Whether or not you’ve seen the JG Wentworth commercials (Google it now; thank me later), you’ve probably at least heard of an annuity. Perhaps you’ve even considered purchasing an annuity from an insurance company as a means of building retirement savings.
Whether the guaranteed income from annuity payments is a worthwhile investment depends on lots of factors.
Don’t worry though: we’ve got a complete breakdown of what the various types of annuities are and in which situations purchasing one would be a good idea.
At a very basic level, an annuity is an agreement between an individual and an insurance company that involves an exchange of money. All annuity contracts consist of two phases, accumulation and payout.
During the accumulation phase, which can last anywhere from one day to dozens of years, you put money into your annuity account. Then, during the payout phase, you receive disbursements from your annuity account.
Beyond these base similarities, there are a few different ways annuities can be set up:
You might make monthly payments over a longer period of time to the insurance company in return for the ability to receive payments of your own upon retirement. You might also make one large, lump sum payment that results in your receiving payments for a period of time thereafter.
There are three broad categories of annuities, each of which differs in how funds grow.
These are the most stable, reliable type of annuity. This is because the interest rate at which your money will grow is…well, fixed. It won’t change based inflation, how the stock market is doing, or because of any other factor that might come up.
At the time you purchase a fixed annuity, the interest rate on your account is set and will not change, either in your favor or in favor of the insurance company with whom you’re doing business.
This means money you invest is protected from market fluctuations, so you don’t have to worry about your money vanishing in the event that the stock market crashes. It also means, however, that your money may not grow ahead of inflation rates.
The average rate given for fixed annuities in the first quarter of 2023 was between 3.6% and 5.25%. Inflation, at the end of 2022, was over 6% (though historically it’s closer to 2%). So, while these might be considered one of the “safer” ways to invest money and create a guaranteed income stream after retirement, they are vulnerable to losing value to inflation.
One of the nice things about fixed annuities, on the other hand, is that you can set them up to provide a specific amount of guaranteed income for the rest of your life. So, if you have a small gap in your monthly budget and need a way to patch that hole, a fixed annuity might be the best way to do it.
Of course, before making any decisions about what kind of annuity you should (or shouldn’t) purchase, you should consult a financial advisor. They’ll be able to give you advice specific to your situation and goals.
As the name suggests, a variable annuity is exactly like its fixed cousin except for the interest rate your investment receives will vary depending on how your money is invested.
During the accumulation phase of variable annuities, you designate where you want your money to be invested (for example, in a bond fund, stock fund, etc.). Then, your funds will grow (or shrink) according to the performance of the fund or funds in which you invested your money.
The allure with variable annuities is that, because your money is being invested, it’s likely to grow at a rate that will considerably outpace inflation. You run the risk, however, of losing money in the event of a catastrophic stock market crash.
Because of the inherent risk, a variable annuity is probably only advisable if you plan to have a longer accumulation phase (where you pay into your annuity fund for 10 to 30 years before cashing out), since your account will be less susceptible to random market fluctuations.
Indexed annuities (also known as fixed index annuities) are sort of like the love children of a variable annuity and a fixed one.
The idea is that you’re guaranteed a minimum interest rate, as you are with a fixed annuity, however you also tie your investment returns to a market index, so you have the opportunity to enjoy increased growth when the market is doing well.
Of course, your minimum guaranteed interest rate is going to be slightly lower than those you’d expect from a standard fixed annuity, and the ceiling of growth will be capped slightly lower than you could get with a standard variable annuity, but that’s the price of getting a bit of the best of both worlds.
If you’re looking for a safe way to set up lifetime income that reaps tax benefits, there’s a lot to love about annuities. Here are a few of the major benefits to an annuity owner:
One of the major benefits of any kind of annuity is the money you contribute will enjoy tax deferred growth, which means you’ll end up with more retirement savings than if you had to pay taxes on your deposits up front.
(Just note that tax deferred does not mean tax free — you will have to pay taxes as you withdraw money post-retirement.)
The income payments from any annuity can be set up so that you receive the same amount of money every month. For folks who need to patch a hole in their monthly budget, having a guaranteed stream of income like this is a real godsend because you can rely on it being the exact same payment every single month.
If you’re concerned that you might lose money by dying before you’re able to recoup the value of your annuity deposits, you can assign an individual or individuals to receive a death benefit from your annuity fund.
This means if you don’t live long enough to get the full value of your annuity payments, the insurance company pays one of your beneficiaries instead.
Despite benefits like tax deferred growth and a guaranteed retirement income stream, there are aspects to annuity contracts that may mean an annuity investment is not a good one (for you).
The relative “safety” associated with an annuity contract does come at a cost.
In general, the fees associated with managing an annuity account are higher than those for other investments. The average annual fees for an annuity contract are between 2% and 3%.
Most annuity contracts begin with a “surrender period,” which lasts for a number of years after you purchase the annuity. If you attempt to withdraw money from your account during the surrender period, you will have to pay surrender charges, which can be wildly expensive. A typical surrender charge will begin at somewhere around 10% and decrease each year you maintain the account.
Because of everything we just said about fees assessed when trying to access money early, annuity owners don’t enjoy the full liquidity associated with other investment options. Though an annuity will provide guaranteed retirement income over time, you don’t have access to that money right off the bat.
So, if your living situation is somewhat unstable and you can imagine a scenario in which you would need to have access to money quickly, an annuity might not be the best option for you.
Overall, annuities are relatively safe ways to guarantee lifetime income and cover gaps in monthly budgets post-retirement. Of course, safety does come at a cost, and they tend to be less lucrative (and have higher maintenance fees) than other investment options.
There are three main types of annuities:
You get a set interest rate which persists throughout the life of your annuity regardless of external market fluctuations.
Your interest rate is tied to specific investments, like stocks or bonds.
You get a guaranteed minimum interest rate lower than with fixed annuities but are able to benefit from market growth, though not as much as with a variable annuity.
Here’s a quick overview of all of the pros and cons of annuities: