Not many understand how annuities work, but that’s because annuities aren’t explained simply. I If set up right, an annuity can be a powerful tool to provide you with a reliable income in retirement. However, you need a strategic plan, or an annuity can drain your finances with high fees and other losses.
Having a guaranteed income in retirement with a series of payments sounds great. However, it’s critical to have the basics of annuities and their pros and cons explained. This will help you decide which type is the best fit for your situation. This is your guide to annuities, explained simply.
Annuities are mainly used as an investment tool for those in or near retirement. It is an insurance contract that provides the purchaser with a fixed income stream. Many seek financial advice to have annuities explained because they are seen as a stable income source after retirement.
The payouts typically last the lifetime of the buyer, and the payout amount is agreed upon when the annuity is purchased. Some people like to view annuities as a pension-replacement to receive guaranteed income in retirement.
Annuities Pros and Cons Explained
Annuities come with plenty of benefits. Depending on which type you choose, it can be a relatively safe investment option since the insurance company must pay the income promised to the buyer. The terms of an annuity are customizable, so you can truly create an agreement that fits your unique needs. Tax treatments for an annuity will depend on the type of annuity.
Not to mention, a stream of guaranteed income brings incredible peace of mind in retirement. Some people have an aversion to annuities because they haven’t had annuities explained properly. But, after a bear market hits, our clients are happy to have annuities as a safety net.
Annuities allow you to diversify your retirement plan. You can have annuity payments along with pensions, social security and other sources of income to create a comfortable retirement. The benefits don’t stop there—some annuities also have death benefits that can add financial security for your family.
No investment tool is perfect, though, so it’s important to have the downsides of annuities explained simply. One reason many people hesitate to use annuities is because of their potentially high fees. These fees can include surrender charges, maintenance fees, and risk charges. Riders are the terms added to customize an annuity contract, and riders add cost, quickly eating up any potential gain for buyers.
If you cash out your annuity early, you’ll be fined, and some investors aren’t comfortable with that level of illiquidity. A surrender period is normal for annuities. If you buy an annuity, you need to wait a few years before you can take money out. For certain types of annuities, the guaranteed income stream may not keep up with inflation.
Although the market risk for an annuity is absorbed by the insurance company, the control is also surrendered to the insurance company, and you may prefer to stay in charge of your own investments.
Types of Annuities Explained
When deciding between types of annuities, it’s important to keep in mind the difference between interest and income. Oftentimes, annuities promising lifetime income conflate those terms. Interest is what you make, but income is what you take.
If you aren’t careful, your “guaranteed income” promised by TV and radio ads can be eaten up by fees. To prevent this, it’s important to pick the right type of annuity.
Immediate annuities, explained plainly, are an exchange of a dollar amount for an income stream by giving a lump sum of money to the insurance company. Payments begin immediately after purchase. This type of annuity is path to transforming retirement funds into a reliable source of income that continues for the rest of your life. However, they do not provide much flexibility and may have limited post-death beneficiary options.
Just like an immediate annuity, a deferred annuity provides payouts in exchange for a lump sum of money, only these payouts begin at a future date. The difference with this type of annuity can be explained by its tax treatment. The dollars grow tax-deferred until the buyer takes out their money.
Fixed annuities can be explained as a fixed rate of return on the principal. With a set rate of return, inflation protection isn’t available for fixed-rate annuities. This type of annuity has been explained as the most predictable annuity type. However, that doesn’t always make it the best option. Be sure to consult a financial advisor before you make any long-term plans.
Although this type of annuity is risky and can be expensive with lots of rider fees, variable annuities offer the largest potential for gain. A variable annuity uses various investment options like stocks and bonds to grow the principal and determine payouts.
For a retirement plan, this annuity can be explained as a risky option. If you want to take market risks, you may be better off with an investment portfolio rather than an annuity.
Annuities can be many combinations of deferred, immediate, fixed or variable to create a unique contract to fit your risk tolerance and income needs. The type of annuity we recommend most for clients is an equity indexed annuity. An index annuity, explained simply, gives you part of the upside of the market without any of the risk.
As a buyer, you’ll receive a guaranteed minimum income from the interest earned. The other portion of the investment is linked to a specific equities index, such as the S&P 500. Although the participation of the annuity buyer is limited to a certain portion for the market gains, the potential risk is mitigated by having a portion of guaranteed income.
Equity indexed annuities keep a good balance between risk and return. We avoid using equity indexed annuities with any rider fees to make sure our clients can maximize their income.
With so many variables built into their contracts, annuities should be discussed with a professional advisor.
Annuities Explained and Designed for Your Unique Needs
When we work with clients at Asset Preservation Wealth & Tax, we make sure to understand their complete financial situation. Our goal is to take their unique retirement goals into consideration before selecting the right option for them. We talk to our clients to have annuities explained so they know their options when investing in their financial future.
We passionately believe education is the key to empowering our clients to make confident financial decisions.
Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products. They do not refer in any way to securities or investment advisory products. Fixed insurance and annuity product guarantees are subject to the claims paying ability of the issuing company; not guaranteed by any bank or the FDIC.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.