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Originally Posted On: https://saveplanretire.com/annuities/

 

What Is an Annuity?

If you haven’t started saving for retirement, you’re not alone. According to a 2022 report from the Federal Reserve, 25% of all non-retired Americans have absolutely no retirement savings. No matter how old you are, it’s never too late to start thinking about the future. With the cost of housing, healthcare and other necessities increasing rapidly, the earlier you start saving, the better off you’ll be when you’re ready to leave your job.

Once you start saving, it’s important to have several types of investments, a tactic known as diversification. A diverse portfolio spreads the risk around, making it easier to weather the ups and downs of the market. For example, if you invest all your money in just one company, you stand to lose everything if that company goes bankrupt. Diversification doesn’t eliminate risk, but it does make it less likely that you’ll experience significant losses.

When you retire, it’s also important to have more than one source of income, such as Social Security, stock dividends, pension payments and rental properties. If one source of income goes down, you won’t be left worrying about paying your bills. That’s why so many people purchase annuities.

An annuity isn’t an investment in the traditional sense, but it’s a good option for anyone looking for an extra source of retirement income. Annuities are insurance contracts designed to produce a steady stream of income, making them less risky than other financial products. You can even choose when to start receiving payments, giving you more control over your finances.

For example, if you’re worried about spending too much money early in retirement, you can purchase a deferred annuity. This type of annuity doesn’t pay out until sometime in the future, ensuring that you don’t spend your retirement funds all at once. As a result, many people use annuities to increase their financial security.

If you’re considering an annuity as part of your retirement plan, it’s important to understand how it works, what types are available and how the income is likely to affect your tax situation. Before committing to an annuity contract, you should also compare several types of annuities with savings bonds, certificates of deposit and life insurance to determine which is most likely to help you meet your financial goals.How Do Annuities Work?

Annuities should be a part of your long-term retirement planning because they produce a set amount of income each month. There are several kinds of annuities, so exactly how they work — and how much you receive in payments — depends on which type you choose. Each contract has specific terms, but this is generally what you can expect.

Annuity Stages

Each annuity has two stages: accumulation and annuitization. During the accumulation stage, you pay premiums, increasing the principal balance of your account. Annuitization is when you begin receiving income from your annuity. The length of the accumulation stage depends on the type of annuity you buy and when you buy it. For example, if you buy a deferred annuity when you turn 30, the accumulation stage may last for 20 or 30 years.

Basic Annuity Terminology

Before you start shopping for an annuity, take a few minutes to review some of the common terms used in the industry. You’ll see these terms in your contract, so you need to know how they affect your finances.

• Administrative fee: Once you buy an annuity, the insurance company must manage your account. The administrative fee covers recordkeeping and other account services. Some companies charge a flat fee, while others charge a small percentage of the value of your contract.
• Annuitant: Insurance companies calculate annuity payments based on the annuitant’s current age and life expectancy. In most cases, the owner is also the annuitant, but it’s possible to use a surviving spouse or a parent.
• Beneficiary: When someone buys an annuity, they can designate a beneficiary. This is the person who receives the death benefit when the owner dies.
• Commission: In a way, annuities are like auto insurance or homeowners insurance policies. When you buy one, the insurance agent gets a commission. This is a percentage of the annuity cost.
• Current interest rate: Insurance companies often change the interest rates on their annuities. The current interest rate is the rate on your contract during a specific period of time. Your insurer can’t change the rate again until that period ends.
• Initial rate: The initial rate is the interest rate in effect for a certain amount of time after you purchase an annuity.
• Minimum guaranteed rate: Even though insurance companies are allowed to change their rates, they can’t go any lower than your minimum guaranteed rate, which is listed in your contract.
• Multiple-premium contract: If you purchase a multiple-premium contract, you make payments over time. A scheduled contract requires you to make payments at regular interviews, while a flexible contract sets some general limits. As long as you stay within those limits, you can choose when and how much to pay each time.
• Owner: This term is pretty self-explanatory. The owner is the person who signs the contract and pays the premiums. Owners also have the right to surrender, or give up, the annuity before the end of the contract term.
• Percentage of premium charge: This is a charge deducted from your premium payment before any interest accumulates. Percentage of premium charges are also known as “loads.”
• Single-premium contract: With this type of annuity contract, you must fund the annuity with a lump sum, also known as a one-time payment.
• Surrender charge: If you want to cash in your annuity before the contract term expires, you may have to pay a surrender charge. This is a percentage of the premiums you’ve paid or the total value of the contract.
• Transaction fee: Every time you make a transaction, such as a withdrawal, the company may charge you a fixed transaction fee.

Annuity Riders

Many insurance companies offer riders, or optional benefits, with their annuities. Some riders are designed for specific circumstances, while others are more general in nature. Riders allow you to customize your annuity contract, making it a better benefit for your unique needs.General Annuity Riders

• Commuted payout: This rider allows you to withdraw lump sums from your annuity account within the first few years of your contract.
• Enhanced earnings benefit: An enhanced earnings benefit rider reduces the tax owed on your annuity earnings when you pass away.
• Guaranteed lifetime withdrawal benefit: With this rider, you don’t have to convert any payments into an immediate annuity to receive an annual income for as long as you’re alive.
• Guaranteed minimum accumulation benefit: This rider guarantees that your annuity will accumulate a minimum value.
• Guaranteed minimum income benefit: When you purchase this rider, you receive a minimum amount of income while you’re alive.
• Guaranteed minimum withdrawal benefit: If you think you’ll need extra income, you can get a guaranteed minimum withdrawal benefit rider, which allows you to draw down the principal each year.

