When preparing for retirement, you may want to consider annuities to supplement your other retirement products such as a 401(k). They offer long-term, consistent income, and some have tax benefits when the owner follows the withdrawal guidelines.
We can help you to understand how they work, depending on your retirement goals so you can make an informed decision when evaluating whether or not one makes sense for you.
How annuities work
Insurance companies offer them as an agreement to provide income in exchange for a lump sum or a set amount of premiums (periodic payments). The payments may start right away, an immediate annuity, or at a later date, a deferred annuity. The income could last for a specific number of years, for a lifetime, or it could extend to a beneficiary.
The two most common types of annuities are fixed annuities and variable annuities.
This type of annuity is an insurance product that acts as savings, paying out a set amount. As with life insurance insurance companies and underwriters base the payout on factors such as, age, mortality rate and life expectancy.
- Benefits - The most attractive benefit is the comfort of knowing exactly what you'll get. The rate stays the same through the growth process, and the payout is a fixed amount.
- Challenges - Although fixed annuities come with a locked-in rate, companies base it partially on market performance at the time the annuity is set up. Rates are also typically low, meaning a low return. There also are other things associated with the fixed annuity that aren't guaranteed, such as the insurance company's stability and your future expenses.
The company also makes the payout guarantee without the backing of the Federal Deposit Insurance Corporation (FDIC) or any other insurer. A typical fixed annuity does not consider inflation either. If expenses rise during your retirement, your payout may not be enough to cover them. Some annuities offer a cost-of-living adjustment, but at a higher price, to offset effects of inflation.
Financial institutions offer them as investment products and have features similar to what insurance companies offer. Variable annuities have separate buckets from which customers can select different investment funds, such as stocks and bonds.
They also treat rates differently. The return can increase or decrease depending on how the investments are doing. The growth and decline happen during the accumulation phase, which is before you begin to take payouts. The amount of money available when it's time to start periodic payments determines how much you'll receive.
- Benefits-The investment funds give you the potential to gain more money at a faster pace. As a result, you could have more to supplement your retirement and cover cost-of-living expenses. Variable annuities also offer a death benefit for beneficiaries, plus tax-deferred earnings.
- Challenges-Because they're variable, you may never get a return, despite all your investing. They also are more costly than a mutual fund, and fees are higher because of administrative costs, fund expenses and mortality risk.
Keep in mind
Know all the details about the annuity you have in mind. Read your paperwork and ask questions. Once you sign the documents and start making payments (or taking payouts), companies may not be willing to refund your money. If your policy doesn't include a free-look period, the seller does not have to cancel it.
If you choose to withdraw funds, fees may reduce the amount of your initial investment. You may also have to pay taxes, depending on the type and amount of withdrawal. You also reduce your spending power with an annuity rather than managing it yourself.
Right after purchasing an annuity, it instantly loses its value and low interest rates means a negative return overall. By the time you receive payments, your guaranteed annuity payments will not be able to keep up with inflation.
Not all annuities transfer to a beneficiary in the event of your death. Even if you just recently set up one, it may not qualify for a refund. Make sure the one you choose meets your wishes for a beneficiary.
Keeping all the gray area in mind, sit down with a professional before making a final decision about an annuity. They can do calculations based on your financial situation and retirement goals. You may find that handling your own monthly distributions or using a different investment works out better.
At Guided Choice we believe in helping people reach financial freedom, and we constantly work to do just that. We are dedicated to bringing you insights and information that help you make better, more informed decisions to improve your future.