Annuities are a financial product that has become a complementary alternative for people to have money during their retirement. Choose the right contract with your insurance company and have this guide at hand.
The United States has several options for you to save for retirement, but few know about annuities, since many do not know how they work. In GLM, we provide you with all the details so that you understand annuities and know if they are right for you to prepare yourself financially for your retirement.
What are annuities?
An annuity is an insurance contract issued and distributed by financial institutions with the intention of paying the funds invested in a fixed income stream in the future. In other words, you pay the monthly premium on an annuity to have a cash flow in the future, usually for retirement, for a specified period of time or for the remainder of the owner’s life.
Annuities are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Agents or brokers who sell annuities must have a state-issued life insurance license, and also a securities license in the case of variable annuities. These agents or brokers typically earn a commission based on the notional value of the annuity contract.
In 2022, annuity sales surpassed the previous record of 2008, when people sought safer investment options during the financial crisis. Today, some contracts offer a guaranteed return of more than 5% per year.
From their characteristics, we can be sure that many Americans receive an annuity from the government and don’t even know it’s an annuity: Social Security benefits. Workers pay Social Security taxes for a period of time, calculated over the best 35 years of earnings, so that they receive a guaranteed monthly income during retirement and for the rest of their lives, based on what they have paid in during their active work period.
As with Social Security, the amount of return in the form of a monthly payment is often too low to maintain a certain lifestyle during retirement, which is why it is advisable to use annuities only as a supplemental means of receiving income in retirement.
How do annuities work?
Annuities go through two phases to generate liquid assets for the annuitant, as investors who purchased an annuity are known. The periods of these financial products are:
- The accumulation phase: is the period of time during which you fund an annuity, before payments begin. Any money invested in the annuity grows on a tax-deferred basis during this phase.
- The annuitization phase: this is the time from when you start receiving your monthly payments.
With these aspects to consider, two types of annuities can be distinguished: immediate or deferred.
- Immediate annuities are often purchased by people of any age who have received a large lump sum of money, such as a settlement or lottery, and prefer to exchange it for cash flows in the future.
- Deferred annuities are structured to grow on a tax-deferred basis and provide pensioners with guaranteed income beginning on a date they specify.
Because of their features, you can open more than one annuity contract, depending on your expectations for future returns.
Like 401(k) and IRA retirement accounts, annuities delay taxes on your earnings, as long as you keep that money in the contract until the stated date. Until the time you are able to receive the income from your annuity, you will owe income tax as you withdraw your money.
Types of annuities
There are several types of annuities, based on various details and factors, such as the length of time that annuity payments can be guaranteed to continue.
As stated above, there are annuities that can be set up to receive payments only as long as the annuitant or spouse is alive. Annuities can also be structured to be payable over a fixed period of time, such as 20 years, regardless of how long the annuitant lives.
Immediate and Deferred Annuities
Single premium immediate annuities (SPIAs) pay out immediately after the pensioner deposits a lump sum.
On the other hand, deferred annuities do not pay out income immediately and, instead, the client specifies an age at which they would like to begin receiving payments from the insurance company, allowing their savings more time to grow.
Fixed and Variable Annuities
A fixed annuity pays a fixed return, guaranteed by the annuity company. This type of annuity bases its performance on some market index, such as the S&P 500. Limits are set on your maximum gain and loss. Hence, the rate of return may be low, but safer, where growth is not high and losses are mitigated.
Variable annuities are more like investment products, such as mutual funds. These annuities allow the owner to receive larger future payments if the annuity fund’s investments do well and smaller payments if its investments do poorly, providing a less stable cash flow than a fixed annuity, but allowing the annuitant to reap the benefits of the strong investment returns of his or her fund.
Because of their variability, these annuities do not offer a guaranteed minimum return or income, as do fixed annuities.
How much do annuities cost?
SPIAs do not usually have annual fees, and if they do, they are low or some companies waive them, because the insurer makes money by investing your deposit to earn more than it will pay you in income.
In contrast, fixed index and variable annuities can be expensive. According to experts, estimate that annual fees could add up to 3% to 3.5% of your balance.
If you cancel your contract before the annuity is due, and you want to transfer your money, you may owe a hefty surrender charge. It is common for annuities to charge 7% of your balance for cancellation in the first year. The penalty gradually reduces over time until it’s gone, perhaps after seven years.
There are annuities that may allow you to withdraw up to 15% of your balance per year without paying a penalty.