August 18, 2021
Annuities: Planning Your Dream Retirement
An annuity is a solid financial tool used for stability and protection throughout your retirement years. There are numerous annuity options available for a variety of situations. These products can provide a steady stream of income throughout retirement once you’ve completed your contributions and entered the distribution phase.
In this guide, we’ll discuss everything you need to know about annuities, including the features and drawbacks, the types of annuities available, and other important details.
What Is an Annuity?
An annuity is a type of insurance contract. You make financial contributions to an annuity in exchange for future payments. The money you contribute earns interest, and some annuities create future income you can use throughout retirement.
Your annuity payments may start immediately or they may start later (after retirement, for example). You can choose to make regular contributions to your annuity, make a single lump-sum contribution, or have flexible payments over your contribution period.
The income you receive from your annuity depends on the type of annuity you choose. Fixed annuities guarantee* a minimum interest rate. Other annuity options are a bit more complicated. We’ll discuss these in more detail later.
While annuities may seem complicated, the basics are this:
- An annuity can be both a savings option and an investment.
- Annuities are often part of a comprehensive retirement plan.
- Annuities can guarantee* monthly income for the rest of your life.
- Annuities help relieve the fear of outliving your retirement funds.
- Annuities can also help you save money, creating a steady stream of cash later.
- Depending on the type of annuity, they are regulated by state insurance departments, the Securities and Exchange Commission (SEC), and Financial Industry Regulatory Authority (FINRA).
Here’s a bit more detail about annuities and how they work.
How Does an Annuity Work?
An annuity is a financial product you can purchase from a life insurance company. The purpose of an annuity is to create dependable cash flow from your contributions. Annuities are usually part of a larger retirement strategy, and you may face withdrawal penalties if you cash out your annuity too early. There are many different types of annuities available, so you should choose one that best fits your retirement plans.
Annuities are common, though the terminology may differ. For example, if you win the lottery, you’re usually given a lump-sum or annuity option. With the lump-sum option, you’ll receive all of your winnings (after taxes) at once. If you take the annuity option, however, you’re guaranteed the full value of the winnings over a certain number of years. Lottery winners often choose the annuity because it provides them with stability and security via guaranteed income.
The Phases of an Annuity
There are two annuity phases: the accumulation phase and the annuitization (or distribution) phase.
You make contributions to an annuity during the accumulation phase. During this phase, your investment grows. Fixed annuities guarantee* a minimum interest rate. Also, by purchasing a deferred annuity, you won’t pay taxes on interest until your money is paid out or you make a withdrawal.
The second phase is the annuitization (sometimes called distribution) phase. This is when your monthly payments begin. This phase typically begins when you retire, but the exact timing can depend on the type of annuity you choose and your personal preferences.
Annuities sometimes also have a surrender charge period. During this time, which usually lasts a few years or more, you will pay a penalty for early withdrawal of annuity funds.
When you purchase your annuity, you have options. You can choose when your monthly payments begin and whether they continue for a certain number of years or throughout the remainder of your life.
Your payments are determined using an annuity formula, which relies on your account balance, your age, interest rates, expected mortality, the length of the distribution phase, and more to average your monthly payments. You’ll receive your payments directly from the company you purchase your annuity through.
What Are the Primary Types of Annuities?
There are many factors that determine the type of annuity you should purchase. Some options allow immediate payments, while others defer payments to a later date. Some require a lump-sum contribution, while others require ongoing contributions for a certain number of years. Some annuities have a fixed payout period, while others continue for life. Some annuities even pay benefits to your spouse upon your death.
Immediate annuities have a payout period that starts right away (within the first year of your annuity purchase). You typically invest a lump-sum of money, and your payments start immediately. The term of the payout period can vary. You might elect a 10-year payout period or receive guaranteed* payments for the rest of your life. Our Advantage 40 Annuity is an immediate annuity.
Deferred annuities don’t have an immediate payout option. Instead, you make contributions to the annuity over a certain number of years, then payouts begin later (a year or more after your annuity purchase). You choose the age when you start receiving annuity payments. Usually, people elect for their payments to start when they retire. Depending on the type of annuity, during the accumulation phase your money may grow according to market conditions. If you have a fixed annuity, your money will still grow, but it won’t be tied to market performance like variable or indexed annuities.
With fixed annuities, your money is guaranteed* to earn at least a minimum interest rate. You may receive interest at a rate higher than the minimum, but you’re only guaranteed* the minimum stated. The insurance company you purchase your annuity from determines the rates.
In other words, a fixed annuity isn’t tied to market performance. These are the most reliable types of annuities because you know the minimum amount you’ll earn.
With a fixed annuity, the company that you purchased your annuity from carries the investment risk. Therefore, they’re more likely to invest in more secure services like bonds.
At BetterLife, we offer fixed annuities:
- Advantage 30 Annuity (flexible payment deferred annuity)
- Advantage 40 Annuity(single payment immediate annuity)
- Advantage 50 Annuity (single payment deferred annuity)
- Single Premium Deferred Annuity
As opposed to fixed annuities, variable annuity earnings will fluctuate. With a variable annuity, earned investment returns are based on the performance of the investment portfolio, aka subaccounts, where you choose to put your money. There’s no guaranteed rate of return with a variable annuity because the value of the subaccounts you elect to put your money can increase or decrease. On one hand, if a subaccount’s value goes up, you could make money. On the other hand, if a subaccount’s value goes down, you could lose money. This makes it more difficult to assume what the income payments will be, because they’re truly variable.
