Can You Buy an Annuity Without a Pension?

Annuities offer a dependable retirement income stream, even without a traditional pension. As pensions are less common today, exploring alternative financial strategies is important. An annuity is a contract with an insurance company, converting a sum of money into regular payments, often for life. This product helps address the concern of outliving savings, providing financial stability.

What Annuities Are and How They Work

An annuity is a contractual agreement between an individual and an insurance company, where the insurer promises to make a series of payments to the individual, either immediately or at a future date. The primary purpose of an annuity is to provide a guaranteed income stream, which can last for a specified period or for the rest of the annuitant’s life. This financial product helps manage the risk of outliving one’s assets, offering a steady cash flow during retirement.

Annuities generally involve two main phases: the accumulation phase and the payout phase. During the accumulation phase, the money contributed to the annuity grows, typically on a tax-deferred basis, meaning taxes on earnings are postponed until withdrawals begin. The payout, or annuitization, phase commences when the individual begins receiving regular income payments from the annuity. The size and frequency of these payments depend on various factors, including the amount accumulated and the chosen payout option.

Several types of annuities cater to different financial goals and risk tolerances:
Fixed annuities offer predictable, guaranteed returns through a set interest rate over a specified period. The principal investment is protected, and the interest earned often grows tax-deferred.
Variable annuities tie returns to the performance of underlying investment sub-accounts, such as mutual funds, offering potential for higher growth but also exposing the investor to market risk.
Indexed annuities link returns to a market index, like the S&P 500, often incorporating features like caps on gains and floors to limit losses.

Annuities also differ based on when payments begin:
Immediate annuities (SPIAs) start providing income payments shortly after a single lump-sum premium is paid, typically within one year. These are suitable for individuals nearing or in retirement who need an immediate income source.
Deferred annuities delay payments until a future date, allowing for a longer accumulation period during which the funds can grow. This option is used for long-term retirement planning, providing flexibility in when to begin receiving income.

The concept of risk pooling and mortality credits underlies the guaranteed income provided by annuities. Insurance companies pool the funds of many annuitants. Mortality credits arise from the portion of the pool contributed by those who pass away earlier than their life expectancy, allowing the insurer to provide higher payments to surviving annuitants. This mechanism enables the insurance company to offer guaranteed lifetime income streams.

Ways to Fund an Annuity

Individuals without a traditional pension can fund an annuity from existing financial resources. Many use personal savings, such as money from savings accounts, certificates of deposit (CDs), or other non-retirement investment accounts. These after-tax funds create a non-qualified annuity, where only the earnings portion of withdrawals is taxed.

Annuities can also be funded through rollovers from retirement accounts like 401(k)s and Individual Retirement Accounts (IRAs). Funds from a former employer’s 401(k) can be rolled into an IRA, then used to purchase an annuity. This direct transfer avoids immediate tax implications, as the annuity maintains its tax-deferred status within the IRA.

Traditional IRA funds can be transferred to an annuity without a taxable event. Roth IRA funds can also purchase a Roth IRA annuity, with tax-free withdrawals in retirement if eligibility is met. These are qualified annuities, funded with pre-tax dollars or maintaining Roth account tax-exempt status. Withdrawals from qualified annuities are generally fully taxable as ordinary income.

Inherited funds or life insurance proceeds can also purchase an annuity. These typically result in a non-qualified annuity, where only earnings are taxed upon withdrawal. Understanding the pre-tax or after-tax nature of funds used dictates the tax treatment of payouts. For non-qualified annuities, withdrawals are generally treated as “last-in, first-out” (LIFO) for tax purposes, meaning earnings are taxed first.

Important Factors Before Purchasing an Annuity

Annuities are long-term financial products; early access to funds can lead to penalties. Most annuities include surrender charges for withdrawing money or canceling the contract before a specified period, often six to ten years. While limited free withdrawals (e.g., 10% annually) may be allowed, exceeding this typically incurs a significant surrender charge.

Annuities, especially variable and indexed types, involve various fees and charges that impact returns. These can include:
Mortality and expense risk charges
Administrative fees
Fees for optional riders
Investment management fees (common in variable annuities)
Understanding these charges is important, as they can reduce net income.

Inflation can erode purchasing power over time. Some annuities offer riders, like a Cost-of-Living Adjustment (COLA), to mitigate this risk by increasing payments annually. These adjustments can be fixed or tied to an inflation index, though they may reduce the initial payout.

Annuities offer various payout options:
Payments for a single life
Joint and survivor options (payments continue for a spouse after the annuitant’s death)
For a specified period certain
Life with period certain (guarantees payments for life, plus a minimum number of years to a beneficiary if the annuitant dies prematurely)
The chosen payout option influences payment amounts and beneficiary benefits.

The financial strength of the issuing insurance company is a consideration, as guarantees rely on the insurer’s ability to meet future obligations. Researching the financial ratings of the insurance company from independent agencies is important. Designating beneficiaries for an annuity ensures any remaining value or guaranteed payments are distributed according to one’s wishes and can help avoid probate. Naming primary and contingent beneficiaries is recommended.