What Is an Annuity—and Why It May Be the Missing Piece in Your Retirement Plan


May 5, 2021

What Is an Annuity—and Why It May Be the Missing Piece in Your Retirement Plan

May 5, 2021

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Do you consider yourself a good money saver? Do you live below your means? Do the market ups and downs make you nervous? If having safety in your retirement portfolio is important to you, annuities may be a good option. Annuities are gaining in popularity because of market volatility and the need for steady retirement income. Planning for retirement is full of complicated choices and important decisions—there are so many options for retirement products and strategies and so much financial and legal jargon to sort through. Annuities can offer a supplement to your retirement income, but they aren’t right for everyone. Consult a financial advisor to determine if an annuity is the right choice for you.

What Is an Annuity?

An annuity is a contract between you and an insurance company with an agreement to pay you a regular income now or in the future; annuities are purchased with a lump sum or a series of payments—this is considered your “principal,” or your initial investment. The insurer uses a variety of strategies (depending on the product) to grow your annuity funds. Annuities can be used to protect or grow your income or to provide you with guaranteed income in retirement. Think of them as insurance for your retirement, helping mitigate the risk of outliving your retirement income.

How Does an Annuity Work?

Annuities are funded either with a lump sum payment or a series of payments. The insurance company then uses these funds to invest into different strategies. There are different types of annuities with varying levels of risk and payment periods—fixed, variable, indexed, immediate, and deferred income. We’ll discuss these annuity types more below.

There are two phases in an annuity’s “life”: The accumulation phase is the time period when an annuity is being funded. No payments are made during this phase. The annuitization phase is when payments begin to the annuitant. These payments can be made for a set time period or for the annuitant’s lifespan, depending on how the annuity is structured.

Types of Annuities

Annuities can have a variety of details and benefits based on the type and insurance company, especially in terms of payment duration. Some annuities may continue payments for the annuitant’s lifespan (or their spouse’s if the survivorship benefit is available and elected). Others may pay out for a specified time period (e.g., 15 years), regardless of how long the annuitant lives. Immediate payment annuities begin paying out as soon as the lump sum is paid. Deferred income annuities don’t begin benefits until the age at which the client specifies they would like to begin receiving payments.

Annuities are generally either fixed or variable. Fixed annuities (e.g., a multi-year guarantee annuity or MYGA) offer regular “fixed” payments with guaranteed minimum interest rates to the annuitant, generally meaning there is less risk and no potential for loss of principal. Rates can change over the course of your investment. Indexed annuities (or fixed indexed annuities, FIAs) are technically a form of fixed annuities with the benefits of both fixed and variable annuities. Your money receives returns from a stock market index, like the S&P 500 (note: your money isn’t actually invested into the index). Annuity providers use participation rates (also known as par rates) or rate caps to limit your investment returns. This means that your returns likely won’t match the stock market gains/growth, as the annuity provider will take a portion of the returns as annuity fees.

Variable annuities carry more risk and may have the potential to lose principal, but they also may pay out more or less depending on the funds in which the annuity is invested in. Those with a higher risk tolerance may elect a variable annuity because it has the possibility of greater returns if the investments perform well. It may be possible to add features, like an income rider or death benefit, to the contract to help protect the annuitant (usually for an additional cost). An income rider is a form of income protection, which guarantees that you’ll receive a minimum payment, regardless of what happens to your investments. Because of the chance of higher returns, variable annuities can be very expensive; it’s important to understand all the associated fees when considering this type of annuity.

A qualified longevity annuity contract (QLAC) is a special income annuity designed to meet specific IRS requirements that allows you to defer your required minimum distributions (RMDs) past age 72—the current age at which you’re required to begin taking RMDs. A QLAC is the only way to legally defer RMDs for a portion of your IRA funds, thus keeping your tax-deferred money in your IRA longer. You can invest up to 25% of your total IRA funds (up to 135,000) in a QLAC; this allows you to delay taking payments from the QLAC up until age 85.

Annuities vs. Life Insurance: What’s the Difference?

To understand the difference, an important distinction should be made between mortality risk and longevity risk—mortality risk is the risk of dying prematurely while longevity risk is the risk of outliving one’s retirement income and/or assets. Life insurance deals with mortality risk; insurance policyholders pay an annual premium to fund a lump-sum payout upon their death. Annuities deal with longevity risk.

Life insurance companies use actuarial science and their experience to hedge their bets that the policyholder will live long enough for the insurer to earn a profit; if the policyholder dies prematurely, the insurance payout from the insurer posts a net loss. Annuity companies assume the risk that annuitants will outlive their initial investment; these companies hedge their bets by selling annuities to higher-risk individuals who may die prematurely before their initial investment annuitizes.

Illiquidity of Annuities and Surrender Periods

Annuities come with a surrender period—the time in which an annuitant cannot withdraw money from the annuity without paying a surrender charge. These time periods can last from months to years, depending on the annuity product purchased. The penalty usually declines over the surrender period as the annuity gets closer to the annuitization phase.

The inability to touch the funds in the annuity contract (without paying a surrender fee) results in that money being considered illiquid. Annuitants need to consider their liquidity needs (e.g., an upcoming large purchase, wedding, healthcare costs, etc.) to determine if an annuity is the right choice at that time. Also, it’s crucial that the purchasers understands that they are paying a liquid lump sum—cash (that could be paid to the annuity insurer through a series of payments)—for a guaranteed income stream, paid out through a series of payments, to hedge the longevity risk.

Tax Implications of Annuities

The tax implications vary depending on the funds you use to purchase your annuity. If you use an IRA funds or pretax money from an IRA or 401(k) to purchase the annuity (called a qualified annuity), all payments would be taxed in full. If you use after-tax money to buy the annuity (called a nonqualified annuity), then a portion of your payment will be tax-free—a return of your already-taxed principal. The rest—your earnings—is considered taxable income. Nonqualified annuities use an exclusion ratio to determine how much of your payment is your principal and how much is earnings; this is designed to spread the payment of your principal out over the annuity’s lifetime. Any taxes you owe will be taxed at your income tax rate, not the capital gains tax rate. Deferred annuities grow the initial principal tax-deferred over the accumulation phase—meaning you don’t pay taxes until you begin receiving payments.

A Word of Caution

Keep in mind that annuities do not equate to ownership of individual stocks, index funds, or mutual funds. They are also not insured by the FDIC, any federal agency, or any bank. Annuities are backed by the financial strength and paying ability of the issuing company. As annuities are illiquid, they do not offer immediate or flexible access to money; they are part of long-term retirement strategy.

An annuity may not be right for everyone. If you feel financially secure about your retirement future, you may not need or want an annuity. But if you want to build some safety from market turns into your portfolio and generate a steady income stream throughout your retirement, annuities may be the option for you. Just don’t put all of your eggs in one basket—a diversified portfolio is the truest form of protection in retirement. Work with a financial advisor to determine if an annuity is right for you; after that, they can help you find and purchase the right annuity type from the right company with the right features.


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