Written by: Canvas Annuity
Annuities can provide lifetime income, but not all annuities are alike, and they’re definitely not right for all investors.
While the concept of annuities isn’t new (some sources say it dates back to ancient Rome), there’s still a great deal of confusion surrounding these products. How does the lump sum work? Who should buy them and when? And do they really provide guaranteed retirement income?
Here’s what you need to know before you choose to invest.
What is an Annuity?
Used primarily by retirees, annuities are a well-known kind of financial product that offers a guaranteed income stream for life.
Here's a breakdown of how an annuity works:
Put simply, annuities are a series of contracts issued and sold by financial institutions. With annuities, the funds are invested so the contract can pay out a fixed income stream later.
According to Investopedia,
“They are mainly used for retirement purposes and help individuals address the risk of outliving their savings. Upon annuitization, the holding institution will issue a stream of payments at a later point in time.”
Annuities actually have two phases: the accumulation phase, during which investors fund the product via a series of regular payments or a single lump-usm, and the annuitization phase, when the product starts paying a set sum out to the annuitant for a fixed period or the annuitant's remaining lifetime.
Annuities can be further broken down into different segments: fixed, variable, deferred, and immediate. This provides flexibility for investors and allows the product to suit a variety of needs.
Who Should Buy Annuities?
Annuities are typically used by retirees, or by people preparing for retirement. If you’re interested in any of the following three things, annuities may be right for you:
- Periodic payments for a set period. This time period could be the rest of your life, or the lifespan of your spouse or another beneficiary.
- Death benefits or payouts. If you die before your annuity starts issuing payouts, the person you name as your beneficiary earns a set payment.
- Tax-deferred growth. One of the benefits of an annuity is that you do not pay taxes on the investment or income from the annuity until you withdraw the money.
How an Annuity Works: Immediate vs. Deferred Annuities
The two primary types of annuities are immediate and deferred annuities. While they sound similar, they serve very different purposes.
Immediate annuities are best for retirees who need to start receiving payouts and income immediately, while deferred annuities are better for people who still have several years to plan and prepare for retirement.
Here’s a breakdown of a few of the key differences between the two:
- People who invest in an immediate annuity have an insurance company’s guarantee that they will receive a fixed payment each month for the duration of their lifespan.
- In most cases, the lump-sum investors pay into an immediate annuity is locked up after it’s been paid. This means investors cannot withdraw money in the case of an emergency.
- Deferred annuities are tax-deferred, and grow continuously until it is time to withdraw funds later.
- Deferred annuities are sometimes called longevity annuities, and they require smaller upfront investments of cash.
- Deferred annuities pay a guaranteed monthly payment when the investor reaches a certain age.
How Much Do Annuities Pay?
Investors know that interest rates have declined year after year, until today, when they’re virtually non-existent.
That, however, is one of the perks of annuities. Even in the current low-interest investment environment, a 65-year-old can buy an annuity that pays a higher rate than 6% on his original investment annually for the rest of his lifespan.
Here’s why that works:
Annuity payouts come from the earnings on the investment and a return of the principal. They insulate you against loss by pooling your risks with other policyholders. As a general rule, investors will receive a higher payout on annuities that stop paying upon the death of the investor.
What About Early Cashouts?
While deferred annuities allow you to cash out whenever you’d like, but doing it may cost you.
Usually, investors will have to pay a surrender charge in the amount of 7%-10% of the account balance in the first year. That surrender charge will decrease year after year, until year seven or ten, when it will disappear altogether.
If you withdraw money before the age of 59.5, you may also have to pay an early-withdrawal penalty of 10%.
What Happens if the Insurer Goes Bankrupt?
One of the biggest questions investors have is what happens to their money if the insurer goes bankrupt. If you purchase a fixed deferred annuity or are already receiving payouts from a fixed immediate annuity, those payouts are protected by the state guaranty association.
You should know, though, that the protection levels vary from state to state. You can find your state limits here.
Is There a Difference in Payouts for Men vs. Women?
Men generally have a shorter life expectancy than women, which means annual immediate annuity payments tend to be higher for men. According to Kiplinger, a 65-year-old man who puts $100,000 into an immediate annuity can receive about $5,820 annually, while a woman in the same position would receive about $5,448 annually.
Buying Annuities Online Could be a Good Choice for You
If you're preparing for retirement, buying annuities online could be an excellent choice. Designed to protect investors from loss while also providing guaranteed lifetime income, annuities are an attractive investment option for many people.
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Related: The Ins and Outs of Annuities