Riders Designed for Specific Circumstances

• Cost of living: A cost-of-living rider prevents your annuity from losing value due to inflation. This type of rider typically has a cap. If you reach the cap, the value of your annuity won’t continue increasing.
• Disability: If you’re out of work due to a disability, the disability rider gives you a temporary payout increase. You can use the extra money to cover medical bills, buy groceries and pay for other necessities.
• Impaired risk: Some chronic health conditions, such as diabetes and end-stage kidney disease, shorten your life expectancy. An impaired risk rider gives you higher payments to account for the risk that you’ll
• Long-term care: In the United States, the cost of long-term care ranges from $4,500 to $9,034 per month, depending on whether you need assisted living or nursing home care. It’s tough to cover these costs if you don’t have long-term care insurance. A long-term care rider increases your annuity payments to make long-term care more affordable.
• Return of premium: This rider ensures that your heirs receive any remaining principal should you die before receiving the annuity’s full value.
• Terminal illness: Ideally, you’ll live long enough to collect the full value of your annuity. Unfortunately, you can’t predict the future. If you develop a terminal illness that results in a drastic change in life expectancy, a terminal illness rider allows you to cash out your annuity without having to pay the surrender charge.
• Unemployment: Market conditions are always changing, leading some companies to furlough or lay off employees. An unemployment rider temporarily increases your payout if you lose your source of income.

Selecting and Funding the Annuity

First, you’ll select the kind of annuity you want to purchase from an insurance company. You’ll need to pay for that plan monthly, quarterly, biannually or annually, depending on the exact requirements the insurance provider sets.

In some cases, you can also make a lump-sum payment to fund the annuity. For example, you could use $100,000 from your personal savings to invest in an annuity and then receive payments from that fund later. If you don’t have that much money in your savings account, don’t worry. You can purchase an annuity for as little as $5,000, making it a little easier to build up your nest egg.

Investing and Choosing Payment Terms

Once you sign the contract, the insurance company invests your money, which generates interest. Although annuities often increase in value, there’s no guarantee that your principal balance will grow. Keep this in mind when you’re comparing annuities with other financial products.

The next step is to decide when to start accepting payments. Typically, the amount you receive is a portion of your original investment combined with the accumulated interest. Depending on the terms of the contract, you may receive monthly payments for anywhere from 5 to 30 years. You also need to account for fees when calculating your benefit amount. Once the annuity matures, you’ll start receiving payments, increasing your income.

Income Benefits

When you buy an annuity, you have several income options:

• Life only: With this type of contract, you receive payments for as long as you’re alive. After you pass away, there are no death benefits for your heirs. This is the most basic income benefit.
• Life with period certain: Like a life-only contract, this type of annuity pays out for as long as you’re alive. The difference is that a life with period certain contract also guarantees payments for a minimum number of years. If you pass away before the end of the period, the insurer will pay your beneficiary until the end of the initial term. For example, if you pass away 16 years into an annuity with a 20-year period, your beneficiary will receive payments for four years.
• Waiver of premium: Your annuity contract may include a waiver of premium clause, which covers your premiums if you can’t work due to a disability.
• Death benefit: Many contracts include a death benefit, which is money paid to your designated beneficiary if you die before you start receiving payments.
• Joint and survivor: Under this type of contract, the annuity pays out for as long as you or your beneficiary are still alive. If one person passes away, the other person has the option of reducing the payment amount.

Types of Annuities

Category	Fixed Annuity	Variable Annuity	Indexed Annuity	Immediate Annuity
Income Payments	Provides fixed, predictable income payments for a set period.	Income payments fluctuate based on investment performance.	Income payments tied to an index, offering growth potential.	Provides immediate income payments after a lump sum payment.
Principal Protection	Offers principal protection from market volatility.	No principal protection; value depends on investment performance.	Principal protection from market losses.	No principal protection; value depends on investment performance.
Accumulation Potential	Fixed interest rate; limited potential for growth.	Potential for higher returns based on investment performance.	Accumulates value based on index performance.	No accumulation phase; immediate income payments.
Investment Options	No investment options; fixed interest rate determined by insurer.	Offers a variety of investment options, including stocks and bonds.	No direct investment options; linked to index performance.	No investment options; immediate income payments.
Risk Exposure	Low risk; stable returns based on fixed interest rate.	High risk; returns depend on market performance.	Moderate risk; returns linked to index performance.	Low risk; stable income payments for the selected period.
Flexibility	Limited flexibility in adjusting terms or payments.	Offers flexibility in investment options and allocation.	Limited flexibility due to index-based returns.	No flexibility in income payments; fixed term and amount.
Surrender Charges	May have surrender charges for early withdrawals.	May have surrender charges for early withdrawals.	May have surrender charges for early withdrawals.	No surrender charges; immediate income payments.
Death Benefit	May offer a death benefit to beneficiaries.	May offer a death benefit to beneficiaries.	May offer a death benefit to beneficiaries.	No death benefit; payments cease upon the annuitant’s death.
Longevity Risk	Provides protection against outliving savings.	Provides potential growth to combat longevity risk.	Provides potential growth to combat longevity risk.	Provides protection against outliving savings.
Tax Treatment	Tax-deferred growth; taxed upon withdrawal.	Tax-deferred growth; taxed upon withdrawal.	Tax-deferred growth; taxed upon withdrawal.	Taxation based on a portion of each payment.

Because there are different types of annuities, each one works a little bit differently. The primary difference between them is the way they pay out, but there are some other factors to consider.

