.

Annuity contracts became popular in the United States during the Great Depression when investors and workers began to worry about the market volatility endangering their investment and retirement plans. Today, pension programs are becoming less common. This is one of the main reasons most retirees prefer annuity investments as an option to ensure a steady income stream and a guaranteed lifetime income.

Beyond these basics, there are complex annuity concepts that you should also know. Annuity contracts and the regulations under which they operate are complex, which is why you should consult with a financial advisor or retirement planning consultant before you make a choice. Remember, annuities give investors limited access to their funds annually, much like the income received from social security.

Should You Buy An Annuity?

Generally, people buy an annuity because it does something that other investment options don’t; providing a guaranteed income for life regardless of how long the investor lives. This makes annuity contracts a common retirement planning strategy. They often offer more tax-sheltered ways to save for your retirement, including tax deferred growth and particularly if you have already maxed out your IRA and 401(k).

Note that annuity contracts don’t have contribution limits, which means you can save the amount of money you want. Remember, this option unlike other investment options will offer guaranteed income in the future. That means it is possible to take a more aggressive investment strategy with the other assets in your investment portfolio.

How Annuity Works

They work by transferring risk from the annuitant (the annuity holder) to the insurance company. Just like other forms of insurance policies, the annuitant is expected to pay the annuity firm premiums to bear the risk. These premiums can be a single lump sum amount of money or a series of periodic payments. Whether paid in lump sum payment or periodic payments, it’s all based on the specific type of annuity you prefer. The premium paying period is commonly referred to as the accumulation phase.

Contrary to other types of insurance, the annuitant doesn’t have to pay the premiums indefinitely. After a certain period of time (the accumulation phase), you will stop paying premiums, and then the annuity will start paying you back. Once this happens, your annuity contract will enter the payout stage.

It is essential to mention that there is flexibility in the way annuity payments are processed. Annuity contracts can be structured to trigger guaranteed payments for a specified number of years to you or your beneficiaries, lifetime payments until you and your spouse have passed away, or a combination of lifetime income with guaranteed payments for a specific period of time. A “lifetime with period-specific annuity” pays the annuitant guaranteed income for life. However, if you die during a certain time frame (a specified number of years), your annuity will pay your heir the remaining part of your payment for the contractual time frame you chose at the time of contract application.

Similar to social security, the lifetime income stream of the annuity is based on your life expectancy, with a series of payments being received in the long term. That means if you start getting income when you are still young, there is a high chance of longer life expectancy, and your payments will be smaller. These payments can be a lump sum, monthly, quarterly, or annual. They can begin immediately or be postponed for many years.

Annuities are highly customizable. You can have an indexed annuity, fixed annuity, deferred income annuities, immediate annuity, variable annuity. So, finding the right annuity that meets your requirements comes down to two essential questions. What do you want the funds to do contractually? When do you want the contractual annuity guarantees to begin?

Types of Annuities

Now that you know what annuities are and how they work, what are the different types of income annuities? There are two primary types: immediate and deferred annuities. An immediate annuity offers income within the shortest period possible (now), while a deferred income annuities offers a stream of income in the future (later). Within these two categories are variable, indexed, and fixed annuities.

Variable Annuities

Variable annuity contracts offer a return that is primarily based on the performance of the mutual funds’ portfolio you (annuitant) have chosen. The insurance company can also guarantee a specific (minimum) stream of income as long as the variable annuity contract has a guaranteed income benefit option.

Unlike indexed and fixed annuities, variable annuities are often considered security (according to federal law). Variable annuities are subject to strict regulations by the SEC (Securities and Exchange Commission) and FINRA. Remember, you should also receive a prospectus if you are a potential investor.

Fixed Annuities

Fixed annuities offer a predictable source of income (guaranteed rate of return) with a considerably low risk during retirements. You will get a specific amount of financial resources monthly for a period you have chosen (like five, ten, or 20 years) or for the rest of your life.

These annuities provide the security of a guaranteed source of income or rate of return. This is particularly true regardless of whether the insurance company earns enough return on its investment to support that rate successfully. That means the risk is on the insurer, not you (the annuitant). This is why you should ensure you are dealing with a legitimate insurance company with high grades from most insurance company credit rating organizations.

