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Annuities can be optimized for income or long-term growth, but they are not short-term investment strategies. These products appeal to people whose objectives include long-term financial security, retirement income, diversification and principal preservation.
- An annuity is a customizable contract issued by an insurance company that converts an investor’s premiums into a guaranteed fixed income stream.
- The type of annuity you purchase determines your future annuity payments.
- The primary benefits of buying an annuity include principal protection, the potential for guaranteed lifetime income and the option to leave money to your beneficiaries. Some annuities may also be optimized to help pay for long-term care.
What Is an Annuity?
An annuity is an insurance product designed to provide consumers with guaranteed income for life.
More specifically, an annuity contract is a legally binding, written agreement between you and the insurance company that issues the contract. This contract transfers your longevity risk — the risk of you outliving your savings — to the insurance company. In exchange, you pay premiums as outlined in the contract.
How Do Annuities Work?
Annuities work by converting a lump-sum premium into a stream of income that a person can’t outlive. Many retirees need more than Social Security and investment savings to provide for their daily needs.
Annuities are designed to supply this income through a process of accumulation and annuitization or, in the case of immediate annuities, lifetime payments guaranteed by the insurance company that begin within a month of purchase — no accumulation phase necessary.
In essence, when you buy a deferred annuity, you pay a premium to the insurance company. That initial investment will grow tax-deferred throughout the accumulation phase, typically anywhere from ten to 30 years, based on the terms of your contract. Once the annuitization, or distribution, phase begins — again, based on the terms of your contract — you will start receiving regular payments.
Annuity contracts transfer all the risk of a down market to the insurance company. This means you, the annuity owner, are protected from market risk and longevity risk, that is, the risk of outliving your money.
To offset this risk, insurance companies charge fees for investment management, contract riders, and other administrative services. In addition, most annuity contracts include surrender periods during which the contract holder cannot withdraw money from the annuity without incurring a surrender charge.
Furthermore, insurance companies generally impose caps, spreads and participation rates on indexed annuities, each of which can reduce your return.
- Free-Look Period
- Most states require insurance companies to include a free-look period that allows a buyer to cancel the contract without incurring a surrender charge.
- Riders are addendums that allow the customization of basic annuity contracts. It’s important that you understand the riders you select and are aware of their additional costs.
- You can add a death benefit rider to your contract to ensure that your beneficiary receives a portion of the contract value.
- Fees and Commissions
- The fees and commissions for annuities vary by the type of annuity. Fixed annuities generally have the lowest fees.
- One of the most attractive features of annuities is their favorable tax treatment from the IRS. If your annuity was purchased with money that you've already paid taxes on, then only your earnings will be taxed when the money is withdrawn.
Cash Now or Cash Later
Annuities come in two basic configurations: immediate or deferred.
The option you select will depend on your financial goals. If you want to begin receiving annuity payments right away, you will choose an immediate annuity.
Alternately, if you would like to set your payments to begin at some point in the future, you will purchase a deferred annuity and specify the start date in your contract.
INCOME NOWImmediate AnnuitiesLearn More
Funded with a single lump-sum payment
Guaranteed monthly payouts
Supplement your retirement savings
INCOME LATERDeferred AnnuitiesLearn More
Tax-deferred premium growth
Guaranteed lifetime income that begins on the date you specify
More income later because your money accumulates longer
Types of Annuities
Different types of annuities exist to fit the diverse needs of the market. Your personal goals and objectives will determine the type of annuity that is right for you.
GUARANTEED INCOMEFixed AnnuitiesLearn More
Earns a guaranteed rate of interest for a set period of time
Rate of interest may be guaranteed for a set period of time or may fluctuate from anniversary to anniversary
Backed by the insurance company that issued it
GROWTH POTENTIALFixed Indexed AnnuitiesLearn More
Earns interest based on a market index, such as the S&P 500
Doesn't participate directly in the stock market and preserves premium
Guaranteed minimum rate of return
FLEXIBLE INCOMEVariable AnnuitiesLearn More
Earns interest through investments you select within the annuity
Does not guarantee a return but offers more growth potential
Reasons to Buy an Annuity
People buy annuities to create long-term income. While most often considered financial solutions for older people who are close to retirement, annuities can benefit investors of any age with a variety of financial goals.