For example, immediate annuities can start paying out right away, but deferred annuities won’t be accessible for many years. Before you purchase an annuity, make sure you understand how each type works.

Immediate Annuities

Immediate annuities are exactly what they sound like — they start paying out almost immediately after you make a single premium payment. One of the drawbacks of purchasing this type of annuity is that you have to fund it with a lump sum. The good news is that you can use post-tax dollars, or money you’ve already paid taxes on, which may improve your tax situation later.

When you purchase an immediate annuity, you don’t have to worry about outliving your income or dying before you can start collecting payments. Immediate annuities are also the simplest to manage, as you don’t have to keep up with a payment schedule or rebalancing your account. Rebalancing is a technique used to ensure your account aligns with your financial goals.

Some people even use immediate annuities as part of their Medicaid planning strategies. Medicaid is a need-based health insurance program, so applicants must meet certain income and asset requirements to qualify for coverage. In general, purchasing a Medicaid-compliant annuity turns a countable asset into a non-countable asset. Non-countable assets don’t count toward the Medicaid asset limit.

• To be Medicaid-compliant, an annuity must meet these general requirements:
• It must be an immediate annuity rather than a deferred annuity.
• The owner’s state must be named as the beneficiary. This is so the state Medicaid program can recoup some of its funds if the owner passes away.
• The annuity must provide fixed monthly payments.

The Medicaid eligibility rules are complex, so it’s worth visiting an experienced estate planning attorney to learn more about the requirements in your state. If you purchase an annuity that isn’t Medicaid-compliant, you may lose your eligibility, making it more difficult to cover your healthcare expenses.

Deferred Annuities

As their name implies, deferred annuities don’t pay out right away. Instead, you start receiving income at some predetermined point in the future. One of the main benefits of purchasing this type of annuity is that you have more time for your money to grow.

Another benefit is that you don’t have to worry about contribution limits. When you open a 401(k) account or Individual Retirement Arrangement (IRA), you can only contribute a certain amount of money each year. For 2023, the IRA contribution limit is just $6,500 — $7,500 if you’re 50 or older. This isn’t enough to cover most people’s retirement expenses.

The main drawback of deferred annuities is that you have to wait to receive payments. Not everyone is in a position to pay premiums without receiving income right away. Inflation is also a major concern for people who purchase deferred annuities. When inflation is high, your purchasing power decreases, which means you can’t buy as many goods and services with your money. Even if your annuity gains value, your payments may not stretch as far as expected.

Fixed Annuities

With a fixed annuity, you receive a fixed interest rate for a certain period of time. The biggest advantage of purchasing this type of annuity is that you always know what to expect. Fixed annuities also have pre-established, guaranteed payouts. The insurance company bears much of the risk, so the fixed rate may be lower than what you’d get with a variable or indexed annuity.

Another benefit of fixed annuities is that most insurance companies have low investment minimums. Instead of waiting to save $10,000 or $20,000, you can buy a fixed annuity for as little as $1,000 to $5,000. This makes it easier to start saving for your future.

When you purchase a fixed annuity, you pay premiums, but it’s the insurance company that invests the money and aims to get the highest possible return. Therefore, you don’t have to worry about picking stocks or figuring out how different markets work. It’s great if you have that knowledge, but with a fixed annuity, you can let experienced professionals handle all the investing.

Some insurance companies offer high “teaser” rates designed to draw you in. Once you’ve had the contract for a few years, the interest rate decreases. Watch out for these teaser rates if you decide that a fixed annuity is right for you. Another disadvantage is that inflation may erode the value of your account, leaving you with less income than you need to cover your living expenses.

Variable Annuities

Variable annuities are the riskiest because they have no guarantees. The value of your account is tied to an investment portfolio, which may contain stocks, bonds and other types of investments. One of the main drawbacks of variable annuities is that they’re more complex than fixed and indexed annuities. If you don’t have much experience with financial products, you may find them confusing.

If you purchase a variable annuity, you may lose money. This is because the value of the underlying portfolio is always changing. For example, the stock market crashed at the beginning of the COVID-19 pandemic, as investors were worried about how the SARS-CoV-2 virus would affect the global economy. Conversely, variable annuities may have higher returns than fixed annuities when the market is doing well.

Indexed Annuities

Indexed annuities are linked to a specific stock market index, such as the S&P 500. An index is a group of stocks chosen to represent a specific market sector, asset class or investment strategy. For example, the S&P 500 measures the performance of the top 500 companies listed on American stock exchanges. This index includes Apple, Microsoft, Amazon, Tesla, Johnson & Johnson, ExxonMobil and other top performers.

The amount of income you receive depends on changes in the selected index. If the index performs well, your income should increase. During market downturns, however, you may see a drop in your income. Here are some terms you should know before purchasing an indexed annuity:

• Participation rate: This is the percentage of the return that an insurance company credits to the indexed annuity. If the market return is 7% and the annuity had a 70% participation rate, you’d receive 4.9%, or 70% of the 7% return.
• Cap: Many indexed annuities have return caps, which limit the amount you receive if the selected index performs exceptionally well. If your indexed annuity has a cap of 5%, that’s all you’ll receive, even if the index returns 9%.
• Bonus: Some contracts include a bonus, or a percentage of your first-year premiums. An insurance company adds the bonus amount to the value of your annuity.
• Riders: If you add a rider to your contract, you’ll have to pay a fee, reducing your return. As a reminder, a rider is an extra benefit.
• Spread fee: The spread fee is a percentage deducted from the index return, reducing the amount you receive. For example, if the index increases by 5% and your annuity has a 1% spread fee, you’ll only get a 4% return.

