The Accurate Guide to Retirement Annuities

Is your retirement income sufficient? Can you count on it being enough for life so that you will not run out of money when you reach old age?


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If you haven’t answered these questions, it’s about time you do.

As one example, a survey by Schroders indicates that people expect to need an average of $1.1 million to retire comfortably, but only 24% expect to reach that threshold.

In addition, 56% of respondents expect to save less than $500,000, including 36% who will save less than $250,000.

Considering that people are living longer worldwide, that should shake you to your core. In fact, between 2020 and 2050, the number of elderly people aged 80 or older is expected to triple, reaching 426 million.

So, yeah. You’re going to need a solid nest egg. But, you also need a guaranteed income that you won’t outlive. That’s a tall glass to fill. However, a retirement annuity might just do the trick.

Retirement Annuities: What Are They and How Do They Work?

With a retirement annuity, you put money aside to receive an income in retirement. A schedule is outlined for the payment of this income. The payment is usually made monthly, quarterly, or annually.

Overall, in your golden years, you will have peace of mind knowing that you have a reliable income stream.

Buying a retirement annuity involves paying a premium. The premiums for retirement annuities are usually paid either in a lump sum or over time. But, this depends on the type of contract you sign.

Retirement annuities can be divided into three categories: fixed, variable, and indexed:

  • Fixed annuities. There is a minimum rate of return on the premium dollars invested with this type of annuity. There can be periodic or even annual adjustments to the rate. As an example with a Due Fixed Annuity, your get 3% a month on your money. With a monthly deposit, you’ll always know how much money you’ll have when you retire.
  • Variable annuities. Payments into a variable annuity are invested in one or more of its subaccounts. The concept of sub-accounts is similar to that of mutual funds. Depending on the performance of the sub-accounts, the value of the annuity will vary.
  • Indexed annuities. Indexed annuities are based on indices, like the S&P 500, and offer returns based on percentages of those indices. Additionally, index annuities generally guarantee a minimum return.

Immediate vs. Deferred Retirement Annuities

It is important to note that some annuities are immediate, meaning that payments can begin as soon as the annuity is purchased. With an immediate annuity, you pay the insurer a lump sum. These annuities are popular with older adults who want to ensure a regular income once they retire

Deferred annuities, however, are used in the long run. You don’t get your money until a certain date after paying in. You have the option of earning interest or profiting from market gains before that date.

Understanding Retirement Annuities

The process of converting your annuity balance into income is known as annuitization. Your funds could remain invested indefinitely if your contract doesn’t require annuitization. In some cases, you may be able to take one-time withdrawals or designate a beneficiary to receive the money upon your death.

In the event that you choose to annuitize, you will receive income based on:

  • Your annuity’s accumulated funds.
  • The investments that have been made with those funds.
  • The duration of your income payments. Your income stream can last for a set period of time, like 20 years, or for the rest of your life.
  • You might be able to adjust inflation as an optional feature.

The Importance of Retirement Annuities

In the face of retirement, an entire generation feels unprepared and unequipped due to the lack of pensions. In fact, the amount of Americans retiring with defined benefit pensions today is less than one-third (31%). No wonder a study by the Insured Retirement Institute shows that only 25 percent of baby boomers think they will have enough money when they retire.

“Americans are living longer and face a variety of risks in retirement,” Michael Finke, a research fellow and dean, and chief academic officer of the American College of Financial Services, said in a 2018 news release introducing the Protected Lifetime Income Index research initiative.

According to Finke, most retirees today use their retirement savings, such as IRAs or 401(k) plans, to pay for their retirement expenses.

“If they had an annuity to accompany their savings and investments, [retirees] could always count on a source of guaranteed monthly income, which would reduce the risk of running out of money. And annuities are a solution that can provide that protected income for life,” added Finke.

Additionally, a variety of studies have shown that retirees who receive guaranteed income in addition to Social Security are happier. Furthermore, a guaranteed lifetime income in retirement can provide a safety net during market downturns caused by unpredictable events like COVID-19.

How Does a Retirement Annuity Pay Out?

The way retirement annuities pay out determines the amount of income they generate. Depending on the type of retirement annuity, immediate or deferred payouts are available.

