What Is a Retirement Annuity?

Converting your annuity balance into income is called annuitization. If your contract doesn't require you to annuitize, you could leave your funds invested indefinitely. You may have the option to take one-off withdrawals and/or designate a beneficiary to receive the money when you die.

If you do annuitize, the income you receive is calculated from:

• The accumulated funds you have in the annuity.
• How those funds are invested.
• How long your income payments will last. You can structure the income stream to last for the rest of your life or for a set duration, such as 20 years.
• Whether you have optional features like an inflation adjustment.

People buy annuities primarily for two reasons: tax-deferred earnings and guaranteed income.

• Tax-deferred earnings: The funds in your annuity will earn either a fixed interest rate or grow in lockstep with underlying investments. The resulting income has no immediate tax consequences. Much like a 401(k), you don't pay taxes until you receive payments from your annuity.
• Guaranteed income: Once you annuitize, the insurer is contractually obligated to make your income payments. If the insurer goes bankrupt, your state's guaranty association should cover at least $250,000 of your annuity benefits. Check with your state for the rules that apply to you.

Skeptics argue that these benefits are watered down by the complexity and expense of annuities.

• Insurers use complex calculations to convert a lump sum of funds into income payments. This makes it hard to understand your real rate of return.
• Annuities may charge administration fees, investment fees, commissions, mortality fees, surrender fees, underwriting fees, and distribution fees. These can add up to more than 3% annually or more if you withdraw funds or surrender your contract.

Dividends: Dividend stocks could also generate lifelong income. Unfortunately, this is not guaranteed. A company always has the option to lower, suspend, or cancel its dividend.

The good news is that some dividend stocks are more reliable than others. Dividend Aristocrats® (the term Dividend Aristocrats® is a registered trademark of Standard & Poor’s Financial Services LLC), for example, are companies that have paid and increased their dividends for 25 or more consecutive years. There's also a group of 50-year dividend increasers called Dividend Kings.

Dividend Aristocrats and Dividend Kings don't guarantee dividends, but they won't be quick to cancel a dividend, either. If you can handle some risk, these stocks are suitable options for retirement income.

Relative to annuities, dividend stocks have more uncertainty but greater income potential. You'll earn the dividend income, plus your stocks should also appreciate over time.

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The premium for guaranteed income

A retirement annuity guarantees income for a specific duration or for the rest of your life. That guarantee can be comforting, especially if you're worried about outliving your savings. A big downside is that annuities charge a premium for the peace of mind they provide.

Fortunately, you don't necessarily have to choose between an annuity and other income strategies.

Your retirement plan can incorporate multiple income sources -- an annuity, a strategically timed Social Security benefit, plus dividend income, for example. Diversifying in that way can soften the drawbacks of each income source, including your annuity's fees and the uncertainty of a dividend portfolio.

A retirement annuity provides guaranteed income in your senior years. That may sound like a solution you need -- particularly if you don't know how long your savings will last. But, like any financial strategy, annuities have their drawbacks. To avoid unpleasant surprises later, it's smart to evaluate the pros and cons before you lock up your cash in an annuity.