One of the main benefits of purchasing an indexed annuity is that you earn more interest if the selected index performs well. Your contract may also have a guaranteed minimum interest rate, ensuring that you earn a little something even if the index has a negative rate of return during a tough year. You can also customize your contract by adding riders.

That said, indexed annuities are a bit riskier than fixed annuities, so they’re not for everyone. The cap on gains is also a major drawback, as it limits the amount you earn if the selected index performs much better than expected. If you’re concerned about these disadvantages, consider pairing an indexed annuity with a fixed annuity.

Advantages of Annuities

Category	Advantages
Retirement Income	Provides a steady and reliable income stream during retirement, ensuring financial security and peace of mind.
Tax Deferral	Offers tax-deferred growth, allowing investments to accumulate earnings without immediate tax liability.
Principal Protection	Some annuities provide principal protection, safeguarding the initial investment against market downturns or losses.
Investment Options	Variable annuities offer investment options, allowing individuals to potentially earn higher returns based on market performance.
Death Benefit	Many annuities offer a death benefit, providing a payout to designated beneficiaries upon the annuitant’s passing.
Longevity Protection	Annuities protect against the risk of outliving savings by providing income for life or a specified period, regardless of lifespan.
Estate Planning	Annuities can be utilized as part of an estate plan, allowing for the efficient transfer of assets and potential tax advantages.
Guaranteed Income	Certain annuities provide guaranteed income, ensuring a predetermined payout regardless of market fluctuations or economic conditions.
Creditor Protection	In some cases, annuities may offer protection against creditors, safeguarding the assets held within the annuity from legal claims.
Customization Options	Annuities often offer customization options, allowing individuals to tailor the annuity to their specific needs and financial goals.
Supplemental Retirement	Annuities can serve as a supplemental retirement tool, complementing other retirement accounts like pensions, 401(k)s, or IRAs.
No Contribution Limits	Unlike retirement accounts, annuities do not have contribution limits, allowing individuals to invest larger amounts if desired.
Probate Avoidance	Annuities can help individuals avoid probate as they pass directly to the designated beneficiaries, bypassing the probate process.

Since annuities are customizable contracts, they have several advantages. Here are a few reasons to consider purchasing an annuity to maximize your retirement income.

Multiple Income Options

One of the biggest advantages of purchasing an annuity is that you have multiple income options. If you’re single and have no children, you can get a life-only annuity, ensuring that you have enough income to get you through retirement. Annuities with death benefits are helpful for married people and single parents who want to leave a little something for their survivors.

Some Flexibility

Annuities are a little more flexible than other financial products. You can get a fixed annuity to reduce your risk, a variable annuity if you’re a little more risk-tolerant or an indexed annuity to get a guaranteed minimum rate combined with the possibility of higher market returns. You also have more control over when you start receiving payments, as you can buy an immediate annuity or a deferred annuity.

Death Benefits

Many annuities come with death benefits, making it a little easier to plan for the future. Death benefits give you the peace of mind of knowing that your beneficiary will receive the current value of the annuity when you pass away.

If you earn a lot more than your spouse, the death benefits from an annuity can help them maintain their financial footing in the months following your passing. For example, many surviving spouses use the funds to pay off mortgages or eliminate credit card debt. Death benefits are also helpful for parents who want to leave something behind for their children.

Increased Security

Nearly 50% of all Americans worry that they’ll run out of money after they retire. Due to advances in medical technology, doctors can diagnose chronic conditions earlier and deliver better treatment outcomes. As a result, many people now live into their 80s and 90s, increasing the amount of income needed to cover housing, transportation and other living expenses.

Deferred annuities are often called “longevity insurance” because you can structure them to start paying out in your 70s or 80s instead of receiving payments earlier in your retirement. This improves your financial security by ensuring you’ll still have a source of income even if your other accounts run out of funds.

Many Customization Options

Annuities are customizable, meaning that you can decide exactly how you want to pay in, how long you want to wait before you get a payout and what happens if you pass away. You can choose how to invest the money based on the kind of annuity you choose, too, helping you protect your principal balance or take greater risks for the chance at a higher income.

Increased Stability

Fixed annuities are a good option if you don’t want your income to fluctuate based on market changes. If you purchase this type of annuity, it will pay out according to the terms of the contract, regardless of whether the market is soaring or crashing. A fixed annuity may even help you balance out losses from an IRA, a 401(k) or another type of investment account.

Investment Options

Variable annuities are riskier than fixed and indexed annuities, but they come with the freedom to choose your own investment strategy. Most variable annuities are based on the performance of mutual funds, which contain a mix of stocks, bonds and money market instruments. These instruments are short-term assets, such as Treasury bills and certificates of deposit.

Tax Advantages

When you purchase an annuity, you don’t pay taxes until it starts paying out. If you purchase a deferred annuity, you may not have to pay taxes on it for a decade or more. Additionally, if you use post-tax dollars to purchase the annuity, you may not have to pay more tax on it when you start receiving payments.

