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What Are Annuities?
Annuity Definition: a contract between an individual and an insurance company promising lifelong income in exchange for an upfront payment.
Annuities, at their core, are simple financial instruments: you give me a chunk of your savings and I send you a monthly payment for the rest of your life, no matter how long you live. In practice, this arrangement gets fleshed out in various ways. The most common scenario is when retirees see that their savings aren’t sufficient to last through all of retirement, and make an upfront payment to a life insurance company in exchange for a promise of life-long monthly income. This arrangement is beneficial to both parties; retirees gain the peace of mind that they won’t outlive their savings and insurance companies make a profit off retirees who live shorter than expected.
Annuities Explained by Type
As always, the devil is in the details. What type of annuities exist and how do they actually work? There a several fundamental types of annuities geared to different retirement planning stages. The two most common stages are:
- Building up a retirement nestegg during one’s working years (deferred annuities)
- Extending the purchasing power of the nestegg after retirement (immediate annuities)
Let’s take a closer look at how deferred and immediate annuities cover both cases:
Deferred annuities are used to generate savings. A deferred annuity works very much like a 401(k) or IRA, allowing investors to deposit small sums of money over the course of many years to build up a sizable retirement nestegg which can then be annuitized (turned into a lifelong income stream).
Immediate annuities are used to extend the purchasing power of an existing nestegg. Immediate annuities work like CDs, where a large chunk of one’s retirement savings is given to a life insurance company in exchange for a life-long stream of monthly payments. This is the “classic” annuity. The key difference between CDs and immediate annuities, is that the annuity pays a higher interest rate and guarantees a stream of income that cannot be outlived, which is ideal for retirees.
Three Other Types of Annuities
Beyond the funding distinction that separates deferred from immediate annuities, there is also the different ways annuities generate income. When the insurance company receives payment, they invest the money in one of three different ways:
- Fixed Annuities: interest earned from debt instruments like CDs, bonds, and mortgages.
- Variable Annuities: interest earned from equity instruments like stocks and commodities.
- Indexed Annuities: interest earned from broad market indicies like the S&P 500.
An investment in fixed-interest instruments like CDs, bonds, mortgages, and various others debt-investments gives rise to the fixed annuity. A fixed annuity most-resembles a CD in that it guarantees a fixed-interest rate up front. The fixed annuity contract specifies an interest rate that funds will earn for every year they’re held by the insurance company. The fixed annuity is perfect for conservative investors because it has virtually no risk of capital loss, short of a total company collapse.
Alternatively, an investment can be made in equities-based instruments and commodities, which gives rise to the variable annuity. A variable annuity most-resembles a 401k in that the account balance fluctuates with the ebb and flow of the markets. The insurance company doesn’t promise a fixed rate of return, but over the long run, equities tend to out-perform debt-based instruments, making variable annuities appealing to more aggressive investors.
The final alternative to how annuity income gets generated is called the indexed annuity. An indexed annuity works by investing money in an equities index, like the S&P 500, but with protection against capital loss. Essentially, the insurance company caps earnings during high-growth up markets in exchange for covering investors against any losses during down markets. Indexed annuities fall somewhere in between fixed and variable annuities in terms of its risk profile and average rate of return.
Why Would Anyone Want to Buy an Annuity?
Annuities serve a unique role in the retirement planning process, making them distinct from instruments like CDs, bonds, 401(k)s, and IRAs. Annuities offer a guaranteed minimum lifelong income that cannot be outlived. No other investment vehicle can make this promise.
Think about this: according to a recent study by the Center for Retirement Research, the average 401(k) account of 60-62 year olds in America holds only 25% of the income needed to maintain their standard of living at retirement.
Social security attempts to bridge this gap, but only covers about 45%. What about pensions? According to the Federal Reserve study, even if you’re one of the lucky Americans to have received a pension (seldom available to younger generations), you’re still likely to face a retirement income gap. Simply put, at retirement, you’ll need 85% of your current income to maintain the same standard of living, but with 401(k) + social security + pension, you’ll still be coming up short.
Given these bleak national averages, forward-thinking retirees who don’t want to lower their standard of living are relying on annuities to bridge the gap. A comfortable retirement may seem like a right, but in today’s global economy it is not a given that 40 years of hard work ensure a retirement at all. In fact, this is not the case for most Americans.
