Gone are the days of relying on your employer to provide you with a comfortable retirement. While pensions were once a staple of most retirement plans, today they're almost unheard of. Those who want a steady stream of income in retirement are now turning towards investment vehicles like annuities.
Are you wondering what an annuity is and how it can help you prepare for your retirement? Here’s what you need to know.What is an Annuity?
In simplest terms, an annuity is a contract you purchase from an insurance company. There are several different types of annuities, and each works differently. However, the basics are the same.
In exchange for paying a premium, the company provides the contract owner with a fixed or variable interest credit. The account compounds on a tax-deferred basis, meaning you won’t have to pay any taxes until you start taking withdrawals. Once you’re ready to start receiving income, your annuity will pay you a certain amount each year, based on the contract terms.
This is considered a "guaranteed" income. However, it's important to note that all guarantees are based on the claims-paying ability of the insurance company. That's why it's important to only purchase annuities from well-known, highly-rated companies.
Types of Annuities
Before you consider adding an annuity to your retirement plan, you need to understand the primary types of annuity contracts and how they work. While there are some variations, the three most common annuity contracts on the market are fixed, variable, and indexed.
A fixed annuity is generally a low-risk option with a predictable return. They come with a set interest rate that will never stray from the terms laid out in the contract. These contracts offer a steady income stream that you can count on throughout your retirement years.
Some fixed annuity contracts have a provision that allows the interest rate to reset after a predetermined time period. Always make sure you read your contracts carefully and include any potential adjustments into your overall income plan.
Variable annuities are tied to investment selections. This means that they offer the possibility of greater gains, but also come with more risk.
When you invest in a variable annuity, the future income you receive is tied to the performance of the underlying investments you select. If the markets under-perform, your contract can lose value, which will result in a lower income stream. Conversely, if your investments do well, you may end up with an additional income boost in retirement.
Indexed annuities go by a variety of different names, including fixed-indexed and equity-indexed. These contracts combine features of both fixed and variable annuities. They’re generally less risky than variable annuities, but they may provide you a higher income potential than a fixed annuity. However, they're typically also more expensive than a fixed annuity.
Annuities are often ideal for retirement planning as they address some of the key concerns you’ll face. This includes longevity, interest-rate risk, and market volatility. When you purchase an annuity contract with a lifetime income benefit, you’re hedging against the risk of outliving your money.
These contracts also help you meet your income needs even when interest rates are at historic lows. At the same time, fixed and indexed annuities can add a level of protection to help keep you from bearing the brunt of sharp market declines. The older you get, the less time you'll have for your portfolio to recover. This makes downside protection even more important as you near retirement.
If you’re thinking this sounds too good to be true, you might be right. While annuity contracts offer many benefits, there are some potential drawbacks to consider. First, many come with significant fees and internal costs, which can drag down your investment performance.
Most contracts allow you to withdraw a certain percentage of your contract value each year. However, taking withdrawals will decrease your contract value and, sometimes, the value of your protected benefits.
If you need to take more than the contract limit, you might also have to pay additional penalties known as surrender charges. Withdrawals made before you reach age 59 ½ are also subject to a 10% penalty fee. In addition, all withdrawals are subject to income taxes.
Is an Annuity Right for You? Find Out Today
If you’re preparing for retirement, an annuity could be an excellent addition to your portfolio. However, they’re not right for everyone. If you’re interested in learning more, contact us. We’ll help you evaluate your investment strategy and choose the right tools to optimize your plan.
1Fixed Annuities are long term insurance contacts and there is a surrender charge imposed generally during the first 5 to 7 years that you own the annuity contract. Withdrawals prior to age 59-1/2 may result in a 10% IRS tax penalty, in addition to any ordinary income tax. Any guarantees of the annuity are backed by the financial strength of the underlying insurance company.
2Please consider the investment objectives, risks, charges, and expenses carefully before investing in Variable Annuities. The prospectus, which contains this and other information about the variable annuity contract and the underlying investment options, can be obtained from the insurance company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
The investment return and principal value of the variable annuity investment options are not guaranteed. Variable annuity sub-accounts fluctuate with changes in market conditions. The principal may be worth more or less than the original amount invested when the annuity is surrendered.
3Indexed annuities are insurance contracts that, depending on the contract, may offer a guaranteed annual interest rate and some participation growth, if any, of a stock market index. Such contracts have substantial variation in terms, costs of guarantees and features and may cap participation or returns in significant ways. Any guarantees offered are backed by the financial strength of the insurance company. Surrender charges apply if not held to the end of the term. Withdrawals are taxed as ordinary income and, if taken prior to 59 ½, a 10% federal tax penalty. Investors are cautioned to carefully review an indexed annuity for its features, costs, risks, and how the variables are calculated.