It provides guaranteed retirement income, but there are downsides to be aware of.
Key Points
- Retirement annuities may provide income, but they are expensive and complicated.
- Annuities grow tax-deferred. Income choices might be for life or for a limited number of years.
- Alternatives to annuities, such as Social Security and dividend stocks, might provide income without the downsides of annuities.
What Is a Retirement Annuity?
Retirement annuities ensure income in your old age. That seems like the answer you’re looking for especially if you don’t know how long your funds will endure.
But like any financial plan, annuities can have their pitfalls. Before you put your funds into an annuity, it’s wise to weigh the pros and cons so you’re not unpleasantly surprised later.
Here’s a deeper look at retirement annuities, including what they are, the varieties you may purchase, pros and cons, and how they compare to other retirement income options.
Understanding retirement annuities
A retirement annuity is a contract you make with an insurer. You pay an insurance premium. In return, your money earns a fixed or variable rate.
Depending on the sort of annuity you choose, you get your assets and profits back in the form of a guaranteed series of income payments, either automatically or on an elective basis.
“Annuitization” is the process of converting your annuity balance into income. If your contract doesn’t compel you to annuitise, you might keep your assets invested forever. You may be able to withdraw money as a one-off amount and/or choose a beneficiary to receive the money after you die.
If you do annuitize, the income you receive is calculated from:
- The accumulated funds you have in the annuity.
- How those funds are invested.
- How long will your income payments last? You can structure the income stream to last for the rest of your life or for a set duration, such as 20 years.
- Whether you have optional features like an inflation adjustment.
People buy annuities primarily for two reasons:
- Tax-deferred earnings: Your annuity’s money will increase at a set interest rate or in tandem with underlying investments. There are no immediate tax ramifications to the income earned. Similar to a 401(k), you won’t pay taxes until you start receiving distributions from your annuity.
- Guaranteed income: When you annuitise, the insurer is legally compelled to pay you your income. If the insurer fails, your state’s guarantee association should protect your annuity benefits up to at least $250,000. Check with your state for restrictions that apply to you.
Skeptics argue that these benefits are watered down by the complexity and expense of annuities.
- Then the insurance companies use some fancy maths to turn a pile of cash into income payments. That makes it difficult to determine your actual rate of return.
- Annuities may have administrative costs, investing fees, commissions, mortality fees, surrender fees, underwriting fees, and distribution expenses. These may build up to 3% a year or more if you take money out or cancel your contract.
Types of annuities
Retirement annuities come in different varieties. Here are five common ones:
- Immediate annuity: An immediate annuity is purchased with a lump-sum payment. The payment stream might start as early as one month or as late as one year after financing the annuity.
- Deferred annuity: An annuity that may be annuitised at some future period. You may pay the premiums either in a bulk amount or in a series of installments. Most delayed annuities enable you to make a single withdrawal when you need cash but are not ready to annuitise.
- Fixed Annuity: With a fixed annuity, your money grows at a guaranteed interest rate. The conditions of the guarantee, however, may differ. Some annuities may guarantee the rate only for the first year, while others may guarantee it throughout the life of the contract.
- Variable annuity: A variable annuity’s growth depends on how well the investments you choose do. These investments are subaccounts, which are similar to mutual funds.
- Lifelong annuity: The income payments do not terminate on a specific date. Instead, your income payments continue until you die. Lifetime annuities tend to pay less than term-based annuities. This is because the insurance company assumes the risk that you will live longer than expected.
These annuity forms are not mutually exclusive. For example, you may buy a deferred and variable annuity. If you want to annuitise, you may choose to receive income for the rest of your life, or for a fixed period, such as 20 years.
Alternatives to annuities
If you want long-lasting income without the fees and complexity of annuities, there are other options. Social Security and dividend stocks are two that may serve your needs.
Social Security
Aside from annuities, Social Security is one of the very few sources of income designed to last you the rest of your life once you start receiving it.
Your Social Security payment is based on your work history. But you can still affect its size, even as you approach retirement. For instance, you may boost your working salary in the last few years of your job to enhance your benefits. You might also delay collecting Social Security to boost your payment.
The obvious benefit Social Security offers over an annuity is that there is no up-front expense. If you postpone retirement to increase your Social Security payment, you give up income up front. But at least the money stays in your savings account.
Dividends
Dividend shares might potentially produce income for life. Unfortunately, that is not guaranteed. A firm has the ability to cut, suspend, or cancel its dividend at any time.
The good news is that there are certain dividend stocks that are more dependable than others. 25 or more consecutive years . Dividend Aristocrats® ( the phrase “ Dividend Aristocrats® ” is a registered trademark of Standard & Poor’s Financial Services LLC ) are firms that have paid and grown their dividends for 25 or more consecutive years . There is also a club of 50-year dividend-increasing stocks, dubbed the Dividend Kings.
Dividend Aristocrats and Dividend Kings won’t guarantee payouts, but they’ll be slow to cancel a dividend, too. If you have any risk tolerance, these stocks are a good choice for retirement income.
Dividend stocks are riskier than annuities but offer more potential income. You will receive dividend income, and your assets should also appreciate over time.
The premium for guaranteed income
A retirement annuity pays you an income for a certain period of time, or for the rest of your life. That promise might be reassuring, particularly if you’re anxious about living longer than your funds. One of the biggest downsides is that annuities have a cost for peace of mind.
Fortunately, you don’t have to choose between an annuity and alternative income options.
Your retirement plan might include many kinds of income — an annuity, a Social Security payment taken at the right time, and dividend income, for example. Spreading out like that helps dull the negatives of each source of income, including the fees in your annuity and the instability of a dividend portfolio.
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