What are the benefits of annuities?

If the definition of annuity is a bit fuzzy to you, you’re not alone. But if you are concerned about having enough income when you retire, it could be a smart idea to take a few minutes to understand what annuities are and how they work. We’ll answer some of the questions you probably have about annuities and help you appreciate their advantages as well as some potential downsides to consider before making this important financial investment in your future. As with all personal finance concerns, consider consulting with an advisor before making any decisions.

What is an annuity?

Simply put, an annuity is a retirement vehicle that can help provide guaranteed income – either for a set number of years, or the rest of your life (which is why it’s also an insurance contract). There are many advantages to investing in an annuity as part of your retirement strategy, alongside any contributions you make to a 401k or an IRA (Individual Retirement Account), rather than putting all your savings into one type of investment. As many financial advisors say, the key is diversification.

There are different types of annuities

All annuities are designed to take a sum of money – the principal – and turn it into a stream of guaranteed payments. But some annuities start paying income right away, and others pay benefits later, giving your principal time to grow. The type of annuity you get determines when the payout phase starts and how the principal grows until that time.

Deferred vs. immediate annuities

An immediate annuity begins to pay out income immediately after it's purchased. The investor makes a lump-sum payment to an insurance company that then provides a steady stream of guaranteed income payments for a specific period – say, 10 or 20 years – or for the lifetime of the annuity holder, depending on the terms of the contract. This tends to work well for people at or very near retirement age who have already amassed the funds they need for retirement.

A deferred annuity lets you invest in an annuity now – with a single, lump-sum payment or periodic payments over time – and start taking income payments at some point in the future (usually after you retire). Deferred annuities can give younger people an additional tax-advantaged way to save for retirement. They can be especially beneficial to those who have maxed out their contributions to other kinds of retirement accounts.

Fixed vs. variable annuities

A fixed annuity guarantees you a specific rate of return on your principal. The insurance company assumes all investment risk and guarantees both the principal and the rate of interest stated in the contract.

A variable annuity lets you invest your deferred annuity in a range of different investment options, such as mutual funds or bonds. The rate of return on a variable annuity is not fixed and will vary based on the performance of the investment options chosen. Since you are selecting the investments, you assume the investment risk, as opposed to the insurance company – and while there may be more upside potential, the value of your annuity can also decrease.

A fixed-index annuity can offer both growth guarantees and upside potential

A fixed index annuity essentially "splits the difference" between variable and fixed annuities. Principal growth is based on a specified equity-based index, such as the S&P 500, which allows for potential market gains like a variable annuity. It also provides a guaranteed minimum return, similar to (but typically lower) the guaranteed returns offered in a fixed annuity. However, the returns are usually capped, which means that if the index performs particularly well, the annuity holder may not fully benefit from all the gains. The benefit of a fixed index annuity lies in its potential for higher returns compared to fixed annuities while still providing some guaranteed growth and protection against market downturns.

A RILA or Registered Index-Linked Annuity is a new type of annuity that gives you control over growth potential and downside risk.
A RILA is for more sophisticated investors who are willing to define a maximum loss level they’re willing accept – and the more risk they take on, the greater potential for upside gains tied to their chosen market index. Since both gains and losses are capped or buffered, a RILA also offers less growth potential than variable annuity, but downside risk is reduced.

Potential advantages of annuities

Here are some of the benefits to discuss with your financial advisor:

Steady stream of lifetime income

As life expectance increases, there’s more uncertainty about how much money you will need to retire – and for how long. Having a source of guaranteed lifetime income can make it easier to budget your expenses and enjoy life in retirement.

Independent of market fluctuations

Different people have different risk tolerances. Once payments start (even with a variable annuity), you can have a fixed, guaranteed stream of income not affected by market ups and downs.

Reduced fear of outliving your savings

While retirement has its advantages, it can also be a source of anxiety for many people. Since you can’t know how long you’ll live, it’s impossible to know exactly how much savings you will need. The lifetime income from annuity payments can provide important financial assurance.

Annuity contributions are tax-deferred

The money you invest in your annuity, whether through a lump sum or periodic contributions, is tax-deferred. If you invest during your prime earning years, this could create considerable tax benefits, and while the payments you receive will be taxable, you will likely be in a lower tax bracket during retirement.

Annuity benefits may be transferrable

Depending on the specific type of annuity and terms, at least some annuity benefits may be transferable to a named beneficiary upon the death of the annuity holder. This feature is known as a "death benefit" which allows a spouse, child, or other named person to receive remaining payments and can be helpful for estate planning.

No contribution limits

Unlike some retirement savings vehicles, such as 401(k)s or (IRAs), annuities typically do not have annual contribution limits. So, for example, if you have "windfall" income from selling a property or business, you can put as much as you want into an annuity, where it grows tax-deferred until retirement.

Annuities can be customized to your needs

Annuities are highly customizable financial products, allowing you to adjust various aspects depending on your unique needs and financial goals. Review the types of annuities listed above as each provides a different level of risk, potential return, payout schedules (lump sum vs. payment schedule), along with the potential to add riders and features, such as a death benefit.

Some potential downsides of annuities

No investment is free from risk or downsides. Consider the following potential disadvantages and discuss them with your financial advisor before making the decision to purchase an annuity.

Annuities are not liquid assets

Liquidity refers to how quickly and easily an asset can be converted into cash without impacting its market value. Annuities often come with restrictions and penalties for early withdrawal. Simply put, this means when you invest in an annuity, you may not be able to withdraw funds beyond the agreed-to payment schedule without paying penalties.

Taxes are paid as you receive the money

When the initial investment (or contributions) in an annuity is made with pre-tax dollars, when you receive future payments, they will typically be taxed as ordinary income.

Annuities can have high fees

The purchase of an annuity typically includes the option to add "riders," which are optional contract revisions, for an additional fee. Mortality and expense fees (which compensate the insurance company for the risk it undertakes under the annuity contract) may also be incurred, administrative fees and more.

Annuity payments may not keep up with inflation

Unless your annuity contains a Cost of Living Adjustment (COLA), your annuity income is not protected against inflation. While the payments won’t decrease, buying power diminishes over time. Consider getting a COLA adjustment rider – an optional feature that increases payments – and can be added to your annuity contract for an additional fee.

Annuities are not considered a high-growth investment

Annuities are typically bought as a low-risk investment because they guarantee a steady income stream for life. However, the risk-limiting features of a fixed or fixed-index annuity also tend to limit the potential for growth. Conversely, a variable annuity offers greater potential returns but provides little or no investment risk protection: your principal can and will decrease when markets are down.

Premature death could leave money on the table

A lifetime annuity will keep paying as long as you are alive, with the potential to pay out far more than you paid in. However, the opposite can also happen: if you die soon after payments start, your total payments could be far less than what you paid in. But many annuities offer death benefit provisions that can provide at least partial payment to your beneficiaries – so be sure to ask about it.

How to decide whether an annuity is right for you

Every person's situation is different, but there's a simple way to determine whether to consider an annuity. First, add up all known regular expenses you'll have during retirement, then subtract other types of income that are guaranteed, like pensions or Social Security. If there's a gap, consider an income annuity as part of your retirement planning strategy, along with 401(k) plans, pensions, life insurance cash value, and other assets. After all, guaranteed income annuities are one of the only financial vehicles that can assure you that no matter how long you live, you won’t outlive your income.

Get help deciding if an annuity is right for your retirement goals

Connect with a local financial professional who can explain different options, including fixed annuities, fixed index annuities, and variable annuities, and then help you decide what makes sense for your situation.