Variable annuities aren’t as stable as fixed annuities, but they can be worth the market fluctuations in the long run. Because you hold the risk with a variable annuity, you have more control over which investments you use.
It’s also worth noting that you can add riders to annuity contracts, which can sometimes offset the risk involved with a variable annuity.
An index annuity is similar to a variable annuity, but is a bit more stable. Your index annuity isn’t dependent on a specific investment you choose. Instead, it’s dependent on the performance of a market index (e.g., the S&P 500). If the index does well, your annuity’s value increases. If the index underperforms, your annuity’s value decreases.
While this type of annuity is riskier than a fixed annuity, there are usually limits in your annuity contract. You’ll have a ceiling and a floor for your gains and losses, so your earnings can’t fluctuate too wildly, even if the market performs extraordinarily well or poorly.
|Lump-sum contribution||Lump-sum or recurring contributions|
|Payouts begin within 1 year of annuity purchase||Payouts are deferred for at least 1 year from the annuity purchase date|
|Guaranteed* minimum interest||Payments depend on investment performance||Payments depend on market index performance|
|Stable growth||Fluctuating growth||Fluctuating growth|
|Annuity company carries risk||You carry risk||You carry (slightly less) risk|
|Least risky; least growth opportunity||Riskiest; best growth opportunity||Moderate risk and growth opportunity|
Reasons to Buy an Annuity
While annuities aren’t the best option for everyone, there are many benefits to this type of financial product, particularly when it comes to retirement planning.
Guaranteed* payments are one of the primary benefits for fixed annuity owners. While standard investments can lose money over time, fixed annuities have minimum guaranteed* interest rates. You can easily budget your money, knowing your annuity account won’t dip below a specific threshold. This is especially helpful during retirement.
Some annuities work with your 401(k) or Roth retirement accounts. You can roll your retirement savings directly into a qualified annuity, then receive regular annuity payments.
If you choose a deferred annuity, the interest you earn is tax-deferred. You won’t pay any taxes until you receive your first annuity payment or until you take money from the annuity.
You can choose either single payment, lump-sum, or flexible payment annuities. You can choose how much you pay into your annuity and how frequently you make the payments.
You can also choose your payout options. Choose when your distribution period begins and how long your distribution period will last. There are many payout options available, and you can customize your annuity to fit your financial goals and retirement plans.
Guaranteed* Interest Rates
Fixed annuities offer guaranteed* minimum interest rates. While you may earn more than the minimum depending on the insurance company’s declared interest rate, you will never earn less.
When you die, your loved ones are often required to wait on probate before they gain access to your assets. With annuities, the proceeds go directly to the beneficiary you name, which prevents delays due to probate.
There are several fees involved with annuities. These are usually paid from the balance of your annuity, and they may affect your payouts. Make sure to read your annuity contract/disclosure and ask your agent to explain the associated fees.
Fees may include:
- Maintenance fees or administration and mortality fees
- Investment fees (for variable annuities)
- Rider fees
The fees you incur depend on the options you choose, but an average is roughly 2.3% to 3.0% of your total account balance each year.**
If you request a withdrawal before your distribution phase begins, you may also incur a surrender or withdrawal charge. The amount typically decreases the closer you are to the end of your surrender charge period. Again, make sure to look at your contract or disclosure for any details regarding how your particular surrender charge works. You should also look for any waivers for events, such as death, along with the right to withdraw a small amount of money per year without paying the surrender charge — this is typically up to 10%. Once you’ve taken all of the money out of your annuity, it’s considered “surrendered” and you’ll no longer receive future income payments.
Another fee that may be included is a Market Value Adjustment (MVA). This could increase or decrease your annuity’s value, cash surrender value, and/or death benefit value if you take money from your account. Typically, if interest rates are lower when you take money out than when you bought the annuity, the Market Value Adjustment could increase the amount you could withdraw. However, if interest rates are higher than when you bought the annuity, the Market Value Adjustment could decrease the amount you could withdraw. Because every MVA is different, talk to your agent or check your contract/disclosure for details.
Annuities vs. Life Insurance: What’s the Difference?
Annuities are similar to life insurance and purchased through life insurance companies. They’re often used in conjunction with life insurance policies as protection for the future. However, their goals are a little different.
The primary goal of life insurance is to provide beneficiaries with financial security after your death. These proceeds may be used for funeral/burial expenses for you and living expenses for your surviving loved ones.
Conversely, the primary goal of an annuity is to provide you with stable income payments throughout your retirement. While annuities may pay your beneficiaries upon your death, this isn’t their primary intention.
Are Annuities Right for You?
So, should you purchase an annuity? That depends on your financial goals and retirement plans.
Annuities are a great option if:
- You value stability and want a safety net for the future.
- You wish to establish a monthly income stream.
- You receive a large sum or inheritance and want to safely invest it for retirement or a future date.
- You got a new job and need to transfer your 403(b) or 401(k) funds to a safe place.
- You’d like a more conservative approach when saving for retirement.
- You’re saving for retirement and want to establish a traditional or Roth IRA.
- You want to give to charity as a final wish.
Annuities are often used alongside other financial planning, such as 401(k) or Roth accounts, life insurance policies, and other investments.
*Guarantees are backed by the financial strength and claims paying ability of BetterLife.
**According to https://www.annuity.org/annuities/fees-and-commissions/