Annuities are a financial product that can provide steady cash flow during retirement. An annuity product isn’t for everyone, but for some individuals who have reached a certain point in life, an annuity contract can set up guaranteed income.

Common Types of Annuities

1. Lump Sum
2. Deferred
3. Fixed
4. Variable
5. Hybrid

Even if someone has saved a seven-figure nest egg, there is still the longevity risk that they will outlive the ability of their assets to fund their retirement. Yes, it’s true that Social Security will provide them with fixed payments for the rest of their life, but even if they wait until 70 to start collecting the maximum 138 percent of their monthly benefit, that may still not be enough to meet regular expenses, personal goals, gifts, and financial emergencies, like a medical procedure or the need for assisted living arrangements.

One popular retirement planning strategy is to create a nest egg out of retirement savings, usually in the form of a mutual fund or mutual funds. However, this type of retirement plan has some drawbacks because there are limits to how much you can contribute to an IRA, and even how much you can contribute to a 401(k).

By contrast, annuity holders are not limited by these constraints and can contribute as much as their annuity contract allows. Generally speaking, mutual funds do have lower fees than what an annuity provider can offer you. However, the income stream you do enjoy from a mutual fund is an investment option tied to financial markets. In some cases, when the market underperforms, your income payments will be reduced. By contrast, an annuity payment is usually fixed—though there are variable annuity contracts, which we will discuss later.

What Are Annuities?

An annuity is sold by a financial institution or insurance company. The annuitant (the one who benefits from the annuity, in most cases they are also the one purchasing the annuity) invests a certain amount of money with the goal of receiving a fixed income later on.

During the accumulation phase, the annuitant funds the annuity, either through regular contributions, a lump sum, or periodic lump sums. During the annuitization phase, the annuitant receives payments for the rest of their life, unless the contract specifies payouts for a specific number of years. If a survivorship benefit is elected as part of the contract, the surviving spouse will receive payments for a specified period as well.

How Does an Annuity Work?

Imagine putting money into a piggy bank you could not touch, and having that money grow 2.5 percent to 3.5 percent every year. Then, when you need additional income options in retirement, that money will be paid back to you in the form of lifetime income. The rate of return may be less than you would enjoy with a mutual fund, but it is more secure in its guarantee. That’s essentially what annuities are: you contribute money that is placed into underlying investments, which is then returned to you in the future.

Incidentally, this is similar to the U.S. Social Security program. During your working life, whether you are employed or self employed, you pay FICA taxes to the IRS. Then, when you retire, the Social Security Administration returns that money to you every month. While all Americans are required to participate in this type of annuity for guaranteed income, purchasing an annuity from a life insurance company or financial institution is optional.

Qualified vs Nonqualified Annuities: Tax Considerations

Another consideration is whether we are looking at qualified annuities or nonqualified annuities.

A qualified annuity is purchased with pre-tax dollars, like funds from earnings diverted into an IRA or 401(k). Moreover, qualified annuities can be tax deductible, which is an added incentive for the annuitant.

Nonqualified annuities are purchased with after-tax dollars, such as cash you have in your checking or savings account. Nonqualified annuities are not tax deductible. These tax deductions are, in part, meant to stimulate retirement savings, but they will also have repercussions once the annuity payments begin.

Because nonqualified annuities are purchased with post-tax dollars, you have already paid taxes on that money, and the withdrawals are not taxed—sort of. While you won’t have to pay taxes on the principal (that is, the amount you invested), you will have to pay it on the money the annuity earns through underlying investments.

As for qualified annuities purchased with pre-tax dollars, your payouts will be taxed as ordinary income. These considerations are something you will have to weigh against other income streams, like income derived from a pension pot or other retirement account, along with Social Security. That’s why working with a retirement planner, like those at Anderson Advisors, is indispensable. Their advice and expertise can make a huge difference in how much you’re able to enjoy retirement.

5 Common Types of Annuities

1. Lump Sum

A lump sum payment is exactly as it sounds–receiving all your money at once. This might come into play when an annuitant dies; their surviving spouse is set to receive payments, and elects to receive the death benefit in one lump sum.

Alternatively, lump sum as it relates to annuities could refer to an annuity type called the immediate payment annuity (or immediate annuity for short), whereby the annuitant starts receiving payments immediately after depositing a lump sum with the insurance company.

