An annuity is a type of insurance investment designed to offer a consistent and dependable flow of income during one’s retirement years. Essentially, it is an agreement between a person and an insurance firm. The insurance company pledges to repay the initial investment with interest through a series of payments starting at a predetermined future date.
There are several types of annuities to consider, such as fixed, variable, and indexed.
Fixed Annuities
Fixed annuities provide a guaranteed rate of return for a certain period, after which the insurance company may adjust the rate. The premiums you give to the insurance company are, in turn, invested into fixed-income securities, such as federal, municipal, and corporate bonds. These bonds or other debt securities are chosen for their stability and risk aversiveness.
Of course, with investing, the more you risk, the greater the reward. And with a Fixed Annuity, you’re not really risking much. Therefore, the payoff will be substantially less with a Fixed Annuity. As of February 2023, you can expect a 4% to 6% yield through a Fixed Annuity, which may not even outpace inflation.
The upshot is that you’ll receive your income regardless of how the markets are doing.
Variable Annuities
Variable Annuities invest in more aggressive mutual funds that consist of a mixture of stocks, bonds, and other assets. Accordingly, the performance of a Variable Annuity is quite volatile, as it has a higher exposure to the whims of the market than a Fixed Annuity. The returns are not guaranteed, and the annuitant bears the investment risk.
On the other hand, there is a higher chance of making a more significant profit. According to SmartAsset, the average Variably Annuity provides an 8% – 10% interest rate – it should be noted, though, that these are more likely to come with higher fees than fixed annuities, which will eat into your profits, just like an actively-managed mutual fund or ETF.
While a Variable Annuity risks losing value, you can add a clause in the contract called a ‘rider’ that will provide a guaranteed rate of return, called a guaranteed minimum income benefit (GMIB). However, it will also come with a fee. The reasoning, however, is simple. The investor is pushing the responsibility of volatility and loss onto the insurance company. That doesn’t come for free!
Index Annuities
An index annuity invests in an industry benchmark consisting of a wide range of stocks that meet benchmark criteria. Indexed annuities typically offer a minimum guaranteed return and the potential for higher returns linked to the performance of a market index, such as the S&P 500. Stock market indexes provide more stability than individual stocks or actively managed mutual funds, but the profits are limited.
Funds are spread across various companies so that, even if one fails, you don’t lose everything. But if one company’s stock soars, you don’t have enough money invested in that company to capitalize on it very well.
An index fund wrapped inside an annuity provides further stability and protection, with less chance of loss but less upside as a consequence. Again, the payoff is that the payment is guaranteed, though at a lesser payout than investing in the S&P 500 would alone.
Two Annuity Phases
Accumulation Phase
The individual who purchases the annuity, referred to as the annuitant, can either buy the annuity with a lump sum or make monthly contributions. This stage is known as the accumulation phase.
During the accumulation phase, your annuity starts earning tax-deferred interest through the investments made by the insurance company with your premium(s). Their investments depend on the specific annuity and can range from more aggressive to more conservative options.
Payout Phase
The payout phase commences when the insurance company begins to disburse your premium. The payout phase can either last for a set period of time, say 20 years, or for the rest of your life. If you purchase a fixed-term annuity, the payment will depend on the kind of annuity.
If you opt for lifelong payments, the insurance company will calculate the monthly payment amounts based on the annuitant’s life expectancy, considering factors such as age, gender, and health. The longer the annuitant is expected to live, the smaller the individual payments will be, as the total payout will be spread over a larger number of years.
Annuities in Retirement Planning
Annuities should be thought of as a safety net in the event that all other investments fail. Traditional investment portfolios are subject to market fluctuations. In some instances, even well-diversified portfolios may not withstand bear markets, particularly if one occurs at the onset of retirement, referred to as the sequence of returns risk.
What about Social Security?
While Social Security is an option, many individuals desire a more comfortable lifestyle than what it has to offer. Plus, being a government program, there’s always the chance, however slight, of Social Security getting legislated out of existence or defunded.
Annuities can supplement Social Security benefits, bridging the gap between the risk of portfolio failure and the modest lifestyle provided by Social Security alone. Essentially, annuities act as insurance against financial market instability. And if your portfolio performs as expected, great! An annuity will only enhance your retirement experience.
With an annuity, you can enjoy a more secure retirement without the fear of running out of funds. In theory, at least. We’ll delve into that later.
The Pros of Annuities
Annuities provide a nominally guaranteed source of income when you need it most, which can help alleviate concerns about outliving one’s retirement savings. Since they are part of an insurance contract, they are safer than directly purchasing securities, plus they provide tax-deferred growth, letting them grow unimpeded from regular tax payments.
The Cons of Annuities
There are also some drawbacks to consider. Annuities can be complex, difficult to understand, and typically more expensive than regular investments. They also tie up a substantial sum of cash due to hefty fees for withdrawing funds early, making them highly illiquid. These are known as surrender charges.
Additionally, they are not FDIC-insured. If the insurance company files for bankruptcy, the state will step in and attempt to salvage annuities by transferring them to another insurance company or, if that fails, move them into the State Guaranty Fund. Limits do apply, however, and they may not cover variable annuities.
In Conclusion
In conclusion, annuities can be a valuable financial tool by providing a steady and dependable income during retirement. By offering a safety net against market fluctuations and supplementing Social Security benefits, one can feel more confident in their financial plan rather than depending on the markets or government programs. However, it is essential to understand their pros, cons, and potential risks before deciding.
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