Future retirees have a lot to look forward to. Besides traveling, spending time with family, or picking up new hobbies, the number of U.S. centenarians increasing from 53,000 in 2010 to over 90,000 in 2020. In addition, we’re likely to see 130,000 Americans celebrate their 100th birthday by 2030, according to the U.S. Census Bureau.
Considering that, what does it mean for how we fund retirement?
It’s essential to invest in a nest egg that will last us a lifetime, as we have a lifetime ahead of us and more passions to pursue. With that said, the right retirement annuity can help you prepare for a long and fulfilling life in retirement.
What Are Annuities?
Annuities are contracts between you and an insurer guaranteeing lifetime income after retirement. You can pay the insurer a lump sum or a series of premium payments in exchange for retirement income payments. You will begin to receive those payments based on when you plan to retire and what type of annuity you purchase.
Investing in annuities can help you ensure that you will not outlive your money when planning your retirement income. Regular payments are also convenient since once you choose your annuity, the payments will be made according to your contract terms.
Annuity contracts have two stages.
- During the accumulation stage, you will save for retirement and potentially grow your funds as you build your annuity’s cash value.
- When you’re ready to begin spending the money in retirement, you’ll begin the distribution phase. In annuities, this is called annuitization. But, it’s simply converting the annuity into regular payments.
Depending on the type of annuity you purchase, you will build retirement funds and cash value (accumulation) and convert those funds into guaranteed income (distribution).
Payout Options for Annuities – When and How Long You Receive Payments
Annuities can be defined as immediate or deferred payments, depending on their payout options. Basically, these describe how you’ll get your annuity income after you pay your premiums.
Immediate Annuity
For people who need a regular income stream in retirement right now, immediate annuities are the best option. After receipt of the investment, payments begin within one to twelve months.
Owners pay the insurance company a lump-sum amount (premium) to guarantee monthly payments to the annuitant for the rest of their lives or for a specified period. Due to the inclusion of principal and interest, payments are typically higher than other annuities, offering a favorable tax treatment.
Purchasing an immediate annuity can supplement Social Security and pension income, which are rarely sufficient to cover retirement expenses. It can also help to pay for healthcare premiums. Additionally, these are popular among retirees and pre-retirees who need a lifelong income stream that is higher than average but are willing to sacrifice the principal.
Deferred Annuity
Deferred annuities are short-term investment products offered by life insurance companies to help people prepare for retirement. These annuities offer tax-deferred growth over time, making them attractive to people who value the ability to grow their capital over time.
Basically, these are for people who want to create a ladder of income over time rather than a guaranteed income now. As an example, they could desire to work in retirement. But know that eventually, they will stop working and will need annuity income at that point.
Until retirement, they “defer” the steady flow of income. During times of low-interest rates, they are attractive alternatives to traditional bank savings products because they tend to offer higher interest rates.
Rates on deferred annuities are usually locked in for a specified period, known as the guarantee period. These periods typically last one, three, five, or seven years. Therefore, deferred annuities can be a good choice in times of stock market volatility due to the rate guarantees.
Also, they offer excellent protection. And, to sweeten the pot, the growth of assets is also earmarked for future healthcare expenses.
How Long Annuities Are Paid by Type
Lifetime Annuity
In many ways, a lifetime annuity functions as a personal pension plan. The reason? They provide lifetime income and are sometimes referred to as “single life,” “straight life,” or “non-refund.” However, additional payments can be made for a spouse or dependent. In this case, the annuity is known as “Joint and Survivor.” This annuity generally provides income for life, although some may offer payments for a specified period of time.
In retirement, a lifetime annuity can be used as a supplement to Social Security checks, 401(k) plans, or pension funds provided by companies. Even after the money you contributed to the annuity is exhausted, you can still receive income from it for the rest of your life.
They may be useful for you if you wish to establish a regular and guaranteed income stream. Your beneficiaries will receive the payment option you chose when you purchased the annuity if you pass away before all the funds have been used up. In some cases, you may not be able to distribute anything to your dependents or other beneficiaries. As a result, you will receive an income you cannot outlive.
A straight life annuity can make sense for you if you don’t intend to use the money invested for dependents or other beneficiaries.
Fixed-Period Annuity
Fixed-period annuities, or term-certain annuities, payout for a specific period of time. Payments from this type of annuity are spread out over a fixed period. In other words, you get payments for a specified period with this option.
