What is an Annuity?

When it comes to retirement, securing a steady income stream is a top priority. One popular option for many retirees is an annuity. But what exactly is an annuity, and is it the right choice for your retirement plan?

What is an Annuity?

An annuity is essentially a contract between you and an insurance company where you make either a lump sum payment or series of payments in exchange for regular disbursements, starting either immediately or at some point in the future. These payments can continue for a fixed period or the rest of your life, ensuring a consistent income stream during retirement.

Types of Annuities

There are several types of annuities, each tailored to different needs:

Fixed Annuity

A fixed annuity provides a guaranteed payout at a fixed interest rate. It’s one of the most predictable and stable types of annuities. With a fixed annuity, the insurance company guarantees both the principal and a minimum interest rate, ensuring steady income during retirement. This is a popular option for those looking to avoid market risks and seeking a reliable source of income. Fixed annuities are often chosen by retirees who want to protect their savings from volatility and prefer a low-risk investment.

Variable Annuity

A variable annuity differs from a fixed annuity in that the payout is not guaranteed and depends on the performance of underlying investments, typically mutual funds. This option offers the potential for higher returns compared to fixed annuities, but it also comes with more risk. If the investments perform well, the payments increase, but if they don’t, the payout can decrease. This option is more suitable for retirees who are willing to accept some level of risk in exchange for the possibility of higher income. It also provides the benefit of tax-deferred growth.

Immediate Annuity

With an immediate annuity, you begin receiving payments almost right after you pay a lump sum to the insurance company. It’s a great option if you’re near retirement or have just retired and want to convert a portion of your savings into a steady stream of income. Payments typically start within a year of the purchase. The main benefit of an immediate annuity is that it provides a reliable income stream for the rest of your life or a set period of time, depending on the terms you choose.

Deferred Annuity

A deferred annuity allows you to start receiving payments at a later date, usually after a period of several years, which gives your funds time to grow. This type of annuity offers tax-deferred growth, meaning you won’t pay taxes on the money until you begin to receive payments, typically in retirement when you might be in a lower tax bracket. Deferred annuities are ideal for individuals who want to invest now but don’t need income immediately. The deferral period allows for compound growth, which can lead to a larger payout down the road.

Why Consider an Annuity?

Annuities are popular because they provide a reliable source of income, which can be critical in retirement. They can protect against the risk of outliving your savings (longevity risk), and certain annuities even offer inflation protection. However, annuities come with their own set of fees and restrictions, so it's essential to choose wisely.

The Role of Annuities in Retirement Planning

Annuities can be a powerful tool for retirement planning, especially when combined with other income sources like Social Security or rental properties. If you're unsure how much you'll need to sustain your lifestyle, using our Retirementize online income calculator can help you understand how annuities fit into your overall strategy.

What Experts Say About Annuities

Experts have a range of opinions on annuities, often shaped by individual financial goals, market conditions, and the variety of annuity products available. Let’s explore what financial professionals, economists, and retirement planners have to say about annuities:

Guaranteed Income & Security

Many experts agree that annuities provide a unique benefit: guaranteed income for life, which is especially valuable during retirement. Financial planners often recommend annuities to retirees who are concerned about outliving their savings. Nobel laureate economist William Sharpe, who has done extensive research on retirement, advocates for the use of annuities as part of a retirement strategy for longevity risk (the risk of outliving your savings).

Similarly, retirement expert David Blanchett from Morningstar highlights that fixed annuities can offer much-needed stability in uncertain times, especially for risk-averse individuals. He notes that retirees benefit from the predictable payouts and protection from market volatility that fixed annuities provide.

Annuities vs. Investments

However, not all experts believe annuities are the perfect solution. Some financial advisors are wary of the high fees associated with certain products, particularly variable annuities. Experts like Suze Orman have cautioned investors to carefully consider the costs and commissions before buying an annuity, especially products with complex fee structures. Orman often suggests focusing on low-cost fixed annuities or deferred annuities for those who are interested in guaranteed income, but recommends steering clear of annuities that come with layers of charges that erode returns.

Ken Fisher, a prominent financial expert, is a vocal critic of annuities. He often highlights that annuities can be a poor choice for wealth-building compared to traditional investments like stocks and bonds. Fisher argues that retirees should be cautious of locking up funds in annuities, as they limit flexibility and can offer lower returns over time than well-managed investment portfolios.

Longevity Insurance

Economists often view annuities as a form of longevity insurance. Experts like Moshe Milevsky, a finance professor at York University, emphasize that annuities can hedge against the financial risk of living too long. He notes that while investments like 401(k)s and IRAs are designed to grow wealth, annuities play a different role: providing guaranteed income when savings might otherwise be depleted.

In this context, annuities can be particularly valuable for those who don’t have access to a pension or sufficient Social Security benefits. Milevsky suggests that incorporating an annuity into a diversified retirement plan can ensure a stable income stream that lasts throughout retirement.

Inflation Concerns

One concern many experts raise about annuities, particularly fixed annuities, is that they often do not account for inflation. While your payout remains the same, the purchasing power of that income may decline over time. Economist Laurence Kotlikoff points out that retirees need to think carefully about how inflation could impact their standard of living over a 20- or 30-year retirement. He recommends considering inflation-adjusted annuities, which offer payments that increase with inflation, though these can be more expensive.

Tax Deferral Benefits

For those who aren’t ready to start withdrawing money, deferred annuities offer a key advantage: tax-deferred growth. Experts frequently mention this benefit when discussing annuities in the context of retirement planning. Tax expert Ed Slott has highlighted that annuities allow you to delay paying taxes on your earnings until you begin receiving distributions, making them a useful tool for long-term planning.

However, experts also caution that the tax advantages of annuities come with limitations. While tax deferral can be beneficial, financial professionals like Ric Edelman remind clients to consider how withdrawals from annuities may be taxed as ordinary income rather than capital gains, which can lead to higher tax bills in retirement.

Annuities as Part of a Broader Retirement Plan

Most experts suggest that annuities can be a valuable component of a diversified retirement plan, but they shouldn’t be the sole strategy. The consensus is that a balanced approach—combining annuities with investments in stocks, bonds, and other assets—can offer both income security and growth potential.

For instance, the "bucket strategy", endorsed by financial planner Christine Benz from Morningstar, involves dividing retirement savings into different "buckets" for near-term spending, mid-term goals, and long-term growth. In this model, annuities could form part of the "near-term" bucket for guaranteed income, while other investments would serve growth-oriented goals.

Conclusion

Annuities are a powerful tool for those who seek financial security in retirement. Whether you're looking to supplement other income sources or want a guaranteed income stream, annuities can provide peace of mind. However, it's essential to evaluate all options carefully and consider fees, restrictions, and your personal financial goals. Don’t forget to check out our Retirementize tool to calculate how an annuity could enhance your retirement income strategy.

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