Are you approaching retirement? If so, you’re probably finalizing your plans. Perhaps you’re projecting your income, developing your retirement budget, or even analyzing your investment allocation. Retirement is a big financial challenge, so it’s important that you develop the right strategy for your needs and goals.
You have a wide range of financial tools at your disposal. From mutual funds to bonds to ETFs, it can be hard to know which tools are right for your objectives. As you examine your options, be sure to consider one of the most effective and popular retirement planning tools – annuities.
Annuities are insurance products that are often used to create predictable income streams. However, they can be used for a variety of financial objectives, including downside protection and tax-deferred growth.
People have used annuities since the times of ancient Roman. The Roman government would offer soldiers a guaranteed lifetime income stream once they retired from service. In the centuries since then, annuities have evolved and advanced. Today they are used by companies, governments, non-profits, and even individuals to meet a wide range of financial goals.
In this article, we’ll discuss the various types of annuities and how you can use them to reach your financial objectives. Annuities can be effective planning tools, but they’re not right for everyone. A financial professional can help you decide if an annuity is right for you and which type best aligns with your needs.
1. Immediate Annuities
[/twocol_one_last]The oldest type of annuity is the immediate annuity. They’re commonly referred to as single premium immediate annuities (SPIA) because you usually only make one premium contribution to the policy.
In their most basic form, you contribute a lump sum into a SPIA and the insurance company converts that lump sum into a guaranteed stream of income. The income amount is based on your premium amount, the duration of the payments, and other factors, such as interest rates. Everything else being equal, the longer the payment duration, the less each payment will be.
Single premium immediate annuities are popular because they provide consistent, predictable, guaranteed income. That can be valuable in retirement, as it allows you to enjoy your retirement with the confidence that you will always have cash flow.
There are a few different variations of the SPIA. There’s no one type that is right for everyone. Below are some of the most commonly used versions:
A. Single Life
In a single life immediate annuity, the income payment is guaranteed for your lifetime. You contribute a lump sum amount and then the insurance company uses life expectancy tables to determine how long you are likely to live. Your income payment is based on their life expectancy estimate.
Generally speaking, the younger you are when open the contract, the longer your life expectancy. Thus your payment will be lower because the annuity is expected to last over a long duration. Similarly, if you are older when you open the policy, your payment may be higher because you have a shorter life expectancy.
It’s important to note that in a single life annuity, the policy is only in-force for your lifetime. If you pass away, the payments end. This is true even if you pass away relatively soon after opening the contract. Be sure to consider how this may impact your loved ones and beneficiaries.
B. Joint Life
A joint life annuity is similar to a single life except that it’s paid over two lifetimes. These contracts are often used by married couples to create guaranteed income over both of their lives.
Joint life immediate annuities operate similarly to single life policies. The key difference is that the life expectancies of both individuals is taken into consideration. There’s also the fact that since the payment will be paid over two lives, it’s likely to have a longer duration than a payment that is made over one life.
Given all these factors, joint life contracts generally offer a lower annual payment than comparable single life policies. However, if you want to create a guaranteed lifetime income stream for you and your spouse, a joint life contract may be a wise strategy.
C. Period Certain
Most immediate annuities offer another variation in which you can add a period certain onto the contract. A period certain is a defined minimum period of time in which the annuity is guaranteed to make payments.
For example, you could purchase a single life annuity with a 10-year period certain. This means that the contract will make payments for 10 years, even if you are not alive. Assume you pass away in year two of the policy. The insurance company would continue making payments to your beneficiaries for the remaining eight years until the 10-year period certain is fulfilled.
The period certain option is appealing because it provides protection to your beneficiaries in the event you pass away soon after opening the annuity. Even if you don’t life long enough to enjoy the annuity payments, your beneficiaries will still receive them for the remainder of the period certain.
D. Other Immediate Annuity Options
Some immediate annuities offer optional benefits to provide enhanced protection. For example, you may be able to choose inflation protection. This type of option increases your payment each year to keep up with the rising prices of goods and services.
You also may be able to choose nursing home or long-term care protection. One of the downsides of immediate annuities is that you loose liquidity. Once you open the annuity, you don’t have access to the funds. You simply have the regular income payment. That lack of liquidity could be problematic if you ever face a costly medical emergency.
However, some annuities also offer long-term care insurance as an add-on benefit. Should you ever need to move into an assisted living facility or hire in-home health aides, you can take advantage of the long-term insurance benefit on the policy. Your annuity payment may end, but instead the annuity will pay some or all of your long-term care costs.
These options are different for every company and policy. Your financial professional can help you determine which optional benefits, if any, are appropriate for you.
2. Deferred Annuities
Deferred annuities are the other broad type of annuity policies. Unlike immediate annuities, deferred annuities offer an opportunity to access and grow your assets before the funds are converted into payments. In fact, in many deferred annuities, the funds in the policy may never be “annuitized,” or converted into income.
