Retirement Planning: Unlocking The Power Of Annuity Investments

Retirement annuities are a type of insurance product that can provide a guaranteed income stream for retirees, often for life. They are a popular option for those seeking to supplement their retirement income and ensure they do not outlive their savings. Annuities can be funded through a lump sum or a series of regular payments and typically offer fixed or variable cash flows. While they are associated with high upfront costs and early withdrawal penalties, annuities can be a secure investment option for retirement planning.

Fixed vs. Variable Annuities

Annuities are insurance contracts that guarantee regular income payments in the future in exchange for payment(s) now. They are a great way to build a predictable income stream for retirement. The two most popular types of annuities are fixed and variable annuities. While they share similar names, they operate quite differently, and each is better suited to a different type of retirement investor.

Fixed Annuities

Fixed annuities offer guaranteed payments, providing stability and predictability. Your principal is protected, and you receive a fixed interest rate over a specified period. This makes them ideal for risk-averse individuals seeking a reliable income stream. The interest is locked in, ensuring that your returns remain stable and unaffected by market volatility.

Variable Annuities

Variable annuities allow you to invest in various sub-accounts, similar to mutual funds. Your returns and eventual income depend on the performance of these investments, which means they can fluctuate. While they offer the potential for higher returns, they come with higher risk as the principal is not protected. Additionally, interest can be lost due to poor performance.

Whether a variable or fixed annuity is better depends on individual preferences and financial goals. Variable annuities offer investment growth potential but carry market risk, while fixed annuities provide stable income but limited growth potential.

"Fixed annuities are a better choice for someone who has a low tolerance for risk," says David Clausen, a certified financial planner (CFP) and wealth management advisor with Northwestern Mutual. "In today's low-interest-rate environment, we are seeing people have a difficult time constructing a bond ladder that provides them the income they need without taking on significant credit risk or burning through principal."

For those willing to tolerate more risk in their retirement funds, or those who want to save a lot for retirement, variable annuities might be the right choice.

Immediate vs. Deferred Annuities

Annuities are contracts sold by insurance companies that promise the buyer a future payout in regular installments, usually monthly and often for life. Annuities can be immediate or deferred, depending on when they begin to make payments.

Immediate Annuities

Immediate annuities allow you to convert a lump sum of cash into an income stream. They do not have an accumulation period and are funded with a single lump-sum payment. The distribution period begins within 12 months of the purchase.

Immediate annuities are ideal for investors who want an investment return that they cannot outlive. The payouts are considered partly a return on the original investment and partly earnings. You are only taxed on the earnings portion.

Immediate annuities are also used to provide benefits from a terminated defined benefit pension plan. In this case, the accrued benefits under the plan are determined for each participant, and a single premium annuity is purchased for each participant, with benefits usually starting at age 65.

Deferred Annuities

With a deferred annuity, you make a lump sum or a series of premium payments and defer the payout until a future date. This is known as the accumulation period, during which the earnings in the annuity are not subject to taxation.

Deferred annuities can provide an attractive investment supplement to IRAs and qualified pension plans. They offer a guaranteed rate of return, with tax-deferral, over a set time period. Any earnings are not taxed until funds are withdrawn.

Immediate vs. Deferred: Which is Better?

The choice between a deferred or immediate annuity depends on your savings and future earnings goals. If you are already retired and need a source of income to cover day-to-day expenses, an immediate annuity may be the best option. On the other hand, if you don't need supplemental income yet, a deferred annuity may be ideal as it allows the underlying annuity to build more potential earnings over time.

Tax-deferred status

Retirement annuities are a type of insurance product that provides a guaranteed stream of income for retirees, often for life. They are typically funded years in advance through a lump sum or a series of regular payments. While annuities are known for their large upfront costs and early withdrawal penalties, they offer a secure income stream in retirement.