Immediate Annuities

An immediate annuity may be purchased as a lump-sum payment right before retirement by some buyers. As such, there is an upfront premium associated with immediate annuities.

As soon as you pay the premium, you’ll receive monthly payments. Depending on the annuity terms, the payout usually begins under a year.

In order to ensure steady payments throughout retirement, people close to retirement age should consider this option.

Deferred Annuities

On the other hand, deferred annuities can be built over several years. It is common for people to pay their premiums over time, but they don’t begin receiving their payout until after retirement. Depending on the type of annuity you have, your money will grow either through interest or through stock and bond market gains.

Annuity Payout Options

Again, depending on your needs, there are a number of different payout periods you can choose from.

“Probably the most common is the life annuity with cash refund option,” explains State Farm agent Patrick Blevins. “With this option, if you’re still living once your initial investment has been paid out to you, you’ll keep receiving the same monthly payment for however long you live.”

“If you don’t outlive your initial investment, your beneficiary will receive a lump sum payment based on whatever portion of the initial amount wasn’t paid out to you, so it guarantees the return of principal,” he adds.

“Period certain options are popular too, where you or your beneficiary is guaranteed to receive payments for a specified number of years,” says Blevins. “If you live past that date, you’ll still continue to receive payments for the rest of your life.”

How to Use Your Retirement Annuity Income

There are several ways in which retirement annuity income can be used. Generally speaking, it should be used in a way that meets your retirement needs and goals.

Some of the most common uses include:

  • Covers your fixed expenses. As a supplement to Social Security, annuity income can be used to cover fixed expenses. These would be expenses like your mortgage, utilities, and groceries.
  • Pays for your retirement lifestyle. Any retirement goals that you have planned can be funded from your retirement annuity income. For example, going on a vacation or picking up new hobbies.
  • Keeps your spending in check. If you’re thinking about a retirement budget, it should include a stream of income, like an annuity and social security payments. By doing so, you avoid overspending. How? When you know what’s coming in, you can make more financially sound decisions.

In these circumstances, retirement annuity income offers the advantage of protecting your retirement savings for other expenses that inevitably arise.

The Advantages of Retirement Annuities

There are two main reasons why people buy annuities: tax deferral and guaranteed income.

  • Tax-deferred earnings. If you invest in an annuity, your funds will either earn a fixed rate of interest or grow with underlying investments. There are no immediate tax consequences associated with the resulting income. As with a 401(k), annuities do not need to be taxed until payments start coming in.
  • Guaranteed income. As soon as you annuitize, the insurer is contractually obligated to pay you an income. In most cases, you’ll receive a monthly payment — often for life. Annuity benefits should be covered by your state’s guaranty association if your insurer goes bankrupt. You can find out the rules that apply to you by checking with your state.

But, there are a couple of other benefits worth mentioning, such as:

  • Guaranteed rates of return. There are some annuity contracts that offer guaranteed returns. Annuities, both fixed and indexed, can have this feature. Although your rate of return can certainly be higher, knowing there is a floor is nice. However, it is possible for this floor to result in a loss instead of a gain.
  • No contribution limits. An annual contribution limit applies to 401(k) and IRA accounts and other tax-favored programs. However, retirement annuities do not have contribution limits.
  • Survivor options. It is possible for survivors of a contract holder to choose from several options offered by annuities. Each insurer will have its own set of terms and conditions. A beneficiary option will typically be included in the contracts to designated beneficiaries upon the death of the account holder. In addition, there might be a joint and survivor option for a spouse, or a period certain option for someone not related to the spouse.

The Disadvantages of Retirement Annuities

Despite the advantages listed above, retirement annuities aren’t flawless. As such, you should also be aware of its disadvantages.

