As you approach retirement, you may worry about running out of money. As people are living longer, retirement savings must last longer. To avoid the risk of depleting their retirement income later in life, investors often turn to deferred annuities.
These annuities are contracts in which investors deposit funds with an insurance company and elect to have their income payouts deferred for a certain period of time. Investors deposit payments either as a lump sum or in installments. In return, they receive a guaranteed income stream for a certain term or for life. Unlike immediate annuities in which payouts start right away, deferred annuity payments start later—maybe in 10 or 20 years. Typically, the longer you defer receiving payments, the higher your income is likely to be. When you defer annuity payouts, the amount you deposited can continue to grow until the distribution period. These arrangements come with the risk that you may not reach the age at which you have chosen to start receiving distributions.
Annuities generally have two phases—accumulation and annuitization. You deposit funds into the account during the accumulation phase. The type of annuity you choose determines how those funds will grow. For example, in an immediate annuity, your contract can be annuitized immediately. In a deferred annuity, you annuitize the contract at a later date. During the annuitization phase, you convert your deposited premiums into periodic payments. When your accumulation period ends, you may elect to take your full cash surrender value or begin to take periodic payments from the contract through annuitization.
Deferred annuities offer several features, including guaranteed payouts, tax-deferred growth and death benefits (paid out to your beneficiary after your death). Two of the most common types of deferred annuities are fixed and variable.
Fixed Annuities. These annuities guarantee a fixed interest rate over the accumulation phase after which the rate typically changes. Fixed annuities are similar to certificates of deposit (CDs) in that you receive guaranteed interest payments. The insurance company sets the accumulation rate with a guaranteed minimum. This could be a 5% rate of return during the first two years and a guaranteed 1% for the life of the contract. After the first two years, the insurance company could increase or reduce the accumulation rate. One notable difference between a CD and a fixed annuity is the tax treatment of earned interest. Any interest earned from a CD is generally subject to taxes the year it was received, whereas interest earned from an annuity can be deferred until you take a withdrawal.*
Variable Annuities. These annuities allow for premiums to be invested in sub-account funds comparable to mutual funds. Types of sub-accounts can vary between contracts, but like mutual funds, they can contain a mix of stocks and bonds. The returns depend on how these underlying sub-accounts perform. Variable annuities don’t guarantee a minimum return. If the value of the investments declines, so will the contract’s value. Most variable annuities are sold with a rider, an additional benefit that, for a fee, guarantees lifetime income when the buyer activates the income stream. Some variable annuities are indexed or benchmarked to a stock market index such as the S&P 500 so that the annuity has a rate floor and cap, typically 3% and 9%.
Generally speaking, deferred annuities include an investment period before contract holders start receiving income from the account. But what if you have an emergency and need access to those funds during the required investment period? This is one problem you could encounter with a deferred annuity. If you decide to withdraw during this period, you may be subject to surrender fees.
Deferred annuities are similar to tax-advantaged retirement accounts in that they allow the deposited funds to grow tax-deferred. Also similar to other retirement accounts, if you withdraw any gains before age 59.5, you may face a withdrawal penalty plus ordinary income tax.
With all these pitfalls in mind, you are probably better off building an investment portfolio with the help of a trusted financial adviser. Our financial professionals can work with you to design a retirement strategy that makes sense for your situation. If you have $500,000 in investible assets, you can use our personalized and comprehensive Annuity Evaluation Service to better understand any annuities you own or are considering purchasing.
*The contents of this document should not be construed as tax advice. Please contact your tax professional.