One of the key advantages of retirement annuities is their tax-deferred status. This means that taxes are only due when the funds are withdrawn, giving owners control over when they pay taxes. This can also help reduce Social Security taxes, as delaying withdrawals results in lower taxable income.

Taxes on Deferred Annuities

Deferred annuities are similar to individual retirement accounts (IRAs) and 401(k)s in terms of taxation. As long as the funds remain in the deferred annuity, capital gains are not taxed. However, when distributions are made, they are taxed as regular income.

It is important to note that if a lump sum withdrawal is made or the contract is cancelled before the age of 59 1/2, the IRS may impose a 10% early withdrawal penalty in addition to income tax on any gains. Additionally, annuity companies may charge a surrender fee for early withdrawals or contract cancellation, usually within the first five to seven years of purchase.

Types of Deferred Annuities

Deferred annuities come in several types, including fixed, indexed, and variable annuities. Fixed annuities offer a guaranteed rate of return, providing predictable income. Indexed annuities base their returns on the performance of a market index, such as the S&P 500, while variable annuities depend on the performance of a chosen portfolio of mutual funds. All three types of deferred annuities offer tax-deferred growth.

Benefits of Tax-deferred Status

The tax-deferred status of retirement annuities provides several benefits. Firstly, it allows for tax-free growth of investments, maximizing the accumulation of assets. Secondly, it enables retirees to manage their tax liability by controlling when they withdraw funds. This can result in reduced Social Security taxes and overall tax payments.

High fees and surrender charges

When considering investing in a retirement annuity, it's important to be aware of the potential for high fees and surrender charges, which can impact the overall value and returns of your investment.

Surrender Charges

Surrender charges are penalties for withdrawing money from an annuity before it matures, usually within six to eight years of purchasing. These charges can be significant, sometimes as much as 7% of the annuity's value, and are designed to deter early withdrawals. The annuity surrender period typically lasts between six to eight years but can be as long as ten years. The surrender charge decreases over time until it reaches 0%, so it's important to check the specifics of your annuity contract.

To avoid or minimise surrender charges, you can wait until the surrender period ends before making any withdrawals. Alternatively, you may be able to take advantage of a "free withdrawal provision" offered by some annuities, which allows you to withdraw a certain portion of your funds (often 10% per year) without incurring a surrender charge. Additionally, there may be circumstances where surrender charges are waived, such as federally mandated minimum distributions or death benefits.

High Fees

Retirement annuities often come with high fees compared to other investment options like mutual funds and CDs. These fees can include insurance charges, surrender charges, investment fees, and fees for optional living and death benefits. Variable annuities, in particular, tend to have higher fees than fixed annuities due to the added complexity and potential for higher returns.

When considering a retirement annuity, it's important to carefully review the associated fees and weigh them against the benefits provided. Look for options with low costs and avoid more exotic variations that may come with complex fee structures. Additionally, consider your liquidity needs and ensure you have access to other funds to cover short-term expenses or emergencies.

Customisable options

Annuities are highly customisable, with a variety of options to suit different retirement goals. They can be tailored to your needs through optional add-ons called riders, which provide additional benefits.

For example, you can choose to receive your payouts as a regular income for a specified period or for life. You can also select a joint and survivor option for a spouse or a "period certain" option for a non-spousal beneficiary.

Annuities can be customised to provide a death benefit, a survivorship clause, or the ability to pass the annuity on to heirs. This flexibility makes them more adaptable than many other retirement savings vehicles.

Annuities can also be customised to suit your payment preferences. You can typically buy into a retirement annuity with either a lump-sum payment or a series of payments.

Variable annuities allow you to choose from a range of sub-accounts, similar to mutual funds, in which to invest your premium payments. The value of the annuity is then determined by the performance of the investments in those accounts.

Fixed annuities, on the other hand, guarantee a minimum rate of return, which can be reset periodically or increased annually.

Indexed annuities track an index like the S&P 500 and offer a capped return based on the total returns of the index, along with a minimum level of return.

Frequently asked questions