Annuities: What Are They?

This blog post was written by Student Advisory Council member, Meadow Hall.

It’s never too early to start preparing for retirement, and annuities are one type of financial product you should consider. Annuities are essentially a long-term agreement between you and an insurance company where you contribute money as an investment now in exchange for a stream of payments from the insurer later. Your contribution can either be a lump-sum payment or a series of payments over time, and similarly, the payments you receive from the insurer may come as a lump-sum or a series of payoffs in the future. 

How do annuities work?

Annuities can be a great way to guarantee yourself income in retirement, but it is important to understand the nuances of how they work. A typical annuity has two stages: An accumulation stage and an annuitization stage. During the accumulation stage, you contribute money to the insurer, and the money is typically invested so that your money grows over time. In the annuitization stage, you start to receive payments from the insurer, and you have the option to receive a lump-sum payment or a regular stream of monthly payments.

Annuities are flexible financial products, and there are many ways to customize an annuity to suit your needs. First, there are three types of annuities. Fixed annuities guarantee you a fixed amount of payments regardless of how your investment performs, providing you a steady stream of income. Variable annuities have payouts that depend on the performance of your investments. If the investments do well, you receive a higher payout, but you also have to bear the risk of lower payouts or losses if your investments do poorly. Finally, there are indexed annuities, where your return is tied to a stock market index such as the Standard & Poor’s 500 Index. While your payouts for indexed annuities depend on index performance, your gains and losses are usually capped, which limits your upside if the index does well but also protects you against downside if the index declines.

Another factor to consider is when you want to receive your payouts. The longer you wait, the larger your payout will be, since your money has more time to grow. You can also customize annuities with riders, which are optional add-on features. Some riders include death benefits, where your beneficiary receives the leftover money you paid for the contract that has not been paid out yet, and cost-of-living adjustments, where you agree to a lower initial monthly payout that increases over time to keep up with inflation and rising costs of living.

Pros and Cons

Annuities provide a guaranteed source of income in retirement and are customizable to suit your financial needs. If you think you’ll need more than Social Security in retirement, annuities can help make sure you don’t outlive your savings. You pay no taxes on the income and any investment gains until you receive your money, and you can name beneficiaries to receive any unpaid money.

However, annuities are long-term investments, with large penalties and surrender charges if you take out money before you’re supposed to. The insurer can also charge recurring maintenance fees and underlying fund expenses. In addition, inflation can erode the purchasing power of the money you receive, and your payoffs are exposed to market risk and can depend on the performance of your investments.

Who should buy annuities?

You should consider buying an annuity if you are looking for a secure, reliable source of income in retirement that can complement your overall investing strategy. Annuities are also a useful form of long-term savings, especially if you have maxed out your contributions to other retirement accounts. However, annuities are not a good choice if you foresee a need to access your money, since there are early withdrawal penalties. Moreover, traditional 401k and IRA plans offer more tax benefits at lower fees, so make sure to max out these plans before investing additional money in annuities. 

Regardless of the current stage of your retirement planning, it is important to understand all your options and carefully weigh the benefits and risks of the different financial options out there. For more information about annuities, check out investor.gov, and for more personalized assistance, consult a financial advisor like those at GreenPath Financial Wellness to see if annuities are a right fit for you.