An annuity is a product sold by an insurance company where you make a lump-sum payment in exchange for guaranteed income. These products aren't well understood by many retirees, so here are eight things all retirees (and pre-retirees) should know about annuities in order to make smart retirement-planning decisions.
1. First, know what an annuity is.
An annuity is a contract between you and a company -- typically, an insurance company. You give the company a lump sum of money, and it promises to make monthly payments to you, either immediately or beginning at some point in the future.
Generally speaking, the motivation for buying an annuity is simple -- to create a guaranteed stream of income from your savings. Annuities are maintenance free, and continue to generate income no matter what the economy does. Essentially, annuities can take the guesswork out of managing your money in retirement.
2. Annuities can be smart tax-planning tools.
Annuities can help you avoid big tax bills in retirement. If you use a tax-deferred account, such as an IRA or 401(k), to fund the annuity, you'll only pay taxes as you receive payments, instead of all at once.
3. Annuity payments are likely to rise with interest rates.
A quick quote shows me that, as of this writing, a 65-year-old man could buy a $100,000 annuity and expect to receive about $565 per month for the rest of his life. This translates to annual income of $6,780, or 6.8% of the annuity cost per year.
This is historically low. In fact, there have been time periods within the past few decades when annuities paid out double what they do today. If interest rates rise in the coming years, as they're widely expected to do, it's a fair assumption that annuity payments will rise, as well.
4. Annuity commissions and fees can be high.
This is especially true with variable or indexed annuities. Be especially wary about annuities being aggressively marketed to you. Find out if advisors are held to the "fiduciary" standard, which requires them to act in your financial best interest, not their own. If they aren't held to this standard, it's not unusual for advisors to recommend annuities and other financial products that simply pay the highest commissions. My best suggestion is to ignore the salespeople and just contact a highly rated insurance company on your own.
5. Immediate annuities vs. deferred-income annuities.
As I mentioned in the first section, annuity payments can begin immediately, or at some time in the future. Immediate annuities are typically purchased by retirees who want to convert their savings into a guaranteed income stream for the rest of their lives. Deferred annuities, on the other hand, start making payments at some point in the future. For example, you may buy a deferred annuity at age 55 that starts making payments when you turn 70.
6. Annuity payments can be fixed, or could increase over time.
Fixed annuities are exactly what they sound like -- they make a certain monthly payment for the rest of your life, or for some pre-determined time period.
Variable and indexed annuities have monthly payments that are tied to the performance of the stock market, so your monthly payments can potentially increase over time. However, it's important to mention that many of these products have high fees and caps on how much the payment can increase in a single year.
If you're worried about inflation, you may be able to have your monthly payouts increased at a certain rate each year. This will lower your initial payments, but may be worth it for long-term peace of mind.
7. Annuities are only as strong as the companies that issue them.
Unlike money in a savings account, annuities are not protected by the Federal Deposit Insurance Corporation (FDIC), or any similar agency, and insurance companies do fail from time to time. A failed insurance company can wipe out your annuity payments.
Therefore, the annuity you buy is only as safe as the company that issued it. When shopping for an annuity, look for the highest-rated insurance companies and consider splitting your money into several annuities issued by several different companies. For example, instead of buying a $200,000 annuity from Company X, buy two $100,000 annuities, one from Company X and one from Company Y.
8. Not all annuity payments expire when you do.
A basic annuity's payments stop coming after the owner dies. However, there are many other options available.
For example, you can have the payments continue until the end of your spouse's life, if he or she happens to outlive you. Or you can buy a period-certain annuity, which continues to make payments for a minimum number of years, even if you die. The point is that many people believe that when you buy an annuity, your money is lost forever if you die within the first few years of receiving payments -- but this doesn't need to be the case.