Disadvantages of Annuities

Category	Fixed Annuity	Variable Annuity	Indexed Annuity
Interest Rate Risk	Fixed interest rate may not keep up with inflation over time.	Variable returns expose the annuity to market volatility.	Indexed returns may underperform compared to direct investments.
Limited Investment Growth	Fixed interest rate limits potential for higher investment returns.	Investment returns depend on market performance.	Returns are linked to the performance of a specific index, potentially limiting growth.
Lack of Flexibility	Limited flexibility to change payment terms or withdrawal options.	Investment options may have limited flexibility or require additional fees.	Limited flexibility due to index-based returns and restrictions.
Surrender Charges	May have surrender charges for early withdrawals or contract termination.	May have surrender charges for early withdrawals or contract termination.	May have surrender charges for early withdrawals or contract termination.
Lack of Liquidity	Limited access to funds during the annuity’s surrender period.	Limited access to funds without incurring fees or penalties.	Limited access to funds without incurring fees or penalties.
Longevity Risk	Potential loss of purchasing power due to fixed income payments.	Investment returns may not keep up with inflation, affecting purchasing power.	Investment returns may not keep up with inflation, affecting purchasing power.
Complex Fee Structures	May have complex fee structures, including administrative fees and mortality and expense charges.	Variable annuities often have higher fees, including expense ratios and management fees.	May have complex fee structures, including participation rates and caps.
Dependency on Insurance Company	Reliance on the financial stability and performance of the insurance company issuing the annuity.	Reliance on the financial stability and performance of the insurance company issuing the annuity.	Reliance on the financial stability and performance of the insurance company issuing the annuity.
Taxation	Tax-deferred growth, but withdrawals are subject to ordinary income tax rates.	Tax-deferred growth, but withdrawals are subject to ordinary income tax rates.	Tax-deferred growth, but withdrawals are subject to ordinary income tax rates.
Inflation Protection	Lack of built-in inflation protection for fixed income payments.	No built-in inflation protection; returns may not keep up with rising costs.	No built-in inflation protection; returns may not keep up with rising costs.
Potential Loss of Principal	Potential loss of principal if the annuity is not protected by a guaranteed minimum death benefit.	Potential loss of principal if investments perform poorly.	Potential loss of principal if the annuity is not protected by a guaranteed minimum death benefit.
Complexity	Can be complex to understand, with various terms and options.	Variable annuities can be complex due to investment options and riders.	Can be complex due to participation rates, index calculations, and surrender terms.

During the growth phase of an annuity, you benefit from not having to pay taxes. That can come back to haunt you later. Annuities are usually taxed as ordinary income, so the amount of tax you pay depends on which tax bracket you’re in once you start collecting payments. If your income increases, so will your tax burden.No Step-Up in Basis

Another tax disadvantage of annuities is that they’re not eligible for a step-up in cost basis. Generally, if you buy stocks and leave them to your heirs, they’ll receive a step-up. This is an adjustment in the cost basis of an asset to its fair market value (FMV) on the date of your death. Cost basis refers to the original value of an asset.

For example, if you pay $25,000 for stocks and the FMV of those stocks is $50,000 on the date of your death, your heirs will receive a step-up in basis. That means they won’t pay any capital gains tax unless they sell the stocks for more than $50,000.

The step-up in basis makes a big difference, especially if the FMV of the asset increases significantly. Without a step-up, your heirs would have to pay capital gains tax on the difference between the sale price and the original cost basis. For example, if they sold the stocks for $60,000, they’d have a $35,000 taxable gain. Annuities aren’t structured this way.

Early Withdrawal Penalties

Unless you qualify for an exception, you may have to pay a 10% penalty if you withdraw from your annuity before you turn 59.5. Many of the potential exceptions are unlikely to apply. For example, the IRS allows you to make a penalty-free early withdrawal if you use the funds to buy your first home.

Since most people buy annuities later in life, you probably won’t be able to use the exception for first-time home buyers. You may qualify for an exception if you become totally disabled or use the funds to comply with certain court orders.

Potential Loss of Principal

One of the biggest disadvantages of annuities is that it’s possible to lose your entire principal balance. This usually happens with variable annuities since their value is tied to the performance of an underlying investment portfolio. Although you’re much less likely to lose your principal with a fixed annuity, it’s not completely impossible.

Additionally, poor investment performance can lead to minimal gains (if any) over time. As a result, you may receive less income from an annuity than you would with another type of account.

Multiple Fees

Contract fees, commissions, surrender charges and other costs add up quickly. These fees reduce the value of your account, which may make it more difficult to reach your financial goals. Before purchasing an annuity, review the terms carefully. If the fees seem unusually high, you may want to try a different insurance company or consider another retirement savings option.

Limited Returns

Annuities typically increase in value, making them less risky than stocks. However, low risk often translates into low rewards. Even if the value of your annuity increases, the return may not be as high as what you’d get with stocks, bonds and other investments.

Lack of Inflation Protection

Unless you pay for a cost-of-living rider, annuities don’t provide much protection against inflation. Since 1958, the U.S. inflation rate has fluctuated from a low of 0.7% to a high of 13.6%. As costs increase, the value of your payments may decrease, especially if you have a fixed annuity.

Limited Bankruptcy Protection

When you purchase an annuity, there’s no guarantee that the insurance company will remain solvent. If your insurer files for bankruptcy, you may stop receiving your annuity payments, leaving you without a critical source of income. Some states offer additional protection for their residents, so it’s a good idea to investigate your options before you commit to the contract.