- Long-term security
- Tax-deferred growth
- Principal protection
- Probate-free estate distribution
- Inflation adjustments
- Death benefits for heirs
Income annuities are generally suitable for people who are within a year of retirement and want the security of guaranteed income. Remember, single premium immediate annuities (SPIAs) begin paying out within a year of purchase. This means there is no accumulation period as there is with deferred annuities.
For this reason, SPIAs are also beneficial for younger people who have inherited a large sum of money and wish to protect the windfall from poor financial management.
In contrast, deferred annuities are generally not recommended for people who have short-term financial needs or younger people with more aggressive investment strategies.
One of the key benefits of an annuity is that it allows the investor to save money without paying taxes on the interest until a later date. Annuities have no contribution limits, unlike 401(k)s and IRAs.
Another significant benefit of annuities is the creation of a predictable income stream to fund retirement. With an annuity, you don’t have to worry about outliving your savings. This is a major advantage in the post-pension age.
Your reasons for investing in an annuity should align with your unique lifestyle and financial situation.
Tax-Deferred GrowthYou save money without paying taxes on the interest until a later date.
No Contribution LimitsUnlike 401(k)s and IRAs, you set the dollar amount you invest.
Fund Your RetirementAnnuities create predictable income streams for life.
Provide for Your FamilyDeath benefit riders allow you to transfer your money to your loved ones.
Although it’s not possible for an immediate annuity calculator to account for every provision in a contract, our calculator uses a principal amount, a fixed annual interest rate, and your gender and age to generate a rough estimate of what your monthly payments could be for the rest of your life.
We use the gender and age provided along with the Centers for Disease Control and Prevention life expectancy table to estimate the number of years you could receive payments starting one month from when you enter your data.
Disadvantages of Annuities
Some consumers see sacrificing liquidity in return for lifetime financial security as a disadvantage. Indeed, if your financial status or short-term goals limit the amount of cash you have on hand, an annuity is probably not the right solution for you. It wouldn’t make financial sense to purchase a valuable, viable product if it’s not valuable and viable for you.
- Commissions and fees
- Conservative returns (as compared with investment products)
- Loss of potential returns from other investments
The loss of potential returns is what’s known as “opportunity cost.” People frequently cite opportunity cost as drawback. This objection is valid for people with higher risk tolerance. For example, younger investors with longer time horizons would most likely benefit from a more aggressive investment strategy because they have time for their money to grow and could bounce back from temporary market losses.
Older investors and retirees, on the other hand, need to assess opportunity costs as they relate to their specific circumstances. It is less likely that people in this age group would consider opportunity costs a disadvantage of an annuity.
Reduce Your Opportunity Cost
For many investors, the main objection to annuities is the risk of losing access to their money for the length of their contract. This means that in addition to the possibility that you won’t be able to cover unexpected expenses, you may miss the opportunity to take advantage of higher interest rates or to invest in the stock market.
This is where your understanding of your long-term goals comes in. Your decision to purchase — or sell — an annuity should be in alignment with your goals, and you should be comfortable with having your money locked down for a modest payout in exchange for guaranteed lifetime income.
To reduce your opportunity cost, consider a partial investment upfront. This will allow you to reserve some of your savings for unplanned expenses and give you the ability to capitalize on a potential rise in interest rates.
How to Get Started
Getting started is as easy as contacting us now. We’ll put you in touch with our partner, Senior Market Sales, for more information on securing your financial future.
- Contact Us
We’ll route you to a financial expert who specializes in annuities and retirement planning.
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Frequently Asked Questions About Annuities
26 Cited Research Articles
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