The allure of guaranteed income has always made annuities a popular choice for some retirement savers. But if you feel like you’re hearing more about annuities lately, it’s because they’ve become increasingly popular in recent years.
In fact, annuity sales totaled $182.7 billion in the first half of 2023, marking the highest-ever sales recorded in the January to June period, according to the Life Insurance Marketing and Research Association. That follows a record-breaking 2022 for fixed annuities, when sales jumped 22% to $310.6 billion from 2021’s total, according to a survey by the association.
A fixed annuity is an insurance product that lets you convert your current savings into future streams of guaranteed income at a fixed rate of return. Basically: You pay an insurance company now in exchange for a promise to be repaid with interest at regular intervals. However, there are other flavors of annuities — including variable and fixed index options — that can make evaluating whether annuities make sense for you a bit trickier.
“Annuities are simple yet complex at the same time,” says Ed de la Rosa, a certified financial fiduciary and founder of Solid Ground Financial. “For most folks, whatever you think an annuity is, that’s not it.” That said, when deployed as part of a well-thought-out retirement strategy, annuities can be “powerful tools,” de la Rosa adds. But before you buy one, it’s important to understand what annuities are, how they work, and how they’ll help you to accomplish your retirement goals. Here’s what you need to know.
What is an annuity?
An annuity offers streams of guaranteed income. When you buy a fixed annuity, you enter into a contract with an insurance company with the promise that, at some point, the company will pay you a set amount of guaranteed income for the rest of your life, explains Cat Irby Arnold, senior vice president of U.S. Bank Private Wealth Management. As a result, there are two phases inherent to an annuity: the accumulation phase and the payout phase.
Fixed annuities aren’t investments but rather insurance products that offer buyers bond-like growth and lifetime income that can potentially payout many times more than your original investment, de la Rosa adds. Sometimes people mistakenly believe an annuity means putting your money in the hands of an insurance company in exchange for receiving regular income — and that once you die, the insurance company keeps the balance, he adds. While those types of annuities exist, there are many other options now that may better suit your needs, de la Rosa adds. That’s why it’s especially important to understand how annuities work.
How do annuities work?
Annuities combine benefits of both insurance and investments, and they’re designed to complement your broader retirement strategy. “They’re really a supplement to your 401(k) or other retirement account,” Arnold sys. “I would never want to see someone in an annuity instead of a 401(k).”
That’s because your money is locked up once you buy an annuity, so withdrawing funds early means you will likely incur hefty penalties and fees — particularly if you’re under the age of 59½. Here’s how buying an annuity works:
– You select the type of annuity you would like to buy. In return, you will get income in the form of regular payments, with that rate of growth either pre-determined at a fixed growth rate (this is true of fixed annuities), a variable rate (which is determined by how the money is invested), or indexed to the performance of a particular market index.
– Your payments from your annuity either begin right away or they are deferred to a later period of time. Once you start receiving payments from the annuity, also receive interest on your principal, minus fees.
– Payments continue until death, often with an option to leave leftover funds to heirs.
Different types of annuities
There are two broad differences among the several varieties of annuities: when you begin to receive payments and how annuity rates are determined.
With respect to when you begin to receive payments, income annuities are categorized as immediate or deferred. As the names suggest, payments either begin immediately or at some specified time period down the road of potentially several decades after your final premium payment.
The next distinguishing characteristic of annuities is how the premium is investing, which dictates both your rate of return and payments:
– Income annuities provide guaranteed income either for the rest of your lifetime or a specified period of time.
– Fixed annuities provide regular payments at a fixed rate, determined at the time of purchase, that is guaranteed for a specific period of time.
– Variable annuities will pay out based on the performance of investments in the underlying portfolio. While buyers are typically guaranteed a minimum payment, the balance of those payments is really determined by the performance of the investments with time.
– Fixed index annuities offer both a guaranteed payout plus a payout that’s based on the performance of a market index, such as the S&P 500.
Even though all of these variations are lumped together under the broad category of “annuity,” there can be wide variations in the benefits each type of annuity provides to buyers, ranging from whether you can access the principal, have control over the money, how you’re taxed, and whether leftover funds are left to the beneficiary upon death. That’s why it’s so important to understand the specifics of an annuity you’re considering before you buy it, Arnold says. “Make sure you educate yourself first.”
If it feels too complex to sort out, or even if you want to think about it for a while, certificate of deposit (CD), offer a time-bound deposit option with a guaranteed rate of return — and little else to consider other than the term and the APY. One-year CDs in particular have very attractive rates right now, in some cases upwards of 5%.
What is the annuity formula?
There are two common formulas that are often cited with respect to annuities. The future value of an annuity calculates how much a series of regular annuity payments will be worth after a specified time period, based on a specified interest rate. Meanwhile, the present value of an annuity will tell you how much money you need today to produce a specified amount of payments in the future, again based on a specified interest rate. Here’s what those formulas look like, where P = payment, r = interest rate (in decimal), and n = number of payments:
There are two common formulas that are often cited with respect to annuities.Hearst Let’s assume a monthly payment of $1,000, an interest rate of 5% and 10 years of payments. That means:
– Future value = $1,000 x (1.0510 -1) / 0.05 = $12,577.89
– Present value = $1,000 x (1-1.05-10) / 0.05 = $7,721.74
Annuities pros and cons
There’s a “buyer beware” element to annuities that scares some people off them altogether. But blanket statements about annuities aren’t entirely fair, both de la Rosa and Arnold note, and may be a result of how insurance companies have sold annuities in the past, along with a lack of understanding among buyers about how they work. “Annuities get a bad rap many times, I think, because most people don’t go looking to buy an annuity but instead are sold an annuity,” he says. “The consumer doesn’t do any research on their own and ends up with something they are not happy with. Usually, when someone is unhappy with an annuity, it is due to unmet expectations.”
Arnold adds: “You have to make sure an annuity is suitable for you. You must go in with eyes wide open.” Here are some of the pros and cons of annuities:
Pros
– Gains grow tax deferred (with some exceptions)
– Provide steady, guaranteed income for the rest of your life — or a specified time period
– Can serve as a diversifier to other allocations in your retirement portfolio
– There are ways to customize your annuity to best meet your needs
– May be a more attractive alternative to fixed income investments, like bonds
– Allow heirs to avoid probate at the time of death by designating a beneficiary
– Funds may be protected against certain types of litigation and from creditors
– You may be able to make unlimited contributions
Cons
– Annuities may not be 100% liquid, though partial withdrawals of 10% each year may be possible