Unfortunately, this is not the end of the story. Over the last fifty years, the average life expectancy of Americans has increased noticeably due to advances in medical technology and lifestyle changes. While generally welcomed news, this now means that Americans have to stretch their savings through 30 years of retirement. Given that the average 65-year-old male has a 40% chance of living to the age of 85 and a 20% chance of living past the age of 90, even 30 years-worth of savings could easily fall short. As medicine improves, your chances of living to the age of 90 increases, but your ability to work during these years (in case of an income shortfall) decreases. In light of these developments a new trend emmerges: annuities are playing an ever-dominate role in the retirement planning strategies of the next generation of retirees.
Annuity Benefits and Downsides
Like any investment vehicle, annuities have their pros and cons. The single most attractive feature of annuities is their relative security and the option of lifelong income. That said, there not all retirees will find annuities suitable for them. Some annuity types are better than others, but in general, whether any annuity is a suitable tool in your retirement planning arsenal will depend on your particular financial profile. Consider the following benefits and downsides of annuity investment:
- Lifetime Income Stream
- Tax-deferred Growth
- Competitive Fixed Interest Rates
- Protection Against Market Downturns
- Death Benefit Options
- Access to a Portion of Your Money
- Administration Fees
- Early Withdrawal Fees
- Taxed as Ordinary Income
- Opportunity Cost of Locking In a Low Fixed Rate
How Annuities Work
We’ve done a pretty good job of summarizing the fundamentals of how annuities work, but in practice, annuity contracts can be tricky to analyze alone. Today, most insurance companies offer custom-tailored annuities for every imaginable financial situation. Sure, everyone is looking to retire comfortably at age 65, but everyone’s finances are also unique. Are you married, widowed, or divorced? What is your investment risk-tolerance? How diversified is your retirement savings? Do you own your own home? Do you run your own business? Answers to these questions ultimately determine which annuity is best for you. Have a look around the site and explore your options.
Click Here for everything you need to get started in fixed annuities! Or use the shortcuts below:
- Fixed Annuity Features — Check out some common features of fixed annuities and how they can benefit you.
- Fixed Annuity Performance — What sort of results can you expect? Take a look at these historical charts.
- Finding the Best Fixed Annuity — These are the factors you should look out for when trying to spot the best fixed annuity.
- Fixed Annuity Disadvantages — Every investment’s got them. Make yourself aware before you invest.
- Fixed Annuity Pitfalls — Ready to buy? Not so fast! If you don’t know these common pitfalls, you might get ripped off.
- Fixed Annuity Alternatives — Have you explored all the options? Other investment instruments like CDs or Mutual Funds might be better.
- Immediate Annuities — Explore common features of immediate fixed annuities, which are perfect for retirees.
- Deferred Annuities — Not retiring quite yet? Deferred annuities have some amazing tax benefits that can make your savings soar.
- CD Type Annuities — Find out how a CD-type annuity differs from traditional fixed annuities.
Click Here for everything you need to get started in variable annuities! Or use the shortcuts below:
- Variable Annuity Features — See how variable annuities function. Are these the features you’re looking for?
- Variable Annuity Performance — How much can a variable annuity yield? Check out these historical benchmarks.
- Finding the Best Variable Annuity — Cherry picking the best variable annuity is easy if you keep these factors in mind.
- Variable Annuity Disadvantages — Don’t jump in until you understand the weaknesses of variable annuities.
- Variable Annuity Pitfalls — You can’t get ripped off if you know all the angles. See the most common variable annuity investment mistakes.
- Variable Annuity Alternatives — This a variable annuity really the best option? Find out how they compare to stocks, mutual funds, and more.
- Immediate Annuities — Need income right now? See how variable annuities can provide a steady cash flow.
- Deferred Annuities — Looking to build towards your dream retirement? See how tax-deferral can get you there faster.
Click Here for everything you need to get started in index annuities! Or use the shortcuts below:
- Index Annuity Features — See how index annuities encompass the best of their fixex and variable counterparts.
- Index Annuity Performance — How much can your index annuity yield? Explore this real-world example.
- Finding the Best Index Annuity — Learn how to identify the best index annuity contracts.
- Index Annuity Disadvantages — Are index annuities right for you? Determine if these disadvantages are deal-breakers.
- Index Annuity Alternatives — What investment choices exist besides index annuities? Find out and compare.
- Index Annuity Pitfalls — Learn to avoid common mistakes made by index annuity investors.
- Fixed Index Annuity — Find out how index annuities compare to fixed and variable annuity types.
Click Here for everything you need to get started in life annuities! Learn about the inner workings of life annuities, how they differ from other types, their major pros and cons, who should invest in them, their tax status, and much more.