What an Annuity Is and Why You May Need One

Planning to retire someday? Worried about how you'll support yourself? How does guaranteed income for a period of time -- such as 20 years or perhaps the rest of your life -- sound? Deploy some of your retirement savings into an annuity or two, and you can create a reliable income stream in retirement.

Here's a look at fixed annuities, deferred annuities, indexed annuities, and variable annuities -- and why you might or might not need them. 

Image source: Getty Images.

What is an annuity?

An annuity is essentially a contract between you and an insurance company. You make one or more payments to the company and in return you receive payments -- starting now or later. The payments 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 the payouts last through the life of a spouse who survives you and/or be adjusted to keep up with inflation over the years.

Some annuity buyers end up dying before they collect what they spent on their annuity, while others live long enough to collect much more than they paid. 

Kinds of annuities

There's more to annuities than the brief description above, of course. For starters, annuities come in a wide variety. Some start paying you immediately, while others, called deferred annuities, start paying you at some point in the future -- say, in 10 or 15 years. Some annuities are referred to as "fixed," paying you a certain sum regularly, while variable" annuities tie their payment amounts to the performance of the stock market or some other measurable securities index. Some annuities will keep paying you for a certain period, such as 10 or 20 years, while others will pay you for the rest of your life -- and, if you've arranged it so, they'll keep paying until both you and your spouse have passed away. Those characteristics aren't necessarily exclusive, either: Fixed-payment annuities come in immediate and deferred form, for example, and they can pay you for a fixed period or for the rest of your life. 

Some annuities, such as indexed annuities and many other variable annuities, are problematic and unsuitable for many people, featuring steep fees and/or restrictive terms, among other downsides. So read the fine print and ask a lot of questions before buying them.

The best bet for many people who want to set up retirement income is one or more fixed annuities, of the immediate and/or deferred variety.

Here's a closer look at key types of annuities.

Fixed annuities

Fixed annuities are best for many, if not most, people, and they're the simplest kind of annuity to understand, too.

While variable annuities offer income that's tied to the performance of the stock market and will therefore fluctuate, fixed annuities offer fixed income. The payments you will receive are spelled out ahead of time, based in part on prevailing interest rates at the time that you purchase the annuity.

To get an idea of just how much money a fixed annuity might send your way, check out the table below.  Different insurers will offer different sums, and the prevailing economic environment can influence payouts as well. 

Data source: immediateannuities.com. The couple examples assume that both spouses are the same age and the examples in this table are for opposite-sex couples.

Men will generally be offered higher payments than women, because women tend to live longer, requiring the insurance companies to pay them for a longer period. 

Deferred annuities (a.k.a. "longevity insurance")

The examples above are for immediate fixed annuities, but you should also consider deferred fixed annuities, which will start paying you after a specified period (such as 10 years). Both immediate and deferred annuities can pay you for the rest of your life, helping you not run out of money, but the deferred annuity can do so in a more targeted way. For example, if you're pretty sure your retirement savings will carry you at least until age 85, you could buy a deferred annuity that starts paying you at age 85, removing any danger of your running out of funds after that age. You'll be promised much bigger checks, too, if you buy that policy 10 or 20 years before you need it to kick in. 

Here are some recent quotes for deferred annuities:

Source: immediateannuities.com.

In this example, a 65-year-old woman would spend $100,000 for an annuity that will start paying her $1,029 per month for the rest of her life beginning in 10 years. That's more than she'd get from an immediate annuity for a good reason: With deferred annuities, you're paying the insurer ahead of time and it gets to hang on to your money for quite a while before having to start paying you. So, it can invest that money and make money from it. Also, it will have fewer payments to make to you than with an immediate annuity, since it starts to pay you when you're older.

If you're wondering about taxes, know that they can be a bit complicated when it comes to annuities. Be sure to look into how taxes would work with any annuity product you're considering. Generally, though, know that if you buy an annuity within a tax-deferred retirement account such as an IRA or 401(k), using money in the account that was contributed on a pre-tax basis, your annuity payments will likely be taxable income -- because that money was never taxed.

If the annuity was purchased outside of a tax-deferred retirement plan, such as if you bought it directly from an insurer, then only part of the payments are likely to be taxed. In the eyes of the IRS, you bought the annuity with post-tax money, so payments from that principal won't be taxed. But that money, paid to the insurer, generates earnings -- which have yet to be taxed. Your payments are typically based on money from both your purchase price and its earnings, so it's common for there to be a taxable component of your payments, based on the portion of the payments tied to earnings. 

Image source: Getty Images.

Variable annuities

No less an authority than the Securities and Exchange Commission has cautioned investors about variable annuities. It has said, specifically: "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." 

