Most adults have a checking account, a savings account, and know how to buy a certificate of deposit. However, if you ask them what an annuity is, you will probably get some shrugs.
Annuities are often misunderstood, so in this article we’re going to cover the basics of what is an annuity, the different types of annuities, and how annuities work.
What is an Annuity?
An annuity is an insurance contract that provides a guaranteed stream of income for a specified period of time or for life. A guaranteed steady stream of income is the holy grail of financial planning, so why isn’t everyone flooding insurance companies to buy an annuity? Because any type of “guarantee” comes at a high cost, and not everyone will need a guarantee.
A financially savvy person saving responsibly for retirement might be able to self-insure instead of buying an annuity. On top of that, annuities are complex and there are different varieties of annuities with hundreds of options, riders, disclaimers, footnotes, and contingencies.
How Do Annuities Work?
To understand how annuities work, you first need to understand the two main types of annuities:
1. Immediate annuity
If you need a guaranteed stream of income right away, you can convert a lump sum of money to an immediate annuity that pays out monthly, quarterly, or annually. You can opt to get payments for a fixed number of years or until you die. Yes, if you have retirement savings, you can start drawing down from that, but there is always the risk of running out of money before you die.
2. Deferred annuity
If you are years away from retirement and want to make sure you have a guaranteed income source in retirement, you can get a deferred annuity. The cash you invest grows tax deferred within the annuity (similar to your 401k) so you receive payments at a later date.
Read More: Do I Have to Buy an Annuity?
More Options to Consider
Purchasing an annuity isn’t as easy as deciding whether you simply want an immediate or deferred annuity. Here are some more annuity options you should consider:
- Single premium – You buy an annuity using a lump sum of money.
- Flexible premium – You make multiple premium payments to the insurance company.
- Fixed – Your money will earn a fixed interest rate set by the insurance company. When you begin receiving income, a fixed payment is guaranteed.
- Variable – Your money will be split into sub-accounts depending on your risk level and invested in stocks, bonds or other investments. The annuity pays a minimum level of income, which could go up depending on the performance of the sub-accounts. The downside is these typically have substantially higher fees than mutual funds.
- Equity-Indexed – A variation of a fixed annuity where the interest rate is based on an outside index, such as a stock market index. Similar to variable annuities, this product pays a minimum rate, which might go up if the index performs better.
- Lifetime income – You receive income as long as you live, even if payments exceed the amount of money you put into the annuity. If you buy an installment refund rider, your beneficiaries will continue to receive payments even after you die until the total amount paid to you and your beneficiaries equals the premium. If you didn’t buy a rider, the insurance company will keep the money.
- Joint and lifetime income – Provides income as long as you or the survivor live.
As with any contract you sign or any financial product you buy, it’s always wise to ask questions and thoroughly understand what you’re buying. Yes, there are regulations in place to protect consumers up to a certain extent, but no one cares more about your money than you do.
So before you buy an annuity, make sure you understand what you’re buying and that you’ve done your research and believe you are a good candidate for the product. (If you need assistance with this, talk to a fee-only financial advisor.) Also make sure you are buying a product that is suitable for your needs and matches your goals and that you’re buying it from the best possible source, taking the fees and risks into consideration.
Here are a few questions to ask as you perform research:
- How will an annuity help my retirement?
- Is the annuity adjusted for inflation?
- What is my risk tolerance and how will buying an annuity influence this versus investing in a mutual fund?
- How much money should I put into an annuity?
- What is the rating and strength of the annuity issuer and what are the fees?
If you are considering purchasing an annuity, make sure you are aware of the potential benefits and drawbacks and how it fits into your overall retirement plan. Being fully informed is crucial, so it’s best to consult a trusted financial advisor to help you understand the complex world of annuities.