If you’re planning for retirement, you’ve almost certainly come across annuities—they’re available through many 401(k) plans and often are recommended by financial advisors.
But what is an annuity, and how does an annuity work? When people do an online search for an “annuity definition,” they often find that an annuity is a contract with an insurance company. That is an accurate—but not especially helpful—definition.
Bottom Line Personal asked Robert Carlson, editor of Retirement Watch, what people really need to know about annuities…
More Helpful Annuity Definition
With an annuity, a customer agrees to deposit money with an insurance company, with the understanding that the insurance company later will pay money to the customer. Depending on the type of annuity selected, an annuity might provide…
- Guaranteed stream of income for the rest of the customer’s life—and perhaps the rest of his/her spouse’s life—reducing the risk of outliving retirement savings.
- Some exposure to stock market gains with little or no exposure to stock market losses, reducing the risk that a poorly timed market rout could devastate retirement savings.
Annuities’ ability to mitigate these retirement risks sets them apart from most investments and is the source of much of their appeal. They offer a potential tax advantage, too—annuity profits are tax-deferred until distributed.
But there are downsides to annuities…
- They can be complicated. Some—though not all—annuities have high fees and complex difficult-to-understand contracts.
- They have surrender charges if the money is withdrawn soon after purchase.
- Their tax-deferred gains are taxed as income, not at lower capital gains tax rates.
- There’s no step up in basis if an annuity passes to heirs, potentially saddling them with big tax bills.
Notable Types of Annuities
One of the challenges of explaining how annuities work is that there are many different types, and they differ in crucial ways. Among the types of annuities potentially worth considering…
Multi-Year Guaranteed Annuity (MYGA). With this very basic form of annuity, the customer deposits a lump-sum payment with an insurance company for a predetermined amount of time, after which that insurer returns the principal plus a fixed interest rate to the customer. It’s like buying a CD, except with tax-deferred interest and, often, somewhat higher yields.
Single Premium Immediate Annuity (SPIA). The customer makes a lump-sum payment, as above, but then receives fixed recurring payments from the insurance company—a guaranteed stream of retirement income. Depending on the annuity’s terms, these payments might arrive every month, quarter or year for the rest of the customer’s life or for a specified period, such as 20 years. The simplicity and guaranteed income of a SPIA is appealing, but their returns can fall short of those of Fixed Index Annuities with income riders (below).
Deferred Income Annuity (DIA) is much like an SPIA, but while payouts from an SPIA begin almost immediately, payouts from a DIA don’t begin until years after the annuity is funded. The customer decides at the time the annuity is purchased when the payouts begin.
Fixed Index Annuity (FIA). The customer deposits money with an insurance company and, as above, that insurer guarantees that this principal won’t decline. But the interest earned by an FIA varies based on the performance of one or more underlying market indexes and a potentially complex formula. For an additional fee, the customer can add an “income rider” that guarantees that he/she will receive no less than a predetermined minimum amount every month, quarter or year for life regardless of the performance of those underlying indexes.
Registered Index-Linked Annuity (RILA) is much like an FIA but potentially riskier. Unlike FIAs, RILAs don’t necessarily guarantee that the annuity buyer’s principal won’t decline. But RILAs tend to offer somewhat higher potential returns than FIAs.
Variable Annuity. The customer deposits money with the insurance company, and that money is invested in mutual funds or similar investments selected by the customer. The performance of the investments, minus fees, determines the value of the customer’s account. The customer can let the account compound for years or can arrange periodic distributions or regular payments from the account. The performance of those investments affects the size of the periodic payments that the customer receives. The complex contracts, risks and often-steep fees of variable annuities make them a poor choice for most people, but they could be appropriate for relatively sophisticated investors who have maxed out their 401(k)s and IRAs and want even more tax-deferred growth.
Where to Buy Annuities
Many annuity owners didn’t set out to purchase annuities—they’re persuaded to do so by financial advisors. That’s a good way to end up with a bad annuity—unscrupulous advisors push clients into complex, high-fee annuities that pay those advisors hefty commissions.
Best: Obtain annuities through your employer’s 401(k) plan. Employers—particularly large employers—often negotiate better annuity terms than are available to individual annuity buyers. Other providers that tend to offer appealing, low-cost annuities include Vanguard, TIAA-CREF and Fidelity.
