It makes a lot of sense to consider annuities for retirement income, as they're designed to deliver regular infusions of cash to you automatically. Making mistakes when buying an annuity can be costly, though, diminishing your financial security. Here are five valuable tips regarding annuities.
Know your annuities
First, it's important to know that there are different kinds of annuities so that you can choose the kind that's best for you. For example, annuities can be immediate or deferred (paying you immediately vs. starting at some point when you're older), fixed or variable (certain payouts vs. payouts tied to the performance of the market or part of the market), lifetime or fixed-period (paying until death or paying for a certain span of time), and so on.
Some annuities, such as indexed annuities and many variable annuities, are problematic and unsuitable for many people, as they charge steep fees and/or carry restrictive terms. 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, 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.
On the other hand, fixed annuities, whether immediate or deferred, are smart options for many retirees or those approaching retirement. You pay an insurance company or financial services company a lump sum (or installments), and in return, you receive payments -- now or later. The payments are often monthly, but can be quarterly, annually, or even a lump sum. They can last for a fixed number of years or for the rest of your life.
Pay a little extra (or accept smaller checks), and you can have your payouts last until your spouse's life ends, too, and/or be adjusted to keep up with inflation over the years. As an example, $100,000 can buy a 70-year-old man about $640 per month, or $7,700 per year. A $300,000 purchase can generate about $23,000 annually.
Consider a deferred annuity
If an immediate fixed annuity doesn't seem to fit your needs, consider a deferred fixed annuity (sometimes called longevity insurance), which doesn't start paying immediately. Instead, the insurer agrees to start paying at a future point, such as when you turn a certain age.
A deferred annuity can be a great protection against the risk of running out of money late in life. For example, if you're rather sure that you have sufficient income for at least 20 years, you might buy a deferred annuity today that will start paying you in 15 or 20 years. Deferred annuities cost less than immediate annuities, as they let the insurance company invest your money for a long time before beginning to pay you. As an example, a 70-year old man might spend $50,000 now and get a deferred annuity that pays him about $850 per month for the rest of his life, beginning in 10 years.
Stick with highly rated companies
An annuity is only guaranteed as long as the insurer or financial services company you bought it from remains solvent, so stick with highly 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 future income will be at risk.
Read up on credit agency ratings, too, and be sure you understand what the rating of an insurer you're considering really means. For example, a rating of "A" from Standard & Poor's, Moody's, or Fitch, is good, but it's not the best possible rating -- which would be AAA or Aaa.
Look into laddering
When buying an annuity, you'll get less bang for your buck when interest rates are low. Since our current interest rates are near historic lows, it can be worth delaying buying until rates rise -- if you can. (The Fed recently hiked rates a bit, and further increases in the coming years are expected, but not guaranteed.)
Given the current low-interest rate environment, you might consider using the "laddering" strategy, where you divide your total planned annuity purchase into chunks and buy installments over time. Perhaps, for example, you'd buy a third of the annuity income you want now, and another third in a few years when rates are likely to be higher, and the last third even later.
Finally, remember that, when it comes to retirement income, annuities aren't your only options. Dividends paid by healthy, growing companies, for example, have the terrific habit of being increased over time. Imagine that you have $300,000 invested in a portfolio with an overall dividend yield of 3%. That would generate $9,000 in dividend income this year. If those payouts are upped by an overall annual average of 5% over a decade, they'll approach $15,000 in 10 years. Technically, dividends don't offer inflation protection, but they do often grow at a faster rate than inflation, which can be very welcome in retirement.
Social Security is another retirement income source to plan for and expect. The average Social Security benefit, after all, was recently $1,350 per month, or about $16,000 per year, though if you were an above-average or below-average earner, you'll collect, respectively, more or less than that. By reading more about Social Security and strategizing well, you can likely boost the size of your benefits checks.
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. Just go about your annuity buying in an informed manner, choosing what will serve you best.
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.