Are you considering adding an annuity to your retirement investment portfolio? If so, we’d urge you to get a sound understanding of annuities before you move forward. While these products may seem like a simple, safe solution providing income you can’t outlive, the reality can be quite different. Annuities are frequently complex and may not meet your expectations.
For starters, consider annuities for what they are: insurance products. You buy an annuity (either one payment or a series of payments) from an insurance company in exchange for a promise that they will provide you income for either a specified period of time, or the rest of your life. It is insurance against running out of money.
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Types of Annuities
To understand annuities, it is important to grasp the major types commonly sold in America today:
- Fixed annuities generally guarantee a fixed or minimum rate of return over a specified time period. A fixed annuity can be compared to a CD: Fixed annuities won’t decline in value due to investment results.
- Variable annuities allow premiums to be invested in a limited number of sub-accounts similar to mutual funds. These sub-accounts may be invested in stocks, bonds or even cash. The value of the contract will fluctuate with the performance of the subaccounts and can decline.
- Equity-Indexed Annuities (sometimes called “fixed-indexed” annuities) may sound more like variable annuities, but they are actually more similar to fixed. Like fixed annuities, the contract value won’t decline due to investment results. However, there is no guaranteed interest rate—the rate you earn will be loosely based on the return of a specific market index, like the S&P 500. This may sound like an opportunity to earn stock market-like returns with little downside risk, but that isn’t the case. The returns you earn are (typically very) watered-down from the actual market index’s results.
The Accumulation Phase vs. the Annuitization Phase
Annuities have two phases of their lifespan: the accumulation phase and the annuitization phase.
- In the accumulation phase, you generally don’t take cash from the annuity. Instead, you try to build it up to a certain value until you use it for cash flow later. In the accumulation phase, money invested in an annuity isn’t subject to tax—capital gains or income tax. However, payments made above the initial amount invested are taxed at ordinary income tax rates upon withdrawal.
- The annuitization phase is the point when you take regular payments from the insurance company to supplement your retirement income. To get this stream of payments, you give up ownership of the assets accumulated to the insurance company, which promises you a stream of payments in exchange.
This is only the beginning of the information you’ll need to truly understand annuities before you buy one. Again, we can’t stress enough the importance of understanding annuities before you buy. They often restrict your ability to get out of them without taking a big loss. We’d advise you to do your research upfront to avoid this outcome. If you'd like, you can download our free Annuity Insights brochure for additional information.