Annuities have a rich history dating back to Ancient Rome. Today, millions of Americans currently use annuities to supplement their retirement income. They can be an important part of a diversified retirement portfolio because they can ensure that your retirement income is protected even when there are downturns in the market.
On the surface, annuities sound great, but they are commonly misunderstood financial products. There are many different types of annuities. And there is an audience of annuity bashers. However, saying you hate annuities is like saying you hate all restaurants.
The trouble is annuities are often sold and not bought. Consumers are often steered into products because that’s what the broker is selling that month. It is important to be an educated consumer when you shop for an annuity.
Here are eight things you need to know about annuities:
- What Is An Annuity? An annuity is a contract between you and an insurance company to cover specific goals such as principal protection, lifetime income, legacy planning or long-term care costs.
- Why Buy An Annuity? People buy annuities because – unlike other investments – it provides guaranteed income for life, no matter how long they live. This makes annuities a popular retirement planning strategy.
- How Do Annuities Work? An annuity works by transferring risk from the owner, called the annuitant, to the insurance company. Like other types of insurance, you pay the annuity company premiums to bear this risk. Premiums can be a single lump sum or series of payments. The premium-paying period is known as the accumulation phase. Eventually, you stop paying the annuity and the annuity starts paying you. When this happens, your contract enters the payout phase. There is great flexibility in how annuity payments are handled.
- What Are The Different Types Of Annuities? There are two main types of annuities: deferred and immediate. Deferred annuities provide a stream of income later, while immediate annuities provide income now. Within the deferred and immediate categories are fixed and variable annuities.
- How Do Fixed Annuities Work? Fixed annuities pay a guaranteed minimum rate of return and provide a fixed series of payments under conditions determined when you buy the annuity. Because your rate of return is guaranteed, the insurance company bears all the investment risk.
- Do Variable Annuities Have Investment Risk? Not all annuities guarantee a fixed rate of return. With a variable annuity, your premiums are invested in a variety of subaccounts, like mutual funds. Each subaccount has an investment objective and charges a management fee in addition to the insurance company’s fees.
The annuity’s rate of return is based on the performance of these subaccounts. The insurance company does not guarantee variable annuity rates, so the annuitant bears all the investment risk as well.
- How Are Annuities Taxed? Annuities are tax-deferred, which means you don’t pay taxes on the money while it’s in the annuity. Like a 401(k) or IRA, you only pay taxes on the money when you withdraw it.
- How Secure Are Annuity Guarantees? When you buy a retirement annuity, consider the financial strength of the insurer. Stick to insurers that are highly-rated by A.M. Best, Moody’s, Fitch and Standard & Poor’s.
In summary, annuities aren’t for everyone. If you aren’t worried about running out of income, you may not need an annuity. Also, if you have health problems that make it unlikely, you’ll reach your life expectancy, an annuity wouldn’t make sense, unless you have a spouse you want to provide for. But if you’re healthy and you want the security of a stream of income you can’t outlive, or you want to provide for your spouse, you may benefit from an annuity. Just don’t put your entire nest egg into one basket.