What is the primary reason for you and other retirees to buy an annuity? Millions of people own annuities, but exactly for what purpose? Generally, annuities can provide lifetime income, protection against risk, and long-term growth with tax advantage. They can also offer contractual guarantees for long-term care spending and death benefit proceeds.
Why you might buy an annuity will depend on your age and where you are at in your retirement-planning journey. These contracts can help you solve problems not only with guarantees in retirement, but also with saving up for later goals during your working years.
Reasons for Buying an Annuity in Pre-Retirement
Say you are in the mid-stages of your career. Then an annuity can offer you the benefit of tax-deferred growth of retirement money.
Over time, the money inside your annuity will grow at a compounding rate, putting off the tax hits until you take withdrawals from the contract. That can boost your overall rate of growth over time and leave you with a larger nest egg when you stop working.
Why Would You Buy an Annuity Near or in Retirement?
If you are closer to the retirement finish line (say in your 60s), then the primary reason you might buy an annuity is for its contractual guarantees. The guarantees of an annuity are pretty rock-solid, and most financial instruments don’t have guarantees in the same way that annuities do.
Annuities are the only financial vehicle capable of truly paying you guaranteed lifetime income. You can have guaranteed principal protection with fixed-type annuities including traditional fixed annuities, multi-year guarantee annuities, and fixed index annuities.
Your money can grow at a guaranteed interest rate each year in a fixed contract. What if you want growth potential above a certain guaranteed minimum? A fixed index annuity can let you benefit from protected growth that isn’t guaranteed. However, its growth historically has been above the growth of its fixed annuity cousins.
With a fixed-type annuity, your money is inside of a contract and therefore not directly in financial markets that can go up and down in value. As a result, you won’t lose money inside a fixed or indexed annuity due to market declines. Your contract assures the protection of your money against this risk.
What if you are concerned about other kinds of risks that can drain your wealth? Or what if you want to leave something for your heirs, but it’s hard to qualify for underwriting with life insurance?
An annuity can also pay you a guaranteed death benefit or enhance your overall retirement strategy with other guarantees, such as nursing home protection.
Guarantees Vary by Annuity Type
The types of guarantees will depend on the type of annuity you buy. Let’s talk more about the primary reasons that retirement investors buy annuities and why they have poured billions of dollars into these guaranteed insurance contracts.
Guaranteed Lifetime Income
If you opt for a lifetime payout, then you will receive a guaranteed stream of income for as long as you live. You will continue to receive this income from the insurer even if you collect more money than the amount you put into the contract plus the earnings.
Annuities are the only type of instrument available in the financial marketplace today that can offer this type of guarantee. For this reason, annuities are sometimes marketed as ‘private pension plans.’
The only other types of entities that can match this form of payout are Social Security and a corporate pension. But, of course, most retirees today don’t receive income from the latter source, so annuities have become a popular substitute for them in recent years.
All types of annuities can pay you a guaranteed lifetime income. It’s a matter of shopping around for different insurance companies and seeing which company might offer the best payout as well as specific income guarantees for your money.
Guaranteed Living Benefit Proceeds
While you can receive a guaranteed lifetime income from all annuities, how you receive your payouts can differ by annuity type.
Some annuities will annuitize your money, turning it into an irreversible income stream and paying you that income stream for as long as you need it. The downside with this is you lose access to your money, as the decision to convert can’t be reversed.
If having some money access is important to you, some fixed index annuities and variable annuities will also pay you a lifetime income but still retain flexibility. They achieve this with an add-on contract feature called an income rider. Income riders are also called other names such as a guaranteed living benefit, a guaranteed minimum withdrawal benefit, and a guaranteed lifetime income benefit rider.
This income rider benefit can permit some access to your money that you wouldn’t have with annuitization. The trade-off is the rider often comes at an additional expense or charge – in many contracts it’s 0.95%.
Your lifetime payout will be based on a minimum guaranteed rate of growth, but it’s important to note that this growth isn’t applied to the money inside your contract. Rather, it’s applied to something called the “income value” – an actuarial number that the insurance company uses in its internal calculations of how much it will pay you in lifetime payments.
You can find out more about an annuity’s income value and riders here. Be sure to ask your financial professional about this benefit, if your annuity comes with it, on top of these other annuity questions.
Guaranteed Protection of Principal
Yes, annuities aren’t insured by the FDIC, as CDs, bank accounts, and other bank products are.
Banks have the backing of the federal government in this regard. Nevertheless, even though life insurance companies don’t have the power to levy taxes or print their own money, they stand behind their annuity contracts with strong assurances.
How is this so? Life insurance companies are required by law to have at least one dollar in their cash reserves for every dollar of outstanding annuity premium that they issue. So, in a way, it doesn’t matter as much that annuities aren’t FDIC insured, as annuity insurers already must have the money in reserves to back them.
Many life insurance companies keep reserves above this dollar-for-dollar reserve requirement for their annuity policies. It’s not uncommon for insurers to hold a dollar-and-several-cents in reserve above the dollar in annuity premium that they hold.