Regardless of whether you’re still alive, you won’t get payments after that. This contrasts with lifetime annuities, where payments are made throughout your lifetime. Time periods can range from five to twenty years or even longer.
There are no health or age restrictions on annuities like these. However, fixed-period annuities earn little to no interest. In addition, you may outlive the fixed period, which is the biggest risk.
Annuities by Growth – How Your Annuity Will Grow
There are three main types of growth annuities: fixed, variable, and fixed indexed. Annuities of this type allow you to preserve your investment while gaining higher returns.
Fixed Annuity
The simplest type of annuity is the fixed one. If you agree to a specific length of the guarantee period, the insurance company will guarantee a fixed interest rate on your investment. For example, the interest rate could last for a year or the whole duration of your guarantee.
If your contract is over, you can either annuitize it, renew it, or move your money into another retirement account or annuity.
Your monthly payments will be exactly the same because fixed annuities are based on a guaranteed interest rate, which does not fluctuate based on market volatility. However, your payments will also not keep up with inflation if there is a potential upswing in the market. Therefore, annuities should not be used for retirement income generation but for growing income during the accumulation phase.
A fixed annuity has the disadvantage that it is guaranteed to earn a lower minimum rate of return than its counterpart. However, it also has a maximum rate of return.
Multi-Year Guaranteed Annuity (MYGA)
MYGAs are types of fixed annuities that are guaranteed for a specified period. It offers a fixed interest rate for a specified period – usually three to 10 years. In general, MYGAs are most suitable for retirees looking to defer taxes while ensuring a return.
Variable Annuity
Variable annuities are tax-deferred annuities that combine the benefits of a 401(k) plan and an annuity contract that guarantees an income for a lifetime. In time, you may be able to keep up with inflation or even surpass it with your sub-accounts.
The performance and risk of sub-accounts are similar to those of mutual funds. Therefore, you will receive a higher payment if your subaccounts do well or a smaller payment if they do not. In addition to a death benefit, variable annuities also offer an income rider that guarantees income to your beneficiaries as well.
Suppose you’ve maxed out your Roth IRA or 401(k) contributions and would like the security and comfort that comes with guaranteed income. In that case, a variable annuity can be a great addition to your retirement income plan.
Again, this type of annuity can be risky due to the performance of selected investments. And, it can have high fees compared to other types of annuities.
Fixed-Index Annuity
Essentially, these are fixed annuities with a variable interest rate added to your contract value if the underlying market index, such as the S&P 500, rises. As a result, they often provide a market-driven upside possibility and a guaranteed minimum income.
The downside is the limitation of upside potential by participation rates, caps, or spreads – all ways to reduce your return on a rising market. Due to this, buyers of these annuities cannot keep up with market changes.
In addition to providing principal downside protection, these products appeal to retirees and pre-retirees who want to participate in potential market gains conservatively.
One more thing. Your annuity payments are calculated based on interest rate risk. A low level of risk yields predictable payments. On the flip side, expectations could be boosted by higher risk.
Annuities by Premium – Which is Best for You?
Deferred annuities can be purchased with a lump-sum premium or in installments.
Flexible-Premium Annuity
You can purchase a flexible premium annuity by paying premiums over time. These are only available as deferred annuities, in which you make payments over a long period and receive a payout later. Depending on the annuity company, you may be given the option to contribute without following a schedule or making minimum payments.
Single premium immediate annuity (SPIA)
In less than 12 months, you can begin collecting a steady income stream after making a single lump-sum payment. Alternatively, it is known as an income annuity or immediate annuity. People near retirement prefer them, accounting for only about 10% of annuities sold annually.
Other Annuity Choices
Besides the most common types, there is a wide variety of annuities. Again, you can customize these to suit your specific needs and long-term financial goals.
In addition to traditional IRAs and 401(k) plans, qualified retirement accounts offer tax breaks. And the payment of an annuity can also be continued after your death if you choose to do so.
- Life-only annuities. Also known as single life annuities or straight life annuities, these pay a lifetime income to the owner alone. However, they do not pay income to a spouse or other beneficiary.
- Long-term care annuities. If you need long-term care in the future, these are tax-deferred annuities with a rider.
- Life annuities with period certain annuities. For a set period of years, these provide lifetime income. Any remaining payments will be made to your spouse or other beneficiaries upon your death.
- Joint and survivor annuities. So long as one spouse is alive, these make monthly payments.