What are variable annuities, though, and why might people buy or avoid them? As you might have guessed, variable annuities are variable -- the payments they issue fluctuate in relation to how the overall market or some other economic measure is performing. A variable annuity will typically feature an "accumulation phase," during which you're making payments to the insurer that are invested and, ideally, grow in value, followed by a "payout phase," during which the insurer sends payments to you. You generally get to decide how the money in your account is invested, and it's often put into stock and/or bond mutual funds.  

Variable annuities can give you more control than fixed annuities, letting you choose how the money in your account is invested -- conservatively or aggressively or somewhere in between. That's great if your choices lead to large payments, but the stock market doesn't always behave as we think or hope it will, and you may end up receiving less than you want or need.

An upside of variable annuities is that the money you've invested in them grows without being taxed. It's taxed later, when you withdraw funds. (You can get this feature from traditional IRAs and 401(k)s, too. You'll get a different kind of tax break with Roth IRAs and Roth 401(k)s: Your investments in them are made with post-tax money, and they grow in the accounts free of taxes and are even free from taxation when you eventually withdraw them.)

Many variable annuities feature a "death benefit," which involves your designating a beneficiary who will receive some kind of payment if you die before you've received all or a certain portion of the payments you were due from the annuity. 

A primary knock against many variable annuities is their fees. A variable annuity generally charges "mortality and expense risk" fees, along with administrative fees. (Mortality and expense risk fees are meant to compensate the insurer for insurance risks taken on, such as the policy holder dying unexpectedly early and triggering death benefits if those are part of the policy. The fees ensure that the company will be able to fulfill its contractual obligations.) Mortality and expense risk fees are typically around 1.25% per year, while administrative fees are often around 0.25% per year. Fees are also charged related to the investments in your account: If you're invested in several mutual funds, for example, they will be charging administrative fees of their own and those are often around 1% to 1.5%. Add all those example fees together, and you're looking at 2.5% to 3% in annual fees, which is a big chunk to be regularly removing from your account.   

To appreciate the effect of all those fees, imagine that you have $100,000 in a variable annuity and that it's costing you 2.75% annually in fees. That's $2,750 per year. If you anticipated average annual growth of, say, 6% for your variable annuity, the fees would knock down that growth rate to just 3.25%. At an annual rate of 6%, a $100,000 account would grow to $320,714 over 20 years, but it would only total around $189,584 growing at 3.25% -- those fees would have cost you more than $130,000!

Indexed annuities

The indexed annuity is a problematic kind of annuity, sometimes referred to as a fixed indexed annuity or an equity indexed annuity or something like that. Indexed annuities have some similarities to variable annuities, such as having their payouts tied to the performance of an index -- typically a stock market index, such as the S&P 500.  

Indexed annuities are sometimes aggressively sold by salespeople who promise buyers that they'll have no chance of losing money or that they'll receive a guaranteed minimum return. That can sound great, but there's a catch: While the amount you can lose is limited, so is the amount you can gain. 

A closer look at indexed annuities will reveal why you may want to avoid them. First, understand that they feature a "participation rate" that reflects how much of the underlying index's return you'll get in your investment's return. For example, if your indexed annuity is tied to the S&P 500, the S&P 500 advances 10% in a given year, and your participation rate is 100%, your return would be 100% of that 10%, or 10%. But if your participation rate is just 80%, your investment would grow by only 80% of that 10% -- or 8%.  

Next, indexed annuities also often cap your upside, and caps range from around 3% or 4% to as much as 15% or so. So, if the indexed annuity's benchmarked index rises by, say, 10% one year, your gain would be subject to that cap. If the cap were 4%, you'd only get a 4% gain, while a 15% cap would allow you all of that 10% gain. Remember, though, that many years see gains of 20% or sometimes much more, and in those big years, your gains would be limited, probably significantly. If the cap is, say, 7%, then even in a year when the S&P 500 surges 20% or 30%, you'll earn no more than 7%. Indexed annuities also often feature annual fees, which subtract even more from your gains. 

It's quite reasonable to want to tie your investment's growth to a broad-market stock index such as the S&P 500, but you don't need an indexed annuity for that. You can instead simply invest your money in a low-cost index fund that tracks the S&P 500, such as the SPDR S&P 500 ETF, an exchange-traded fund. Annual fees for S&P 500 index funds can be as low as 0.10%, and are sometimes even lower. Your downside won't be limited as it is with an indexed annuity, but know that the stock market tends to go up much more often than it goes down, and even after big crashes, it has always recovered and eventually gone on to hit new highs. 

Image source: Getty Images.