You can see how much in surplus reserves that the insurance company has by looking at its solvency ratio. Life insurers tend to report their solvency ratios in their reports and materials on their financial strength.
The solvency ratio will be something like “104” or “110,” which simply means that the insurer has a dollar-and-four-cents in reserves or a dollar-and-ten-cents in reserves, respectively.
Historically, life insurance companies have done an effective job of managing their risks. They have held strong in times such as the Great Depression.
This dollar-for-dollar reserve requirement by state insurance regulators is part of the reason why. Even then, it’s just one way that your annuity insurer guarantees your principal.
However, the guarantee of principal protection only applies to fixed annuities, fixed indexed annuities, and immediate annuities. It doesn’t apply to variable annuities.
Instead, the money inside the variable annuity contract is invested in a portfolio of mutual fund subaccounts that will rise and fall in value along with the financial markets.
Fixed annuities pay a guaranteed rate of interest just like bonds or CDs. This guaranteed rate lasts for a certain period. The longer that the period is, the higher the guaranteed rate tends to be.
Many fixed contracts will even pay a higher rate of interest during the first year to entice people to buy the contract for the rate. This higher initial rate is typically referred to as a “teaser” rate.
Fixed annuities will pay their stated rate of interest for a set period. How long this term lasts depends on the type of fixed annuity you are looking at.
In general, traditional fixed annuities have a guaranteed rate for a year, then the insurance company will give you a new rate depending on what interest rates overall are doing.
In a multi-year guarantee annuity, the term is longer. In today’s market, you can find MYGAs with 2-yr to 10-yr terms for paying you a guaranteed interest rate per year.
At the end of the term in both annuity types, the annuity holder has the option to either leave the contract or commit their money for another term. From there, the annuity will start paying a new rate of interest based on prevailing interest rates.
Guaranteed Death Benefit
Many annuity contracts come with some feature for a death benefit. But some types of annuities can pay out an enhanced death benefit on the backend. Fixed index annuities and variable annuities stand out in this regard.
The value of a variable annuity will fluctuate according to market conditions, but most variable contracts today will offer some sort of minimum guaranteed death benefit.
What’s more, some fixed index annuities will pay out an enhanced death benefit that is a stepped-up percentage of what the value of your money is at that point in time. Other indexed annuity contracts may use the amount that you put into the contract as the basis for calculating how much of a death benefit your heirs might receive.
If an annuity contract you are considering has this feature, be sure to check the details and conditions of the contract before you commit to it. Your financial professional can walk you through the pros and cons accordingly.
Tax-Advantaged Retirement Saving
Annuities are fundamentally unique vehicles in the world of financial products. They are the only type of instrument that can grow on a tax-deferred basis without having to be housed inside an IRA or retirement plan.
Also, there is no limit on the amount of money that can be placed inside an annuity at one time. For example, the IRS doesn’t impose any limits on the amount of money that can be placed into a non-qualified annuity contract.
Of course, most annuity carriers have proprietary limits on how much they will accept into one of their contracts at one time.
Accelerated Payment Riders
Some annuities provide an increased payout to a policyholder who becomes disabled or incurs long-term care expenses.
Certain conditions must usually be met before the payout is increased. However, there are generally no underwriting requirements for this type of benefit.
For example, an annuity that is paying a guaranteed lifetime stream of income to someone may double the monthly payout under certain conditions. Those conditions apply if that person goes into a nursing home or becomes unable to perform at least two out of the six activities of daily living (ADLs).
The increased payout can continue until the principal and growth in the annuity are exhausted. While some contracts will let you receive the increased payout until you no longer need it, other contracts allow for the increased payout for only a certain amount of time (often 5 years).
Once that happens, then the monthly payout can revert to its former lower amount for the rest of that person’s lifetime. Or the annuity may stop paying income, as the increased payout dwindled the contract value to zero.
Check on the specific terms and conditions of your contract on what this benefit involves before you buy the contract. Ask your financial professional who knows annuities for help in deciphering them and understanding any upsides and downsides.
Should You Buy an Annuity for Your Retirement?
Annuities can provide a unique array of benefits that can’t be matched by other types of financial instruments. They can provide safety, income, growth, accumulation of money with tax advantage, death benefit proceeds, and long-term care protection, among other benefits.
However, annuities aren’t for everyone. What’s more, other instruments may be a better fit for some of your goals, such as high growth potential, than annuities can provide.
Should you determine that an annuity makes sense for your goals and situation, then you will want to find the right contract for you. Consult your financial advisor for more information on annuities and how they can benefit you.
Finding the Right Solution for Your Needs
How can you navigate all the annuity options in the market and determine a list of options that are worthwhile to explore for your needs?
By working with an independent financial professional who understands annuities and their inner-workings, you can greatly save on time, money, and headaches. For your convenience, many independent financial professionals are available at SafeMoney.com to assist you in your quest.
Use our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your goals and explore a working relationship at no obligation. Should you need a personal referral, please call us at 877.476.9723.