Annuities Could Transform Your Retirement Income—Here’s How

Annuities are savings and income products offered by insurance companies. They are often included in retirement planning as potential sources of income.

Technically, they’re not investments, however. They act more like irons in the fire, waiting and ready to provide you with income at a time and in a manner that you choose.

Read on to learn about their impact on your retirement income and whether they might play a part in your planning.

What Is an Annuity?

An annuity is a contract between an insurance company and an individual that ultimately turns an asset (your money) into a year-long income stream.

To purchase an annuity, you can pay one significant premium, or you can make a series of payments over a designated period known as the accumulation phase. You can elect to take the money in a single lump sum payment, or you can spread out payouts according to predetermined terms. You can begin taking withdrawals right away, or you can wait until retirement.

An annuity certain makes payments to you over a set number of years, or term. Payments will pass to your named beneficiary if you should die before the term expires. A life annuity will pay out until you die or for an agreed-upon number of years, whichever is longer.

Some insurance companies will let you purchase riders as well, allowing you to add on additional benefits. All terms are set forth in the contract between you and the insurer at the time of purchase.

Types of Annuities

Most annuities fall into one of three categories: fixed, variable, or indexed.

Fixed Annuities

A fixed annuity pays interest on the amount you paid in, at an agreed-upon rate. All costs and charges incurred by the annuity are deducted first. Then interest is paid on the remaining balance.

This type of annuity can be either deferred or immediate. With a deferred annuity, the insurer guarantees that the interest rate will never drop below a certain point.

An immediate fixed annuity guarantees you an ongoing, predetermined payment (usually monthly) that lasts for a specific period of years or for your lifetime.

Variable Annuities

This type of annuity crosses the line into investing. The insurance company will invest your purchase money into bonds, stocks, or other securities, according to your preference. Fees are deducted from your money before it’s invested. Your annuity account balance can suffer if the investments you choose fall in value.

The Securities and Exchange Commission (SEC) regulates and monitors variable annuities along with state-level insurance commissioners in some cases. Other types of annuities are regulated only at the state level.

“Variable annuities are more complex because they have the potential to achieve higher returns by investing in a range of underlying investments, including equities and fixed-income,” says David Rosenstrock, CFP®, MBA, and Director of Financial Planning and Investments at Wharton Wealth Planning.

“Your payout won’t be as big if your investments do poorly, just like any other investment.”

Indexed Annuities

With indexed annuities, the insurance company guarantees a minimum return. It’s based on the return of an index, often the S&P 500.

Your purchase money grows not only due to earned interest but also on changes in the index’s value, always assuming that’s a positive change. A negative change in the index’s value reduces the value of your account.

Indexed annuities also fall into two categories: equity-indexed (EIAs) or registered index-linked (RILAs). EIAs guarantee a minimum rate of interest plus interest earned on the performance of the associated market index. RILAs are subject to buffers or floors, the terms of which you can elect. A buffer is how much of a loss the insurer will take on before it passes losses on to you.

A floor allows you to cite the percentage you’ll take as a loss before additional losses pass to the insurer.

Benefits of Annuities

1. One significant benefit of saving with an annuity is that its value grows tax-deferred until you take that lump sum payment or begin taking regular payments.

Because your growing balance remains undiminished by taxes, more of it can keep on working for you. This applies to dividends, interest, and any capital gains.

2. Another benefit: a reliable and predictable stream of income throughout your retirement years until the time of your death (if you spread out the payments rather than take a lump sum).

“Certain types of annuities can guarantee income for life. This guaranteed income can be a great hedge against the risk of outliving your savings,” says Matt Hylland, a financial planner at Arnold and Mote Wealth Management in Cedar Rapids, IA.

3. You can also contribute as much money as you like to an annuity, unlike 401(k)s or individual retirement accounts (IRAs), which have contribution limits controlled by federal law.

4. Certain types of annuities—for instance, an immediate income annuity—guarantee a fixed income payout no matter what’s going on with stocks or interest rates. Your savings won’t be affected should markets drop in value.

Downsides of Annuities

Annuities come with some important drawbacks as well.

1. The taxation benefit won’t last forever. Your annuity’s growth is tax-deferred, not tax-free. You’ll have to pay taxes on any gains when you take money out in either a lump sum or via regular scheduled payments. The Internal Revenue Service (IRS) may hit you with an additional 10% penalty if you do so before age 59½.

2. The payments you receive in retirement aren’t adjusted to keep pace with inflation. So the purchasing power of the money you originally gave the insurance company could be radically different from what it is for the money you receive later in retirement.

“Most annuities don’t provide payments that increase with inflation,” Hylland says. “This is most important for those who purchase an annuity early in retirement, when they may still be facing a few decades of inflation. You shouldn’t only consider the cash flow you need today when deciding how much of an annuity to purchase, but also how much you’ll need a decade or more from now.”

You can sometimes add a cost-of-living rider to an annuity, but, of course, there will be a charge for that.

3. Annuities come with numerous fees, costs, and charges. Some of them are ongoing, such as annual maintenance fees, and others are triggered by certain events.

“Significant fees, surrender charges, and potential hidden costs can eat into your returns,” says Rosenstrock. “These fees are often not transparently disclosed upfront, leading many investors to realize the actual cost after they’ve made the purchase and see it live.”

4. In addition, there’s always the possibility that the insurance company will fail. Should this occur, you’d have no protection from financial loss because annuities aren’t guaranteed by any federal agency such as the Federal Deposit Insurance Corporation (FDIC).

Is an Annuity Right for You?

Your choice can ultimately come down to weighing the common pros and cons of annuities against the issues that matter to you most.

Is a steady income in retirement more important to you than getting financially dinged if you change your mind or otherwise realize that you have to liquidate early?

Do you prefer a steady and reliable stream of income or investing your capital in the stock market or other securities in the hope of significant returns?

“An annuity might make sense for very conservative and risk-averse individuals who are nearing retirement and seek a guaranteed income stream to cover expenses during their later years,” Rosenstrock points out.

The Bottom Line

An annuity can provide those in retirement with a welcome, steady income stream that they can depend on for years. It can enhance other income streams such as Social Security benefits and annual payments from retirement accounts.

But they can be complicated, and they’re not for everyone.

If you’re interested, be sure that you understand exactly how they work. Ask about any fees, expenses, costs, and other charges cited in the contract so you’re prepared for them going in. Ask whether there are any costs that aren’t clearly spelled out, too.

Check in with a financial professional and perhaps even a tax consultant before you sign on the bottom line, just as you should for any other savings and investment product.