Annuities 101: How They Work And What They Can Do For You
Saving for retirement can be a daunting prospect — no one can be absolutely certain exactly how much money they’ll need, and market risk looms larger the closer you get to leaving the workforce. Diversifying your assets by having multiple income streams in addition to Social Security is one way to ensure a successful retirement, which is why some people turn to annuities — tax-deferred investments offered by insurance companies — that can serve as personal pensions of sorts, offering guaranteed monthly income when you need it, often for the rest of your life.
The marketplace for annuities can be a complex one, however, which has led to more than a few myths and misunderstandings around these products. We checked in with experts to get a breakdown on what’s fact and what’s fiction. Their answers might surprise you.
Tell Me More About Annuities And How They Work?
First of all, they’re nothing new. Benjamin Franklin was a fan and Jane Austin wrote about them in her books. Social Security is also an annuity, one that adjusts for inflation — which has been very helpful in recent years. According to the Alliance For Lifetime Income, a not-for-profit education-focused group, “in simple terms, an annuity is a contract between an individual and a life insurance company. Depending on the type of annuity, you purchase an annuity with a portion of your retirement savings in either a single payment or with multiple payments over time.” From there, there are some variations in annuity types. Fixed annuities offer a fixed interest rate and guaranteed monthly payments. Fixed index annuities provide a minimum guaranteed monthly payment with potential for some upside based on the performance of the markets. And variable annuities allow you to have a hand in how your money is invested — which can lead to bigger gains or losses — although a monthly guaranteed income is also possible. It’s a lot to understand, which is why you should talk to a financial advisor before you consider one. (And if you’re looking to learn more about investing, you might want to consider a class that will explain all the ins and outs of the stock market so you can be confident about all the money decisions you’re making!)
How Much — In Fees — Does It Cost To Buy One?
All annuities have some fees baked in, because they are insurance contracts, explains Brian Karimzad, co-founder of MagnifyMoney. For example, if you want to ensure that you’ll have a guaranteed income for life (no matter how long you live) and that the initial amount you invest (your principal) will never decrease, those guarantees will come at a cost. There are also commissions you pay to the person who sells you the product — and you should understand how much (in dollars) those costs are. “Many people think the trade-off is well worth it,” Karimzad says. As with any investment, the most important thing is to understand the cost structure and what you’re getting in return. Because of the menu of annuity products, there is also a menu of typical costs.
How Do The Payouts Work?
Some annuities are immediate annuities. You put your money in, and the payout or income stream starts shortly thereafter. Others are deferred annuities. You deposit money (either all at once or over time), and it has a period of years during which it grows. Then you turn on the income stream down the road.
Many people want to know that if their retirement goals change or a life emergency happens, they can access their cash early. There is often a surrender period, early on during the life of an annuity, during which you can withdraw up to 10% of your account balance (or your earnings growth, whichever is greater) free of charge. But pulling out of an annuity isn’t something you should plan on going in. There may also be tax implications to making an early withdrawal, so you should check with your financial advisor.
How Can Annuities Fit Into A Retirement Portfolio?
It’s often helpful to think of an annuity as part of your retirement solution rather than a one-and-done. One way people use annuities is to — when coupled with Social Security and other forms of protected income like pensions — create a monthly paycheck that will cover their fixed expenses. Then, they invest their remaining assets in a diversified portfolio for growth.
Because annuities offer a guaranteed income, they often free up investors to take bigger risks with other investments, explains David Littell, retirement income program co-director at The American College of Financial Services. “When you’ve got the promise of payments for life, you’re going to feel more comfortable being more aggressive with other parts of your portfolio,” he says. “So indirectly, annuities can lead to great returns.”
While annuities are vehicles for retirement, they’re not something that you only buy in retirement. You can start to supplement your retirement plan with annuities in your 40s and 50s knowing that you won’t be turning on the income until down the road. You will — in the near future — likely start to see annuity solutions showing up in your 401(k)s and other work-based retirement plans, thanks to a change in the law that allows the addition of them to the menu.
One strategy to pay particular attention to is something called a QLAC, which stands for Qualified Longevity Annuity Contract. This allows you to take up to $200,000 from an IRA and use it to purchase a deferred annuity (sometimes called longevity insurance) where the payout doesn’t start until a day down the road (the latest you can put them off is your 85th birthday). The money you use to purchase the QLAC has the added benefit of reducing RMDs or Required Minimum Distributions, which can be a tax benefit.
What’s The Bottom Line?
Annuities should not tie all of your money down, but they can be a helpful part of your retirement strategy. Think of them as another piece of the puzzle that can help balance out your whole financial picture.