What an Annuity Can and Can't Do for You

You can choose from several types of annuities.

Annuities can give you a way to increase your tax-deferred retirement savings. While annuities are typically purchased from an insurance company, you can also think of your retirement savings as an investment in an annuity: that is, a sum of money that can provide a fixed amount of income throughout retirement. Since there are various benefits and limitations of annuities, you should understand how they work and determine how and if they might fit into your overall retirement plan before you invest in one.

What Is an Annuity?

Annuities are typically offered through insurance companies. When you purchase an annuity, you agree to make either one large upfront payment or a series of smaller payments over a period of time to your insurance company, in exchange for which you receive a series of payments either immediately, if you choose to make a lump sum payment, or at a future date, if you make installment payments over time. There are three basic kinds of annuities you can invest in: fixed, indexed, or variable. Contributions to an annuity are taxed, but once money is inside your annuity account, it grows tax deferred until you withdraw it. As with other retirement plans, you will typically face a 10 percent penalty plus tax if you withdraw money before you turn 59 1/2. Annuity contracts are typically characterized by various forms of guarantees from the insurance companies that provide them. In exchange for the guarantees, you can expect to pay stiff fees.

Fixed Annuities

Fixed annuities are characterized by a guaranteed rate of return for the life of your investment. Fixed annuities also pay you a predetermined and fixed periodic payment that can either be for a limited period of time or for an indefinite period of time such as for the length of your lifetime or your lifetime and the life of your spouse. Fixed annuities typically offer a lower rate of return in exchange for the security of a guaranteed periodic payment and rate of return.

Indexed Annuities

Indexed annuities provide a return on your investment that is tied to an index, such as the S&P 500. However, the performance of your annuity will be less than the actual performance of your selected index. Indexed annuities typically guarantee that your investment will never fall below a certain amount, regardless of the performance of the selected index. Indexed annuities will generally offer a higher rate of return than fixed annuities, though you may lose some of the value of your investment, depending on the index's performance.

Variable Annuities

Variable annuities, which are regulated by the SEC, allow you to choose from a variety of investment options. The return you receive on your variable annuity depends on the performance of your investment choices, which usually include a variety of mutual funds called subaccounts that invest in some combination of stocks, bonds and/or money market instruments. Variable annuities often come with a death benefit payable to your beneficiaries if you die before you begin receiving payments from your annuity.

Benefits of Annuities

Some people choose to invest in annuities as a way to supplement their retirement income. If you've already maxed out your annual contributions to other retirement plans, annuities can be an additional way to reduce your tax liability for retirement savings. Annuities also offer a predictable stream of income at a predetermined date, which can help you better plan for retirement many years out.

Limits of Annuities

Depending on the type of annuity you select, your control over its investment options may be limited. This can either be a good or bad thing, depending on the level of control you like to have over your investments. Annuities are also purchased according to a predetermined plan that can make it difficult to change the terms of your annuity later. Thus, while you may later find that other retirement options offer higher returns, you may be already committed to contributing to an annuity, and you may experience stiff exit fees if you try to roll your money into some other plan. Finally, many insurers charge substantial fees to set up and maintain annuity accounts, which can reduce your total investment yield. It pays to remember that a guarantee in an annuity contract -- whether it is a guaranteed rate of return or a guaranteed minimum account value or a guaranteed stream of retirement income -- is never free.

Final Thoughts

If you are considering supplementing your retirement savings with an annuity plan, you should consult with a qualified financial advisor who can help you understand the impact of annuities on your overall financial plan and better determine whether annuities are right for you.

References

• Securities and Exchange Commission: Annuities
• Securities and Exchange Commission: Variable Annuities

Resources

• Securities and Exchange Commission: Investor Tips: Variable Annuities