The primary downside of fixed annuities is that in the event that the investment markets perform unusually well, the insurance company will reap the benefits, not the annuitant. What’s more, if there is severe inflation, low-paying fixed annuities may lose spending power a year after another.

Note that your state’s or country’s department of insurance has jurisdiction over all fixed annuities as these are considered insurance products. State regulations require that all advisors have a valid insurance license to sell these annuities.

Indexed Annuities

These assets are also known as fixed-indexed or equity-indexed annuities. Fixed indexed annuities combine the features of the fixed annuities (discussed earlier) with the possibility of extra investment growth, based on the performance of the financial markets. These investments guarantee certain minimum returns, plus returns pegged to any increase in the relevant market index like S&P 500.

Remember, the level of participation in the index is capped. It’s important to mention that indexed annuities are highly regulated by the state insurance commissioners as they are considered insurance products. Besides, most states require insurance agents to have a valid securities license and insurance license to sell annuities.

The Financial Industry Regulatory Authority also requires its member organizations to monitor all annuity contracts that their advisors or agents sell. Therefore, if you deal with an organization affiliated to FINRA, there is another set of eyes unofficially watching those transactions.

Benefits of Annuities

Here are the benefits of annuities you should consider before you make any investment decision.

Predictable retirement income

Once you put your financial resources into a 401 (k) or IRA account, the amount of retirement income you will receive depends on the performance of your investments. You are probably aware that the stock market can be extremely volatile, and if an investment portfolio drops in value as your retirement nears, the chances are that you will get less retirement income than you expected.

On the other hand, fixed annuities guarantee specific amounts of retirement annuities regardless of the performance of the stock market. In this regard, annuity contracts can spare you the risks linked to many investments.

Tax-free growth

As mentioned earlier, fixed annuities guarantee a specific amount of income, while variable annuities pay a specified amount of income depending on the performance of your investment account. It is true you can’t fund your variable annuities with pre-tax money, but once the money is in your investment account, it will grow on a tax deferred basis. That means you will not have to pay taxes on your investment profits until you begin making withdrawals (tax deferred growth) In this regard, income annuities are similar to 401 (k) and IRAs.

The traditional 401 (k) and IRA distributions are taxable in retirement. But things are different when it comes to annuity investments. There comes a point in time when you are no longer required to pay taxes on your income withdrawals. This is because annuities are taxed on a last-in, first-out basis. That means when you take distributions, the money that comes out first is considered earnings and is subject to taxes. Once the value of your annuity contract falls below the amount of money you distributed to it, your income withdrawals will not be taxed anymore.

No yearly contribution limits

401(k) and IRA offer important tax benefits, but there is a limit to the amount you are allowed to contribute each year. For example, workers under 50 years can put a maximum of $5,500 annually into IRA and $18,000 per year into their 401(k). Employees who are 50 years or older can contribute a maximum of $24,000 to their 401(k) and up to 6500 dollars per year into their IRA account. These limits may seem generous for some workers, but people who wish to save above such thresholds often feel restricted.

One of the top benefits of annuities is that there is no annual limit on contributions. In case you have maxed out 401(k) or IRA but still want to invest financial resources in a tax-advantaged way, you may want to consider an annuity.

Annuities protect you from outliving your retirement savings

In a recent study, 60 percent of baby boomers revealed that they were afraid of outliving their savings. Income annuities can protect you from outliving your retirement savings, which is apparently considered a fate worse than sickness or death.

If you buy a deferred income annuity, the insurance company will guarantee a certain amount of income for a specified period of time. That means if you plan to retire at 65 years and are probably concerned that your retirement account might run dry by the time you hit 85 years, a deferred income annuity can cushion you from financial challenges once your savings account is depleted.

Summary

Annuities are associated with many benefits such as lifetime income in some cases, which is why they are an excellent choice for most investors. However, they are not an ideal option for some investors. This is because they are expensive and usually come with long term surrender periods and surrender charges. If you have exhausted your savings options with 401 (K) or IRA, an annuity is a great option.