What Does an Annuity Protect the Annuitant Against?

An annuity is a contract established with an insurance company, designed to provide a stream of income, often for retirement. This financial arrangement involves an individual making payments, either as a lump sum or through a series of contributions, to the insurer. In exchange, the insurance company agrees to provide regular payments back to the individual, known as the annuitant, either immediately or at a future date. Annuities serve as a financial tool offering security and mitigating financial uncertainties, particularly those associated with long-term financial planning and retirement.

Protection Against Longevity Risk

Annuities provide a defense against longevity risk, which is the financial challenge of outliving one’s savings in retirement. As individuals live longer, the possibility of depleting their financial resources increases. Annuities address this by offering guaranteed income streams that can last for the annuitant’s entire life.

The process of converting accumulated funds into these lifetime payments is known as annuitization. When an annuitant chooses to annuitize, they transfer the risk of outliving their money to the insurance company. The insurer assumes the responsibility of providing payments for the annuitant’s lifetime, offering financial security. This guarantee ensures that a baseline income continues, even if an individual lives well beyond their projected life expectancy.

Protection Against Market Volatility and Principal Loss

Certain types of annuities offer safeguards against fluctuations in investment markets and protect the original amount invested. Fixed annuities, for instance, provide a guaranteed interest rate for a specified period, shielding the principal from market downturns. This feature ensures that the initial contribution will not decrease due to market performance.

Fixed-indexed annuities (FIAs) offer a blend of principal protection and potential growth linked to a market index, such as the S&P 500. While they do not directly invest in the market, their returns are based on the index’s performance, with a built-in floor that prevents losses to the principal due to negative market movements. This structure allows annuitants to participate in some market gains while providing a cushion against investment losses. Earnings within these annuities grow tax-deferred, meaning taxes are only paid upon withdrawal, which can enhance growth potential over time.

Protection Against Income Gaps and Unpredictability

Annuities provide a consistent and predictable income stream, valuable for budgeting and long-term financial planning. This regular flow of funds helps cover ongoing living expenses, filling potential income gaps from other retirement sources like Social Security or pensions. The reliability of these payments allows annuitants to plan expenditures with greater certainty.

To address unpredictability, some annuities offer optional features, known as riders, for an additional cost. An inflation rider can increase annuity payments over time to help maintain purchasing power against rising costs. These riders often provide a fixed percentage increase, aiming to mitigate inflation’s impact on real income. Many annuities also include a death benefit feature, ensuring a designated beneficiary receives the remaining contract value or a guaranteed minimum amount upon the annuitant’s passing. This provides a predictable financial legacy for heirs.