  • Hefty fees. In comparison with mutual funds and CDs, annuities are expensive. In many cases, these are sold by agents, whose commissions are paid upfront. However, buying direct from the insurer can help you avoid those high upfront fees. Despite this, you may still be faced with significant annual expenses, often exceeding 2%. In addition, if you increase your coverage with special riders, you’ll pay even more.
  • Early withdrawal penalties. Withdrawing funds from your retirement annuity before age 59 ½ will result in income tax and a 10% penalty.
  • Illiquid asset. It is not possible to change the terms of the payments once you have annuitized. If you sell or surrender your annuity, you will lose some of your principal invested. Whenever you attempt to withdraw from your annuity within the first few years of your contract, you will incur a surrender fee. It usually takes 6-8 years for the surrender period to expire.
  • Higher tax rates. One of the main selling points of these products is the tax-deferred status of interest and investment gains. You will, however, need to declare ordinary income when you withdraw your funds. In some cases, the capital gains tax rate is higher than the income tax rate.
  • Complexity. There can be a lot of complexity involved with annuities. Sometimes, it can be difficult to understand what you’re paying for.
  • Possibility of insurer default. It is the insurance company that issues the contract that guarantees annuities. Although there haven’t been many annuity defaults, it is possible. The guaranty association in your state provides backup for the insurance company. Before investing in an annuity contract, it’s a good idea to check the insurer’s financial stability.

How Does a Retirement Annuity Fit into Your Retirement Portfolio

Annuities can be a valuable part of your retirement plan. However, a well-rounded retirement plan should also include IRAs, 401(k) plans, life insurance, and other traditional financial tools.

As a retirement income replacement, an annuity can also provide a source of income. Upon receiving the payout, you will continue to receive a steady, scheduled income for the rest of your life. In this way, retirement annuities protect you against outliving your retirement savings.

In short, annuities give you financial flexibility in retirement by diversifying your retirement portfolio.

To determine if an annuity is a good choice for retirement, it may be a good idea to speak with an advisor familiar with annuities. Ideally, you should avoid working with advisors who receive commissions when they sell annuities. And, as with any large purchase, always shop around.

It would also be helpful to create a written financial plan to determine if an annuity is right for you. A financial plan can then include an annuity that fulfills a specific retirement goal. You may not be a good candidate for an annuity if it does not fulfill a specific financial goal.

Frequently Asked Questions

1. What is an annuity?

In simple terms, an annuity involves a contract between you and an annuity provider. In many cases, through an insurance company. If you give the insurer money, they will guarantee that the money will be returned plus interest (deferred annuity) or that you will start receiving income fairly soon (immediate annuity).

2. What is tax-deferred?

While interest accrues on annuities, they aren’t taxed until they are withdrawn, which means they accumulate interest. As a result, annuity earnings increase.

3. How can I protect myself when buying an annuity?

It’s important to make sure that your insurer will be able to honor its commitment to you in the long run. It is easy to find financial strength ratings from agencies such as A.M. Best, Moody’s, Standard & Poor’s, and Fitch.

The state insurance departments that regulate annuity insurers require them to file regular financial reports. Annuities are also protected from failure by state guaranty associations up to certain limits.

Besides doing your research on the annuity company you’re considering, you can spread your annuity money across more than one insurer so you’re fully protected by the guaranty association if you’re investing a lot of money.

4. What happens to my annuity when I die?

There is one unique benefit to an annuity: the death benefit. Survivors of an annuity owner who die before all payments are disbursed can inherit the remaining assets. In the absence of a beneficiary, all remaining annuity assets are surrendered to the company that issued the annuity.

5. Are there alternatives to annuities?

Besides annuities, there are other options for long-lasting income without the fees and complexity of them. Two options that may be helpful to you are Social Security and dividend stocks.

  • Social Security. Aside from annuities, Social Security is one of the few income streams that can last a lifetime. The amount of your Social Security benefit is determined by your earnings history. As you near retirement, you still have some influence over how much you receive. For example, raising your work income or delaying your benefits. A major advantage of Social Security over an annuity is that it does not require any upfront payments.
  • Dividends. In addition to generating lifelong income, dividend stocks can also generate capital gains. This isn’t guaranteed, however. Dividends are always subject to reduction, suspension, or cancellation by a company. Some dividend stocks are more reliable than others, which is good news. Dividend Aristocrats, for example, are companies that have paid and increased dividends continuously for 25 or more years. In addition, Dividend Kings are a group of dividend increasers who have increased their dividends for more than 50 years. The dividend stock market offers more uncertainty than annuities, but it also offers a greater potential for income. With time, your stocks will appreciate, as well as you’ll earn dividend income.

While it’s worth exploring retirement options that meet your needs, you shouldn’t put all of your eggs in one basket. In other words, to have a comfortable lifestyle in retirement, you should have a diversified portfolio.

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