Find out from Money Girl what an annuity is, and the pros and cons of using one for retirement income.
Saving enough for a comfortable retirement is the most important financial goal you can have.
Getting a big fat pension is a luxury that fewer American workers can look forward to these days, and relying solely on a meager Social Security payment will probably leave you scrambling to pay for basic living expenses in retirement.
If you’re worried that you won’t have enough income for the lifestyle you want in retirement, this episode is for you. I’ll discuss what an annuity is, and the pros and cons of using one for retirement income.
What Is an Annuity?
An annuity is a contract between you and an insurance company that promises to pay you income. Different types of annuities are sold by a variety of institutions and professionals, such as insurance companies, banks, and financial advisors.
You can purchase an annuity by making a lump sum payment, or making multiple payments--called premiums--over time. In return, the insurance company invests your money and typically gives you a series of payments, which is called annuitization.
If your payments start right away, it's called an immediate annuity; if they're delayed until some time in the future, it's a deferred annuity. The income you receive from an annuity can be paid out monthly, quarterly, yearly, or even as a lump sum payment.
A big advantage of annuities is that you can contribute as much as you want for retirement. Unlike other tax-deferred vehicles—such as a workplace 401(k) or an IRA—annuities have no annual contribution limits.
Having the option to put away more money is critical, especially if you’re close to retirement age and need to catch up. Annuities were created to provide an income stream that lasts a certain period of time, or even for as long as you live, so you never run out of money in retirement.
What Are the Main Types of Annuities?
Before I cover the pros and cons of using annuities for retirement income, it’s important to understand the basic differences between the 2 main types: fixed and variable.
It’s important to understand the basic differences between the 2 main types: fixed and variable.
A fixed or guaranteed annuity gives you a minimum rate of return that never changes, no matter what happens in the financial markets. The insurance company handles all the backend investing and agrees to pay you a minimum, pre-determined rate of return and payout. In other words, the insurance company assumes all the risk, and you receive a stable cash flow.
On the other hand, a variable annuity does not give you a stable payout. The rate of return depends on the performance of the financial markets. You decide how to invest your money in investment sub-accounts held within the annuity.
Unlike fixed annuities, variable products are securities that must be registered with the Securities and Exchange Commission (SEC.) They do give you the potential to earn more than a fixed annuity, but the cash flow is much less stable, and you can lose money.
The value of using variable annuity products for retirement income is hotly debated. In addition to having higher risk, they also come with higher commissions and fees compared to fixed products, which may make them unsuitable for many investors. Therefore, for the purpose of this article, I’m just going to focus on fixed annuities.