Annuities are insurance products that can provide guaranteed income in retirement – income you cannot outlive. While annuities have been criticized for high fees and complexity, they can play a valuable role in retirement planning when used appropriately. This guide explains how annuities work, the different types available, their advantages and disadvantages, and how to determine if an annuity is right for your retirement strategy.
In This Article
1How Annuities Work
At their core, annuities are contracts with insurance companies. You pay a premium (either a lump sum or series of payments), and in return, the insurance company promises to pay you income for a specified period or for life. The insurance company pools money from many annuity holders and uses actuarial calculations to determine payment amounts. Because some people will die earlier than expected and some later, the company can guarantee payments for life while still remaining profitable.
2Types of Annuities
Immediate annuities begin paying income right away, typically within a year of purchase. Deferred annuities accumulate value over time before converting to income payments. Fixed annuities guarantee a specific interest rate and payment amount. Variable annuities invest in sub-accounts similar to mutual funds, with payments varying based on investment performance. Fixed indexed annuities offer returns linked to market indexes with downside protection. Each type has different risk and return characteristics.
3Advantages of Annuities
The primary advantage of annuities is guaranteed lifetime income – you cannot outlive your payments. This addresses longevity risk, one of the biggest concerns in retirement planning. Annuities also provide predictable income that simplifies budgeting, tax-deferred growth during the accumulation phase, and protection from market volatility (for fixed annuities). For those who worry about running out of money, annuities can provide valuable peace of mind and financial security.
4Disadvantages and Considerations
Annuities have significant drawbacks to consider. Fees can be high, especially for variable annuities with riders and guarantees. Surrender charges may apply if you need to access your money early. Once you annuitize, you typically cannot access the principal. Inflation can erode the purchasing power of fixed payments over time. Annuity income is taxed as ordinary income rather than capital gains. The insurance company credit risk means your payments depend on the company’s financial strength.
5When Annuities Make Sense
Annuities are most appropriate for retirees who have maximized other tax-advantaged accounts, want guaranteed income to cover essential expenses, are concerned about outliving their savings, prefer predictable income over investment flexibility, and have a long life expectancy. Consider using annuities to cover the gap between Social Security and essential expenses, while keeping other assets invested for growth and flexibility. A partial annuitization strategy often makes more sense than putting all retirement savings into annuities.
Key Takeaways
- Annuities provide guaranteed income you cannot outlive
- Types include immediate, deferred, fixed, variable, and indexed
- Fees can be high, especially for variable annuities
- Best used to cover essential expenses gap after Social Security
- Consider partial annuitization rather than all-or-nothing approach
Conclusion
Annuities can be valuable tools for creating guaranteed retirement income, but they are not right for everyone. The key is understanding how different annuity types work, their costs and limitations, and how they fit into your overall retirement plan. If you are considering an annuity, work with a fee-only financial advisor who can provide objective guidance without commission incentives.