We will all need income in retirement, and fewer and fewer of us have pension money to look forward to. One often overlooked but very powerful way to support yourself in retirement is via annuities. Learn more about them and see whether they can play a valuable role in your retirement plan.
First, though, let's review just what an annuity is. It's essentially a contract with an insurance company. You pay an insurer a sum of money (often a hefty sum), and in exchange, the insurer will commit to sending you regular payments immediately or in the future for the duration of the contract. Of course, it's a bit more complicated than that.
Choose a fixed annuity, not indexed or variable
There are many different kinds of annuities, and some are much more problematic than others. Here are the main distinctions to understand: immediate vs. deferred (paying you immediately vs. starting at some point when you're older), fixed vs. variable (certain payouts vs. payouts tied to the performance of the market or part of the market), and lifetime vs. fixed period (paying until death or paying for a certain span of time).
Fixed annuities are preferable to many of their counterparts. Indexed annuities and many variable annuities, for example, are problematic and unsuitable for many people, charging steep fees and/or carrying restrictive terms. Variable annuities feature more fees than fixed annuities, and together they can take a big bite out of your investment. A typical annual fee (for expenses, administration, management, and insurance) might top 1.5%, meaning that if your account is worth $50,000, you could be forking over $1,500 to $2,000 annually! No less an authority than the Securities and Exchange Commission has warned, "For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity." Indexed annuities, meanwhile, also feature major drawbacks, such as capped returns. If your annuity bases its return on the S&P 500 and features a 4% cap, the S&P 500 might surge 20% in a given year, but you'll only get a 4% gain.
Fixed annuities are generally simpler, with clearly defined -- and fixed -- benefits, along with generally lower fees.
Choose a solid insurer
Annuity income is not 100% guaranteed. The insurer does promise to pay you according to the terms of the contract, but that promise is only as reliable as the insurance company that sells it. Thus, it's important to seek out the best-rated insurers and perhaps divide your purchase money between a few of them. For example, if you were going to spend $300,000 on annuities, you might buy a $100,000 contract from three different highly rated insurers. In the unlikely event that one runs into trouble, only a portion of your nest egg will be at risk.
Structure your annuity carefully
Finally, structure your annuity carefully. A basic one will pay you for the rest of your life or for a certain minimum number of years, but there are many other options. Read up and choose whatever makes the most sense for you. For example, you can pay more and get a joint fixed annuity that pays until both you and your spouse have passed away. For $200,000, a 70-year-old couple might get around $1,000 per month via an immediate fixed annuity for as long as at least one of them is alive. A 70-year-old woman who spends $100,000 may get about $577 per month, vs. $641 for a 70-year-old man. (Women will usually receive less because they tend to live longer than men.)
Consider whether you want your fixed annuity to start paying you immediately or in the future. A deferred annuity will pay you more per dollar you spend, because on average, it will have to pay you for a shorter period and it can invest your purchase amount while it waits. Deferred annuities (often called "longevity insurance") can help you not run out of money by supplying income later in your life. A 70-year-old woman who spends $100,000 on a deferred fixed annuity that will start paying when she turns 80 can expect around $1,450 per month.
Think, too, about interest rates. Annuities generally pay more in higher interest rate environments. Prevailing rates are expected to rise over the coming years, so you'll likely get better deals in the future. If you're ready to buy an annuity now, perhaps only spend a portion of what you want to spend now, and save the rest for future years.
Find out about all the forms your annuity can take and all the features you might include. If you're willing to pay a little more or receive a little less, for example, you might have your payouts adjusted for inflation.
Keep in mind
While annuities can provide considerable retirement income, they're not your only option. You can build other kinds of income streams for yourself, such as via dividend-paying stocks. That income is far less guaranteed, but spreading your money across a bunch of solid blue chip stocks can reduce a lot of risk. If you have $250,000 in dividend payers that average a 4% yield, you can collect $10,000 per year.
When planning for your retirement, it's worth considering a fixed annuity, whether immediate or deferred. Don't leave your retirement up to chance or up to Social Security. The average Social Security benefit, after all, was recently $1,350 per month, or about $16,000 per year. If you don't expect your Social Security income to be enough, consider other income streams, such as annuities.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.