Including an annuity in your retirement plan can be a smart decision for retirees.
There are many considerations before purchasing an annuity. This article will help you make the best decision based on your situation.
Examples of decisions to make include:
- Fixed or variable annuity
- Deferred annuities, market index, or fixed indexed annuities
- Using retirement savings or individual funds
Before we dive into the different types of annuities for retirement, you must create a retirement plan with an advisor.
We also recommend that you consult with a qualified advisor before purchasing an annuity of any type.
A well-designed retirement plan includes an inventory of assets and liabilities. It should include how much income you have from all sources and your expenses. There are two types of expenses. One category is “need-based,” which includes essentials, such as rent, taxes, insurance, utilities, and groceries. And another is “want-based” expenses, such as entertainment, travel, dining out, and extra clothing and accessories.
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What is an Annuity?
An annuity is a financial product that provides a series of payments made at equal intervals. It is typically used as a tool for managing and distributing funds, often for retirement planning or income generation. Annuities are offered by insurance companies, and they can be tailored to meet various financial goals and needs.
Considerations of the types of annuities for retirement
Lack of Liquidity
Most annuities are illiquid investments. If you need a large sum of money for an emergency or another financial goal, you may not have easy access to it without incurring significant penalties. There also may be a penalty if taken before the surrender charge is over or if you take money out before the allowed age. A “surrender charge” is a type of sales charge you must pay for a certain number of years if you sell or withdraw more money than the allowed withdrawal from an annuity.
All annuities are complex. Before investing in any annuity, you should consult with a qualified, independent advisor to confirm an annuity is appropriate based on your financial goals, liquidity needs, and risk tolerance.
Always review the contract, disclosures, terms, and fees before investing in an annuity.
Types of Annuities
There are several types of annuities, including:
With an immediate annuity, you make a lump-sum payment to the insurance company, and they start making regular payments to you. These payments can be for a fixed period or the rest of your life, providing a guaranteed income stream. They also can be for your life and a guaranteed period in the event you die early.
Immediate annuities provide a steady stream of income that is guaranteed for a specified period or for life. This can be particularly beneficial for retirees who want to ensure a regular income in retirement.
Less Market Risk
Unlike investments in stocks or bonds, immediate annuities do not expose you to market fluctuations. Your income remains consistent, regardless of how financial markets perform.
Protection Against Longevity Risk
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Immediate annuities are straightforward. You make a lump-sum payment to the insurance company, and in return, you receive regular payments. There is no need to manage investments or worry about market conditions.
A portion of the annuity payments you receive may not be subject to income tax.
Loss of Principal
When you purchase an immediate annuity, you typically give up access to the principal amount you invest.
Lack of Flexibility
Immediate annuities are not very flexible. Once you start receiving payments, you usually cannot change the payment amount or the payment schedule.
Annuity payments are typically fixed and do not adjust for inflation, reducing your purchasing power.
Low Interest Rates
When interest rates are low, the initial payments from an immediate annuity may also be relatively low.
Fixed annuities offer a guaranteed interest rate for a specified period, similar to a certificate of deposit (CD). They provide a predictable income stream, making them a conservative option for those who want stability.
The interest rate is typically guaranteed.
Safety and Security
The principal is safe and protected, and the income is stable and predictable.
Earnings grow tax-deferred.
Simple and easy to understand compared to other annuities.
Because of the guarantees, the returns are generally less than other annuities and investments.
Less flexible than some other investment options
You typically can’t access your money without incurring penalties or surrender charges for a period of time.
Surrender Charges and penalties
If taken out early, there may be surrender charges, penalties, and taxes.
Lack of Liquidity
Funds may lack liquidity if you have a long surrender period.
Also, review the terms of your contract before investing money in any annuity.
Variable annuities allow you to invest your contributions in various investment options, such as stocks, bonds, or mutual funds. Your returns are not guaranteed and can fluctuate based on the performance of your chosen investments.
There is a potential for more investment growth than other annuities.
Funds may grow tax-deferred until you make withdrawals.
Your investment choices can be tailored to your risk tolerance and financial goals.
Death Benefit Option
Generally, you can name a beneficiary who will receive the proceeds at your death.
Riders and Options
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Market Risk and Investment Loss
If the investments perform poorly, you can lose money.
Higher Fees and Expenses
Variable annuities tend to have higher internal costs than other investment options.
Complex and Inflexible
Variable annuities are often difficult to understand. Before buying an annuity, regardless of the type, you need to review the contract, product, terms, fees, and potential risks. Variable annuities are generally considered illiquid investments.
Surrender Charges and Penalties
Also, check your contract for fees, charges, and penalties if you take money out early.
Indexed annuities provide returns linked to a specific financial index, such as the S&P 500. They offer the potential for higher returns than a fixed annuity while also providing some level of downside protection.
This means your principal is protected from market downturns. You won’t lose money due to poor market performance.
Index Annuities are linked to the performance of a specific financial index, such as the S&P 500. You can benefit from market gains without taking on the full risk of the market.
They also offer various indexing strategies, allowing you to choose the one that best aligns with your risk tolerance and financial goals.
Variable annuities provide tax deferred growth. This means you do not have to pay taxes until you take your money out.
Guaranteed Lifetime Income
They also provide a range of income options, including guaranteed lifetime income streams. This can help address the risk of outliving your savings in retirement.
Death Benefit Option
Indexed annuities typically offer a death benefit feature, but the specifics can vary from one annuity contract to another. Always check on the options including death benefit prior to purchasing an annuity.
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Complex in Nature
Because of the complex nature of the strategies, you must review the contract, product, terms, fees, and potential risks before purchasing.
We recommended that you always consult with a qualified advisor before you purchase any annuity.
Limited Market Participation
Because you typically can’t lose your principle, there is a limit to your gains.
Surrender Charges and Penalties
Review the contract for charges, fees, and penalties before you withdraw money out.
Like most annuities, you can only take out a specified amount of money each year, i.e. 10%. Other withdrawals taken before the annuitization phase, retirement age, or surrender period may result in penalties and fees.
Recap – Different Types of Annuities for Retirement
Annuities can serve different purposes, such as providing retirement income, ensuring longevity risk protection (the risk of outliving your savings), or creating a predictable income stream for a set period.
However, it’s important to note that annuities are complex financial products, and their suitability depends on an individual’s financial goals, liquidity needs, risk tolerance, and overall financial situation.
They often come with fees and penalties for early withdrawals. It is crucial to thoroughly review the annuity contract and understand the terms and conditions before investing in one.
We strongly recommend that you consult with a financial advisor to help you make an informed decision based on your financial situation.
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