- Group annuity contracts. Employees receive these benefits as part of their retirement benefits.
Finding the Right Annuity Type for You
Every annuity type has its own pros and cons. Depending on your current financial situation, different types of annuities may be better suited to helping you achieve your long-term financial goals. Additionally, factors like years until retirement, risk tolerance, and retirement goals must be taken into account.
The number of years until retirement.
Investing in a deferred annuity may be the best option for those who don’t require current income and wish to accumulate money tax-deferred. Annuities with deferred payments come in several varieties, including fixed, fixed-deferred, and variable.
With deferred annuities, you can accumulate significant assets before retiring. The type of deferred annuity you choose will depend on how much risk you can tolerate.
Tolerance for risk.
To determine your annuity risk tolerance, you should consider two main factors: How close you are to retirement and how much money you currently have. A person near retirement has a lower risk tolerance than someone who isn’t planning to retire anytime soon. The best bet in this situation may be a fixed annuity.
On the other hand, a variable annuity may be a better option for you if retirement is a distant dream, as you have more time to recoup losses. Furthermore, you may not want to risk your assets in a high-risk annuity if you have low-to-moderate assets.
A variable or fixed indexed annuity might be the right option for adventurous investors with enough money.
In either case, you should define your retirement goals and understand your risk tolerance before purchasing an annuity.
Retirement goals.
Your retirement goals might be the most important factor when choosing an annuity. For example, fixed immediate annuities are ideal for those who prefer to live at home and want to cover basic living costs with a guaranteed income stream in retirement.
For world travelers with significant assets, you may want to defer payouts to let your money earn while you travel. You may benefit from a variable deferred annuity if that is the case.
As you begin your retirement journey, there are annuities available that can meet your specific needs. However, it is possible to compare several different annuities with a financial professional’s help to determine which is best suited for your needs.
FAQs
1. Why buy an annuity?
As an immediate payment (lifetime annuity), annuities can guarantee a lifetime income stream. There aren’t many financial instruments that can offer this kind of value.
You can accumulate funds tax-deferred when you purchase a deferred annuity. Annuities can offer rates of return that far exceed those of savings accounts and CDs. Annuities are a smart investment choice for diversified portfolios due to their tax deferral benefits and guaranteed lifetime incomes.
2. In what ways are annuities classified?
In terms of annuity types, there are several ways to categorize them. An example is the types of annuities based on payout, growth, and premium options. When buying annuities, people tend to consider these factors the most important.
3. What are the main types of annuities?
Annuities can be paid out immediately or deferred, depending on how you want to receive the money.
- When you pay a lump sum premium for a single premium immediate annuity (SPIA), a steady income stream is immediately generated.
- With deferred annuities, you can pay premiums over time while receiving payments months or years in the future.
Annuities that grow over time are called growth annuities.
- Your contributions are guaranteed a fixed interest rate over a certain period with fixed annuities.
- A variable annuity pays a return based on the performance of its subaccounts – the funds invested with your premium payments.
- Market indexes such as the S&P 500 and Dow Jones Industrial Average are used to calculate fixed-indexed annuity payments.
The type of annuity you choose can also depend on how you want to pay your premiums.
- The amount and frequency of premium contributions can be adjusted with a flexible premium annuity.
- In a single premium immediate annuity (SPIA), a single premium is required, and payments begin immediately.
4. What is the best type of annuity product?
There is no one-size-fits-all annuity. Annuities should be chosen based on your current financial situation and long-term financial goals. In order to find the annuity that best fits your goals and needs, you must compare different annuities. When choosing an annuity, you should consider how you will pay, what kind of growth and payout you are looking for.
5. How do you fund your annuity?
Annuities can be purchased using qualified or non-qualified funds.
A qualified annuity can be purchased with pre-tax dollars. In other words, this is income that hasn’t been taxed yet. An individual retirement account (IRA) or 401(k) is the most common source of these funds.
Also, IRS-mandated required minimum distributions (RMDs) apply to qualified annuities. At 72, qualified annuity owners must begin receiving distributions from their accounts. Alternatively, you can use non-qualified dollars to fund your annuity.
In the case of non-qualified annuities, they are post-tax. So your annuity will be funded with income you’ve already paid taxes on, perhaps from savings accounts or CDs.
In relation to non-qualified dollars funded annuities, there are no restrictions regarding when you must take distributions.