Annuities vs. Savings Bonds

Category	Annuities	Savings Bonds
Purpose	Provide a guaranteed income stream during retirement.	Serve as low-risk savings and investment vehicles.
Returns	Offer potential for higher returns based on investment performance.	Offer fixed interest rates determined by the government.
Risk	Investment risk varies based on the type of annuity chosen.	Considered low-risk investments backed by the government.
Liquidity	Limited liquidity with potential penalties for early withdrawals.	Can be redeemed at any time, but early redemption penalties may apply.
Term	No fixed term; can be structured for a specific period or for life.	Have specific maturity dates, typically ranging from 1 to 30 years.
Tax Treatment	Tax-deferred growth; withdrawals subject to ordinary income tax rates.	Interest is subject to federal income tax, but exempt from state and local taxes.
Contribution Limits	No contribution limits; investment amount can vary.	Maximum annual purchase limit set by the government.
Inflation Protection	Some annuities offer built-in inflation protection options.	Savings bond interest rates can adjust for inflation.
Estate Planning	Can be utilized as part of an estate plan to transfer assets.	Can be included in an estate plan for beneficiaries.
Flexibility	Variable annuities offer investment options and customization.	Limited flexibility; fixed interest rates and terms.
Purchasing Process	Typically purchased through insurance companies or financial institutions.	Purchased directly from the U.S. Department of the Treasury.
Use in Retirement Planning	Often used as a long-term retirement income vehicle.	Can be utilized as a part of a diversified retirement portfolio.
Availability	Offered by insurance companies and financial institutions.	Available for purchase online or through financial institutions.

When you buy a savings bond, you give the U.S. government a loan. In exchange, you earn interest on your investment. EE bonds come with a fixed interest rate, making it easier to estimate the potential return. You can also buy them in any amount ranging from $25 to $10,000, giving you a little flexibility as you plan for retirement. The government guarantees that these bonds will double in value every 20 years.

I bonds are a bit different, as they come with a fixed rate and an inflation-based rate. The inflation-based rate changes twice each year to account for market changes. While EE bonds are only available in electronic format, you can purchase electronic I bonds ($25 minimum) or paper I bonds ($50 minimum).

One of the major differences between annuities and savings bonds is that savings bonds aren’t intended to produce a steady stream of income. You invest your money and get interest in return. Therefore, if your main goal is to generate income for retirement, you may be better off purchasing an annuity.

Savings bonds also have yearly purchase limits. The limit for EE bonds is $10,000 annually, while the limit for I bonds is $15,000 — $10,000 in electronic bonds and $5,000 in paper ones. The higher limit has a catch, though.

You can only buy paper bonds if you use your tax refund when you file your annual return. That means you can’t wait for a refund check and buy them later. If you break even or have a balance due, you’re out of luck. You’ll have to stick with $10,000 in electronic I bonds.

The annual limits are somewhat low, so if you’re looking to spend a lot more money to improve your financial future, annuities have an advantage over savings bonds. That said, government savings bonds are one of the safest investment options available, as there’s an extremely low risk that the U.S. government will default on its obligation to repay you. If you have a low level of risk tolerance, you may want to buy government-backed bonds instead of annuities.

Annuities vs. Life Insurance

Category	Annuities	Life Insurance
Purpose	Provide a guaranteed income stream during retirement.	Offer financial protection and a death benefit to beneficiaries.
Income Payments	Provide regular income payments during retirement.	Generally do not provide income payments during the insured’s lifetime.
Risk	Investment risk varies based on the type of annuity chosen.	Provide financial protection against the risk of premature death.
Cash Value Accumulation	Can accumulate cash value over time, depending on the type of annuity.	Some types of life insurance, such as whole life, offer cash value accumulation.
Death Benefit	Some annuities may offer a death benefit, but it’s not a primary feature.	Provide a death benefit to beneficiaries upon the insured’s passing.
Tax Treatment	Tax-deferred growth; withdrawals are subject to ordinary income tax rates.	Death benefits are generally tax-free to beneficiaries.
Flexibility	Limited flexibility in adjusting terms or payments.	Can provide flexibility in terms of premium payments and coverage.
Term	No fixed term; can be structured for a specific period or for life.	Offer coverage for a specific term (term life) or for life (permanent life).
Investment Options	Variable annuities offer investment options and potential growth.	Generally do not offer investment options like stocks or bonds.
Estate Planning	Can be included as part of an estate plan for efficient asset transfer.	Can be utilized for estate planning and wealth preservation.
Use in Retirement Planning	Often used as a retirement income vehicle to supplement other sources.	Not typically used directly for retirement income, but for protection and wealth transfer.
Underwriting Requirements	Generally, less stringent underwriting requirements.	Typically require more thorough underwriting and medical evaluations.
Availability	Offered by insurance companies and financial institutions.	Offered by insurance companies and financial institutions.

A life insurance policy pays money to a designated beneficiary. The insurance company makes the payment when the policy holder dies or after a certain period of time. Like annuities, these policies come with premiums, which you must pay annually, semiannually, quarterly or monthly.

When you buy life insurance, you have two basic options:

• Temporary life: Temporary life insurance covers you for a certain period of time. It’s a popular option for people concerned with leaving enough money to pay off a mortgage, wipe out credit card debt or send a child to college. Term life, level term life and renewable term life are all examples of temporary life insurance policies.
• Permanent life: Rather than covering you for a set period of time, a permanent life insurance policy covers you for as long as you pay the premium. These policies also build cash value, so some people use them as an investment. Universal life and whole life are both considered permanent forms of life insurance.

As long as you pay your premiums and meet other policy terms, life insurance provides a death benefit to your beneficiary when you pass away. Annuities don’t necessarily come with death benefits, so life insurance may be the better option if your primary concern is leaving something of value for your heirs.

Another difference between the two is that life insurance doesn’t pay out until your death, while annuities give you a source of income while you’re alive.

