Are Annuities a Good Investment for Your Future?

Annuities are financial products often considered for retirement planning. This article provides an understanding of annuities, helping readers determine if they align with their financial objectives.

What Annuities Are

An annuity is a contract between an individual and an insurance company. Its purpose is to provide a steady income stream, typically during retirement, or to accumulate savings on a tax-deferred basis. The individual makes payments to the insurer, who then makes regular disbursements back to the individual, either immediately or at a future date.

Annuities are categorized by investment growth and payout structure. Fixed annuities offer a guaranteed interest rate for a specified period, providing predictable growth and principal protection. The insurer bears the investment risk, ensuring a predetermined return regardless of market performance.

Variable annuities allow the contract owner to invest in sub-accounts, similar to mutual funds. The annuity’s value fluctuates with the performance of these underlying investments. While variable annuities offer potential for higher returns, they also carry market risk, meaning value and future income are not guaranteed and can decline. Fees, such as mortality and expense charges, can impact returns.

Indexed annuities combine features of both fixed and variable annuities. They link returns to a market index, without directly investing in the market. These annuities include a “floor” that protects against market losses and a “cap” or “participation rate” that limits upside potential.

Annuities are also distinguished by when income payments begin. Immediate annuities, also known as Single Premium Immediate Annuities (SPIAs), require a lump-sum payment and begin providing regular income almost immediately. This option is chosen by individuals nearing or in retirement who desire an immediate and predictable income stream. Payments are fixed and continue for a specified period or for the annuitant’s life.

Deferred annuities involve an accumulation phase where money grows over time before income payments commence. Funds grow tax-deferred, meaning earnings are not taxed until withdrawn. This annuity is suitable for individuals who wish to save for retirement over many years and convert savings into an income stream later.

Annuities can be funded with pre-tax or after-tax money, classified as qualified or non-qualified. Qualified annuities are purchased with pre-tax dollars, often within a retirement plan, and all withdrawals are taxed as ordinary income. Non-qualified annuities are purchased with after-tax money; only earnings are taxed upon withdrawal.

How Annuities Work

Annuities feature tax-deferred growth, meaning earnings are not taxed until withdrawn. This allows the investment to grow more rapidly compared to a taxable account. When withdrawals are made from a non-qualified annuity, the “last-in, first-out” (LIFO) rule applies, meaning earnings are withdrawn first and taxed as ordinary income.

Withdrawals from an annuity before age 59½ may incur a 10% federal income tax penalty, in addition to regular income taxes on earnings. Exceptions exist, but annuities are intended for long-term financial planning.

Annuities offer various payment options once the income phase begins. Common choices include “life only,” which provides payments for the annuitant’s lifetime but ceases upon death, and “life with period certain,” which guarantees payments for a minimum number of years. “Joint and survivor” options provide payments for the lifetimes of two individuals. The process of converting accumulated value into payments is “annuitization.”

Annuitization can involve relinquishing control over the principal for guaranteed income. Some annuities allow systematic withdrawals, where the contract owner takes regular distributions without fully annuitizing. This preserves access to the remaining principal, though it does not offer the same longevity guarantee as full annuitization.

Annuities come with fees and charges that can reduce returns. Surrender charges are common, particularly with deferred annuities, and are penalties for withdrawing more than a specified amount during an initial period. These charges typically decline over time.

Variable annuities have additional fees such as mortality and expense (M&E) fees, which cover guaranteed death benefits and other insurance risks. Administrative fees cover contract management costs. Optional riders incur separate fees.

Liquidity considerations are important because annuities, especially during the surrender charge period, are not designed for easy access to funds. While some contracts allow partial withdrawals, exceeding limits triggers surrender charges. This illiquid nature means funds committed to an annuity should not be needed for immediate expenses.

Many annuities offer optional riders that can be added for an additional cost. A Guaranteed Minimum Withdrawal Benefit (GMWB) rider allows withdrawals of a specified percentage of initial investment annually, even if the account value declines. A Guaranteed Minimum Accumulation Benefit (GMAB) ensures the annuity’s accumulation value will not fall below a certain amount after a specified period. A Guaranteed Minimum Income Benefit (GMIB) guarantees a minimum income stream in retirement.

Evaluating Annuities for Your Financial Plan

Annuities can fit specific financial goals, such as securing guaranteed lifetime income, protecting principal from market downturns, or facilitating tax-deferred growth. They can also serve as a tool for legacy planning, as some annuities allow beneficiaries to receive remaining funds upon the annuitant’s death.

Your risk tolerance determines the suitability of different annuity types. Fixed annuities, with guaranteed interest rates and principal protection, suit conservative investors. Variable annuities, which involve market-linked sub-accounts, suit individuals comfortable with market risk and potential for higher returns. Indexed annuities offer a middle ground, providing market participation with downside protection.

The time horizon for your financial goals is another factor. Annuities are designed for long-term savings, particularly for retirement, given their illiquid nature and tax implications. If you need access to funds in the short to medium term, an annuity might not be appropriate due to surrender charges and limited liquidity.

The interest rate environment influences the attractiveness of fixed annuities. In periods of higher interest rates, newly issued fixed annuities may offer more competitive guaranteed rates. In low-interest-rate environments, guaranteed rates may be less compelling.

Inflation risk is a consideration, particularly for immediate fixed annuities that provide a level income stream. Inflation can erode the purchasing power of a fixed income payment. While some annuities offer inflation riders, these come at an additional cost and may not fully offset significant inflation.

Annuities can help mitigate longevity risk, the risk of outliving savings. By providing a guaranteed income stream that can last for a lifetime, annuities offer peace of mind that expenses can be covered. This feature is valuable for retirement planning, ensuring a consistent income floor.

Conducting due diligence on the insurance company issuing the annuity is important. Guarantees are only as strong as the insurer’s financial stability. Researching credit ratings from independent agencies like A.M. Best, Standard & Poor’s, and Moody’s provides insight into financial strength.

Annuities can serve as a component within a diversified financial portfolio, complementing other investment vehicles. They can provide a stable income foundation or a tax-deferred growth component, allowing other parts of the portfolio to take on more market risk for higher returns.