2. Deferred

A deferred annuity, also known as a deferred income annuity, means that payments will not begin until the annuitant reaches a specified age. Before this point, the annuity may be in a surrender period wherein the annuitant cannot touch the invested money without facing a surrender charge.

Deferred annuities can also be fixed or variable, which we will look at next. A fixed deferred annuity is a good option for someone a few years or perhaps a decade away from retirement who wants to enjoy the security of fixed payments.

3. Fixed

Fixed annuities have contractually agreed upon payouts that are fixed once the annuity matures. This type of annuity represents an excellent way to stabilize a retirement portfolio. However, you should not think that just because the monthly payout of a fixed annuity is set in stone that the money is just being returned to you without any growth. You can expect a rate of return for the annuity, and this is because the premiums you pay or the lump sum you provide to the financial institution will almost certainly be invested by them into different asset classes.

4. Variable

Variable annuities have payouts that are not fixed in nature, and instead reflect the growth of the money that was invested in the annuity. If the investment does well, payouts can be larger. But if it does poorly, payouts can be smaller. As such, a variable annuity is less stable than a fixed annuity, but affords greater possibility for reaping larger payouts.

5. Hybrid

There are also hybrid annuities that blend the variable annuity and fixed annuity, usually through the addition of a contract rider (a sort of addendum). A hybrid fixed-variable annuity can benefit from any potential upsides if the invested money does well, while resting securely with minimum withdrawal benefits. A fixed indexed annuity is one example of this type of annuity contract.

Pros and Cons of Annuities

Now that we’ve talked about the different types of annuities, let’s talk about the pros and cons of using them as an investment tool.

Annuity Pros

Security

Imagine knowing that you will be comfortably provided for in your retirement. That’s the feeling you can get if you have an annuity, especially a fixed annuity. Annuities can eliminate longevity risk because they can be structured in a way that guarantees periodic payments for the rest of the annuitant’s life.

Growth

A variable annuity is a great way to grow your money. Rate of return varies from annuity to annuity. Some of them are actively managed, while others are tied to the performance of a stock market index. Whatever the case may be, the rate of return may be significantly better than what you would get from having your money in a savings account or CD.

Annuity Cons

Upfront Cost

Annuities need to be funded by the annuitant, and that can present a significant cost, whether that means forking over a sizable lump sum or making large periodic payments to your insurance company. As such, investing in an annuity might be cost prohibitive for some individuals, which can serve as a downside.

Risk

In most cases, if the annuitant dies before the annuity matures, the life insurance company will keep the premiums they’ve collected, as well as the money they would have needed to pay out. There may be a survivor benefit rider attached to the contract, but in most cases, this will be a financial win for the insurance company.

In fact, annuities are a common strategy insurance companies use to hedge against losses from insurance payouts. While they will be reluctant to sell a life insurance policy to a high-risk individual (since that presents a high degree of financial risk to the company), they won’t mind selling an annuity to the same at-risk client. That’s because (not to get too morbid) the company is essentially betting that you won’t make it long enough to collect annuity payments.

Who Should Invest in Annuities?

Investing in annuities is a long-term investment strategy that comes with high up-front premiums. Therefore, it isn’t really recommended for younger individuals who need high amounts of liquidity. This is especially true if major life events, such as a wedding or real estate purchase, are on the horizon, as those require quick access to large amounts of cash.

However, an older individual entrenched in a well-paying career field who is financially set and more than solvent should consider annuities. For example, someone approaching retirement whose home is paid off (or mostly paid off) and whose children are all grown and/or married should consider an annuity as a complementary product to their life insurance; one will pay their surviving family members if they die, and the other will provide a steady stream of income if they live.

Annuities Are a Solid Investment for People Approaching Retirement

Annuities are for the long haul. But if you are approaching retirement, they are certainly something you should consider for making life easier through the guarantee of a steady fixed income.

If you have permanent life insurance, you can typically convert your policy to an annuity with zero tax implications using a 1035 exchange. This can be a good strategy for someone who is about to transition to an income stream provided by a lifetime of investments, since changing their policy into an annuity allows the potential annuitant to recoup some of the investment they’ve made into life insurance during retirement.

Looking for more retirement investment opportunities? Join our Infinity Investing Workshop! Our experts will help you develop a simple plan for financial independence so that you can enjoy a comfortable retirement!