You may have heard the term “annuity” bounced around here and there. And the truth is, you may only hear the term from older adults close to retirement, which means annuities may be the furthest from your mind at this stage.
Do you think it’s too early to consider annuities as a retirement solution for yourself? If so, you may want to think again. Why? Because you’re never too young to start thinking about what your retirement will look like. If you’re really serious about planning a comfortable retirement, you may want to give annuities a look – even now.
What Are Annuities?
An annuity is a financial instrument issued and backed by a life insurance company to provide guaranteed income payments to its owners for a set period or life. Regardless of market conditions, annuity payments are paid out monthly to their owners and can be left to a beneficiary after death, just like life insurance payouts.
Why Buy Annuities?
Most people buy annuities to have income in retirement. Just as social security provides a monthly income stream to retirees, so do annuities. Unlike social security payments, which are based on your time in the workforce, annuities are more intentional. They have to be purchased.
Annuities can be purchased over time with a series of payments like insurance premiums, or the purchase can be made in a one-time lump sum. Annuities are a great way to ensure an income in later life.
How Soon Do Annuities Pay Out?
There are two different ways annuities pay out: immediate or deferred. Which one you purchase determines how you get paid. Knowing the type of annuity best depends on your financial situation and goals.
If you want to begin receiving annuity payments immediately, you would make a lump sum payment. Just as insurance payments require payments, a lump sum payment of an annuity is considered a single premium payment. A one-time lump sum annuity can guarantee income for the rest of your life. A Single Premium Immediate Annuity (SPIA) skips the accumulation phase (monthly payments) and begins paying out income within a year after you have purchased it.
Deferred annuities are acquired by making monthly premiums toward the annuity purchase. Deferred payments must accumulate over seven to ten years before the payout starts so that the principal can build on it. The rate at which an annuity grows is based on several factors in the different annuities.
What Are the Different Types of Annuities?
The type of income you have from your annuity depends on the growth of your annuity during the accumulation phase. When you purchase an annuity, you have some input in that growth by choosing one of the three types of annuities:
When you purchase a fixed annuity (immediate or deferred), you’re purchasing an annuity with a fixed rate of return regardless of the market. If the market falls, you’ll still get your fixed rate. However, if the demand increases, you will still be limited to receiving your fixed rate. While fixed rates protect you against a volatile market, it doesn’t protect you against inflation.
Fixed annuities are the most straightforward type of annuity to purchase. They eliminate the guesswork and are reliable forms of income. Fixed annuities also have the lowest fees.
Indexed annuities offer a hybrid effect of the stock market. It provides a minimum guaranteed (fixed) interest rate combined with rates tied to the stock index, like the S&P 500 or the Dow Jones Industrial Average. If you enjoy investing conservatively but still want a little more return to account for inflation, this option is a good one. It gives protection against market losses and profit from the market gains.
Variable annuities are usually investments in sub-accounts of stocks, bonds, money market instruments, or a combination. Although they have greater potential for earnings, they can also lose you the most money due to the rises and falls of the market. Less conservative investors would value this type of annuity.
What Fees Come With Annuities?
Annuities come with a cost. Not only are you paying for the annuity, but different annuity types have different fees attached. In fact, the more complicated the annuity, the more fees are associated with them. For example, fixed annuities are the simplest type and have fewer fees. However, variable annuities are riskier, more complicated, and incur more fees. While the indexed annuities are somewhere in between.
Average fees on a variable annuity can be as little as 2.3% or more than 3%. Annuities come with not just the premium, but commissions, administrative fees, and surrender charges if you withdraw from it too early, just as with 401(k) accounts. Withdrawing from an annuity before the payout period could cost you 10% in surrender fees. The surrender fee usually decreases yearly as the surrender period expires. Withdrawing money before reaching a certain age (59 ½) could also cost you a 10% early withdrawal fee.
When Should You Buy an Annuity?
Most people purchase annuities to have guaranteed income in their retirement years. Still, for that to happen, premiums need to be planned early on to ensure an adequate accumulation period. The principal and interest must build over time before the payouts start.
Annuities can be purchased by investors of any age and used for various financial goals, not just retirement. Annuities can be used for estate planning, regular income, and retirement income.
The Bottom Line
It’s never too early to start planning what your retirement years will look like. For many, being financially comfortable in retirement means planning early, and purchasing annuities can become part of that plan.
Annuities can be used for more than just retirement. If you’re wondering if an annuity could benefit your financial goals, seek the advice of a financial planner to learn if it makes sense for you. Compare multiple providers (life insurance companies, brokerage firms, banks, financial planners, and insurance agents) and investigate their track records before making a final decision.
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