Annuities vs. Certificates of Deposit

Category	Annuities	Certificates of Deposit (CDs)
Purpose	Provide a guaranteed income stream during retirement.	Offer a safe and fixed return on investment over a specific term.
Returns	Offer potential for higher returns based on investment performance.	Fixed interest rate determined at the time of purchase.
Risk	Investment risk varies based on the type of annuity chosen.	Considered low-risk investments with principal protection.
Liquidity	Limited liquidity with potential penalties for early withdrawals.	Generally have penalties for early withdrawals before maturity.
Term	No fixed term; can be structured for a specific period or for life.	Have fixed terms ranging from a few months to several years.
Tax Treatment	Tax-deferred growth; withdrawals subject to ordinary income tax rates.	Interest earned is subject to ordinary income tax rates.
Contribution Limits	No contribution limits; investment amount can vary.	Limited by the amount deposited in the CD account.
Inflation Protection	Some annuities offer built-in inflation protection options.	Generally do not offer built-in inflation protection.
Estate Planning	Can be included as part of an estate plan for efficient asset transfer.	Can be utilized as part of an estate plan for beneficiaries.
Flexibility	Variable annuities offer investment options and customization.	Limited flexibility; fixed interest rates and terms.
Purchasing Process	Typically purchased through insurance companies or financial institutions.	Purchased directly from banks or credit unions.
Use in Retirement Planning	Often used as a retirement income vehicle to supplement other sources.	Not typically used directly for retirement income.
FDIC Insurance	Not FDIC-insured; subject to the claims-paying ability of the insurance company.	FDIC-insured up to the maximum limit per depositor and per bank.
Availability	Offered by insurance companies and financial institutions.	Offered by banks, credit unions, and other financial institutions.

A certificate of deposit, commonly called a CD, is a type of savings account. You deposit money and leave it there for a set period of time, creating an opportunity to earn interest. CDs are extremely safe, especially if you buy from a bank that’s backed by the Federal Deposit Insurance Corporation. This agency insures up to $250,000 per depositor, per account type, per bank. If the bank fails, the FDIC ensures you don’t lose your deposit.

Certificates of deposit aren’t designed to produce a steady stream of income, so they’re not the best option for individuals searching for a way to increase their earnings during retirement. A CD is a good choice if you want to earn a little interest over a short period of time instead of waiting to receive payments.

Another difference is that CDs generally have lower penalties for early withdrawals. You’re supposed to hold an annuity until you retire, so insurance companies charge high withdrawal fees to discourage customers from cashing out early. If you think you’ll need your deposit back in the next few years, it may be wise to open a CD instead of purchasing an annuity.

The main benefit of purchasing an annuity over opening a CD is that annuities tend to pay higher interest rates. These rates reflect current and future risk conditions. Because you hold an annuity for much longer than a CD, there isn’t as much risk to the insurance company. In contrast, banks take on a lot of risk when you open a CD with a 6-month or 1-year term. If conditions change drastically, there’s not much time for the market to recover.

Overall, CDs are better for short-term savings, while annuities are better for generating a stream of income at some point in the future. One easy way to diversify your portfolio is to buy both products. You can earn short-term interest on the CD and use the income to cover your retirement expenses.

Including Annuities in Your Retirement Plan

Pros	Cons
Guaranteed income stream	Limited liquidity and penalties for early withdrawals
Tax-deferred growth	Complexity in terms and fees
Diversification of retirement portfolio	Limited investment growth potential
Protection against longevity risk	Dependency on the financial stability and performance of the insurance company
Death benefit for beneficiaries	Potential for inflation eroding purchasing power
Potential for higher returns based on investment performance	Limited flexibility in adjusting terms or payments
Option for inflation protection	Potential surrender charges or fees
Offers peace of mind and financial security in retirement	Requires careful evaluation and understanding of the terms and features
Can be included as part of an estate plan	Potential loss of purchasing power due to rising living costs
Provides a stable and predictable income source	May not be suitable for all individuals’ retirement needs
Offers tax advantages and deferred taxation	Not easily accessible for emergencies or unexpected expenses

When you’re planning for retirement, diversification is the name of the game. You shouldn’t rely on annuities to provide the full amount of income you need to cover your expenses. Compared to other types of investments, annuities are relatively low-risk, so they’re a good complement to stocks, mutual funds and other investments.

Think About Your Goals

Before you start shopping, take time to think about your financial goals. Are you willing to take a risk on a variable annuity, or would you feel more comfortable buying a fixed annuity? Do you have enough money to make the single premium payment required by an immediate annuity contract? If you invest a large lump sum, will you have enough money to pay your bills?

It’s important to plan for the future, but don’t buy an annuity if it leaves you without the funds you need to take care of today’s expenses. It’s also a good idea to meet with a financial planner or tax advisor to determine how each type of annuity will likely affect your tax situation.

Compare Several Options

If you decide that an annuity is right for you, don’t just buy the first one you read about. Request information from several insurance companies, compare your options and ask follow-up questions as needed. Pay close attention to how agents treat you when you contact each insurance company. If you encounter long wait times or agents who seem to be in a hurry to rush you off the phone, keep looking.

It’s also important to vet each insurance company carefully. Visit the company website, read online reviews and use other sources to answer these questions:

• How long has the company been in business?
• Does it have a positive reputation?
• What is the company’s mission?
• Is the company in a good financial position?

Read the Fine Print

The insurance company must provide a disclosure containing the following information:

• Contract name
• Product name
• Insurance company’s legal name
• Insurance company’s contact information
• Detailed description of the contract terms

Your disclosure should cover guaranteed and non-guaranteed terms, the impact of riders on the value of the annuity, flat fees and percentage charges, death benefits and other information to help you understand exactly what the contract includes. Read this disclosure carefully before you agree to purchase the annuity.