Why an annuity makes sense

Although there a lots of angles to be aware of, it's well worth considering an annuity for your retirement -- for several reasons:

• Stability: Annuity income will arrive regularly and on schedule, thus giving you less stress than investments in the stock and/or bond markets, which will be more volatile. If you have, say, 10% of your net worth in a stock and it tanks, you'll take a significant hit. The whole market can head south, too, occasionally by double digits, and it can stay down for some years. With fixed annuities, you don't have to worry about how any market is doing. (By the way, if the unthinkable happens and your insurer goes out of business, all may not be lost. Each state has an agency overseeing insurers that will likely be able to mitigate losses.) 
• End-of-life protection: Lots of people are living well into their 90s and beyond, and that's generally a good thing. But it does increase the possibility that they'll run out of money before they die, as retirement coffers are usually not as plump as we'd like them to be. With an annuity, you'll be guaranteed regular income -- for the rest of your life, if that's what you signed up for.
• No attention needed: Finally, annuities require little of you once you buy them. You won't have to be studying the stock market or following much business news. As we age, that's something many people don't have the interest or skill to do. It's a fact: Many people experience cognitive impairment as they age.

Annuity strategies

If you're considering buying one or more annuities, here are some strategies to keep in mind:

• If possible, consider paying a little more (or accepting a little less income) in exchange for having your payouts adjusted for inflation. This is particularly valuable if your annuity might last for several decades, during which time inflation can significantly shrink the buying power of the payments.
• If you're married, consider buying one or more joint annuities instead of separate ones for each of you. It's true that you'll likely get less total income per month spending $200,000 on a joint annuity than if you each bought a $100,000 annuity. But remember that when one spouse dies, a joint annuity will keep paying the full amount to the survivor, whereas the other strategy will leave the survivor with only his or her own annuity income.
• Consider interest rates, because insurers will offer less income in times of low rates and more when rates are high. You might, therefore, delay buying any annuities until rates rise. That offers the added benefit of your being older when you buy the annuity, meaning you'll be offered greater income as it will be expected to be needed for fewer years. Another option, especially if you'd rather set up at least some annuity income now, is to use the "laddering" strategy. With that, you divide your total planned annuity purchase into chunks and buy installments over time.
• Only buy from highly rated insurers. Remember that an annuity is only as sound as the insurer that sells it. It's guaranteed income as long as the insurer is solvent. So, don't just buy from any company. You might even split your purchase between several insurers, to reduce your risk. You can find out how an insurer is rated by calling and asking it or by using a search engine to look for its name along with the name of a rating agency. Ratings vary by rating agencies, though, so you can use the following table to help you make sense of the top ratings from the major agencies.

Data source: Securian.com. 

• Finally, give deferred annuities special consideration. You might not want to spend a lot on immediate annuities if you have a sizable nest egg and believe it can support you through retirement, but if you buy a deferred annuity that will start paying at, say, age 85, it can provide a little extra support in case your funds are running low late in life. You might even want to buy the deferred annuity while you're still relatively young, as it will pay you more if there's a long period between the purchase and payouts starting.

Alternatives to annuities

There are alternatives to annuities, of course, and annuities needn't make up all of your retirement income. A pension, for example, should deliver similarly reliable income, if you're lucky enough to have one. And most of us will have Social Security income coming to us in retirement, though it may not offer as much income as you think it will. The average monthly retirement benefit check was recently $1,472 -- or about $17,666 per year. That's clearly not a lot, and while you'll get more than that if your earnings were above average, there are some ways to increase your Social Security benefits further as well. So, consider those.

You may well have IRA and/or 401(k) accounts, too, and perhaps some regular, taxable brokerage or savings accounts to tap. You can generate annuity-like income from a portfolio of bonds that pay interest and/or stocks that pay dividends. Many healthy and growing companies have stocks with dividend yields of 3% or more, and some such stocks occasionally have yields topping 5%. Even an index fund based on the S&P 500 offers a dividend payout. It recently yielded about 1.85%. Here are some well-regarded stocks with significant dividend yields:

Data source: Yahoo! Financial.

If you've spread $300,000 across a handful of solid dividend payers with an average overall yield of 4%, you can expect to collect $12,000 each year, which would be $1,000 per month. Better still, you can expect that payout to increase over time, as healthy and growing companies regularly hike their dividends. That offers the added benefit of income that can keep up with inflation. Remember, however, that dividends are never guaranteed. If a company falls on hard times, it can reduce, suspend, or eliminate its dividend. Thus, dividend investors should spread their dollars across a bunch of strong companies and plan to keep an eye on their holdings.  

Annuities may not be for everyone, but they can serve many retirees very well. Spend some time thinking about what income you expect in retirement and how you want to structure it. You might draw dollars from a handful of sources, such as Social Security, your savings, dividends, and/or an annuity or two.