Know Your Cancellation Rights

Like life insurance policies, annuities come with a “free look” period. That means you can change your mind and cancel without paying a penalty. In most cases, the free look lasts for 10 days. If you don’t cancel before the deadline, you’ll have to pay a surrender charge if you want to sell the annuity.

Frequently Asked Questions

What Factors Affect the Interest Rate on an Annuity?

Every insurance company considers several factors when determining the interest rate on an annuity contract. One of the most important considerations is the current interest rate environment. Interest rates go up and down according to the demand for borrowing. When demand is strong, rates increase. If demand is weak, lenders charge less, causing rates to decline.

The rate also varies based on your life expectancy and the type of annuity you buy. If you expect to live for many more years, the insurance company may give you a lower rate to make up for the amount of time you’ll be receiving payments.

What Is an Intermediary When Buying an Annuity?

An intermediary is an organization that helps facilitate the purchase of an annuity. In most cases, you don’t buy the annuity directly. The intermediary works on behalf of the insurance company to sell it to you.

When Is the Best Time to Buy an Annuity?

It depends on your goals. If you want a deferred annuity, for example, you can buy it in your 40s or 50s and let it grow until you’re ready to receive payments. Since immediate annuities start paying out right away, you may want to wait until you’re at least 70.

Life expectancy is another important consideration. If you have a history of stroke, heart attack or another condition that could reduce your life expectancy, it doesn’t make sense to wait as long as you would if you were in better health.

How Does an Insurance Company Determine Annuity Payment Amounts?

Insurance companies base their annuity payouts on these factors:

• What type of annuity you buy
• How many riders you add to your contract, if any
• Your age
• Your life expectancy
• How much money you invest
• Because insurance companies charge for riders, adding extra benefits to your contract will reduce the amount of money returned to you.

What Happens to an Annuity When the Annuitant Passes Away?

It depends on the terms of the contract. If the annuity has no death benefits, then the insurance company gets to keep the remaining value. The beneficiaries won’t receive any money after the annuitant’s death. If the contract includes death benefits, the remaining value goes to a beneficiary or surviving spouse.

What Is a Mortality & Expense Fee on an Annuity?

Your annuity contract may include a mortality and expense fee, also known as an M&E. This fee compensates the insurance company should it suffer any losses due to the annuitant’s sudden death or any other unexpected event.

How Are Annuities Regulated?

Most annuities are regulated by state insurance commissions, which investigate complaints against insurance companies, make consumers aware of their insurance-related rights and issue licenses to industry professionals. Indexed annuities are subject to national regulation, so you can contact the Financial Industry Regulatory Authority (FINRA) or the Securities and Exchange Commission (SEC) if you have a problem with one.

Is an Annuity the Same Thing as a Pension?

No. Although they’re both used to produce income in retirement, annuities aren’t the same as pensions. To qualify for a pension, you must work for an employer that offers one. While you’re working, you and your employer contribute to the pension fund. When you retire, you may qualify for monthly payments or a single lump sum. If you want an annuity, you must purchase it on your own.

How Do You Find a Lost Annuity?

The National Association of Insurance Commissioners (NAIC) has an online tool designed to help users find annuity contracts and life insurance policies. To use it, you must set up an online account and provide the following information:

• Legal name
• Date of birth
• Social Security number
• Date of death

Because you have to include the date of death, you can’t use the NAIC tool to search for your own annuity. You can use it if the annuitant is deceased, however.

Is an Annuity Better Than a Mutual Fund?

Annuities aren’t investments, so it’s difficult to compare them against mutual funds, which take contributions from many people and invest the money with the hopes of generating a return. Mutual funds are much riskier than annuities because they consist of short-term assets, stocks and bonds. The heightened risk makes mutual funds a better choice for individuals looking to maximize growth.

In some cases, the minimum investment for a mutual fund is lower than the minimum investment for an annuity. Mutual funds are also more “liquid” than annuities. Liquidity describes how easy it is to convert an asset into cash. With annuities, you can’t cash out early unless you pay a surrender charge, but you can sell your mutual fund shares at any time.

Some people prefer annuities because they offer more income options than mutual funds do. Even if a mutual fund pays dividends, you generally don’t make big gains unless you sell shares. Buying an annuity gives you more flexibility when it comes to how much you receive each month and how long you receive those payments.

What is the Investment-Expense Ratio on an Annuity?

If you have a variable annuity, you must pay an investment-expense ratio and other fees. This fee covers the cost of managing the investments in the underlying investment portfolio. Think of it as a service charge you pay to ensure that the investment portfolio performs as close to your expectations as possible.

Should You Avoid Annuities?

• Although you shouldn’t invest your entire nest egg in annuities, few people need to avoid them entirely. They provide an extra stream of income during retirement, making it easier to cover monthly expenses. You may want to look for other options if you meet any of the following criteria:
• You have no savings. You can’t purchase an annuity unless you have money to pay the premiums. If you have medical bills or higher-than-average living expenses, you may not be able to purchase this insurance product.
• You have a defined-benefit pension plan. With a defined-benefit plan, you receive a fixed monthly payment once you retire, making it easier to estimate your income. Depending on the terms of the plan, you may receive more income from a pension than you would from an annuity. If you’re eligible for Social Security and a pension plan, you can really maximize your retirement earnings.
• You’re satisfied with your Social Security benefits. If your Social Security payments cover your monthly expenses, you may not need another source of guaranteed income. Instead of purchasing an annuity, think about buying stocks, bonds and other types of investments.
• You have a high net worth. If you have a paid-off mortgage and plenty of money in the bank, you may be able to live well into your 80s or even 90s without running out of money. Adding an annuity to your retirement plan won’t hurt, but it won’t help much either.