There are various types of deferred annuities, but they all have a few things in common. Below are a few components that you’ll find in every deferred annuity:
Cash Value: Unlike immediate annuities, deferred annuities have a cash value component. This is an account inside the annuity which can accumulate cash over time. When you open your annuity contract, the premiums are deposited into the cash value account. The account can then grow over time, although the accumulation method depends on the type of deferred annuity.
The annuity company will deduct fees out of the cash value account each year. You also may be able to take withdrawals out of the cash value, although you may have to pay surrender charges.
Tax Deferral: Annuities are tax-deferred investment vehicles, much like IRAs and 401(k) plans. You don’t pay taxes on your growth as long as the funds stay inside the annuity. However, unlike other qualified accounts, you don’t get a tax deduction when you put money into an annuity. You may have to pay taxes on gains when you take money out of the policy. You also may face an early distribution penalty if you take a withdrawal before age 59 ½.
Death Benefit: Deferred annuities offer death benefits so you can protect your loved ones. In most cases, your death benefit will equal the greater of your contract value or your initial premium less any withdrawals that you took.
You also may be able to purchase enhancements to the death benefit. For instance, some annuities offer annual lock-in features. That means your death benefit is equal to your highest ever contract value.
There are other optional riders that grow your death benefit by a certain percentage each year or at the time of your passing.
Surrender Period: Deferred annuities are more liquid than immediate annuities, but they also have some liquidity restrictions. These usually come in the form of surrender charges, which are in place for the first several years of a deferred annuity.
You pay surrender charges if you take a withdrawal during the surrender period, which may last for the first 3 to 7 years of the contract. The surrender charges usually decline each year until they disappear completely after the last year of the surrender period.
All annuities allow a “free amount,” such as 10 percent of contract value, that you can withdraw each year without paying a surrender charge. You only pay the penalty if you withdraw more than the free amount in a given year. However, it’s often wise to keep liquid assets outside of the annuity so you don’t have take an excess withdrawal from your annuity contract.
As mentioned, these four components are present in nearly every deferred annuity. However, not all deferred annuities are the same. There are several different kinds, and each offers a different level of risk exposure and growth potential. Below are three of the most popular types of deferred annuities:
A. Fixed Annuities
Fixed annuities offer a low-risk avenue to grow your assets in a tax-deferred manner. You contribute a lump sum into the contract and then earn a set annual interest rate for a defined period of time. After that period of time, your interest rate may fluctuate.
For example, you might open a fixed annuity that pays a certain interest rate for three years. Each year, that interest will be credited to your cash value. After three years, the annuity company will offer you a new interest rate. You can either accept the new rate or do something else with the funds, assuming you are out of the policy’s surrender period.
While your rate may fluctuate after the initial rate period, your policy will also have a guaranteed minimum interest rate. Your interest rate will never be less than the guaranteed minimum.
Fixed annuities are appealing because they offer security and predictability. You can’t lose money to market fluctuation or volatility. In fact, the only way to lose money in a fixed annuity is through surrender charges. That means you can grow your money through tax-deferred interest accumulation without worrying about potential losses.
B. Variable Annuities
Variable annuities offer greater growth potential than fixed annuities, but also increased risk exposure. These annuities let you invest in the financial markets via subaccounts, which are similar to mutual funds. Your contract value fluctuates based on the performance of your investments. Most contracts offer a broad menu of subaccount choices so you can choose the allocation that best aligns with your needs and goals.
Variable annuities also come with a variety of annual fees, which you usually won’t find on a fixed annuity. There’s an annual mortality and expense fee, as well as management expenses for your underlying subaccounts. You also may have to pay fees for any optional benefits you select.
A variable annuity isn’t right for everyone, but it can be helpful in certain situations. They offer a tax-deferred vehicle for asset accumulation, which could be appealing if you’re maxing out your contributions to other qualified accounts.
C. Fixed Indexed Annuities
Want the low-risk approach of a fixed annuity, but also exposure to the market’s growth potential? A fixed indexed annuity is a good middle ground that offers the best of both worlds. There are a few different kinds of fixed indexed annuities, but all align with the same basic concept.
In a fixed indexed annuity, you earn interest each year, much like you do in a fixed annuity. However, the interest rate isn’t set each year. Instead, it’s based on the performance of an underlying market index. If the index performs well, you get more interest. If it performs poorly, you may get little or no interest.
Like fixed annuities, fixed indexed annuities have guaranteed minimum interest rates, so you’ll always know the least amount of interest you could receive in any given year. Fixed indexed annuities also offer a principal guarantee. Even if the underlying index declines, your contract value won’t go down.
A fixed indexed annuity may offer more interest in certain years than you would earn in a fixed annuity. However, there’s no guarantee that will happen. There could be years where you earn little or no interest.
D. Hybrid Annuities
Do you think you could benefit from both a fixed annuity and a variable annuity? Or maybe a fixed indexed annuity and a variable annuity? If so, you may want to look into a hybrid annuity. These contracts combine multiple types of contracts into one policy.
For example, you may choose a contract that has both a fixed and variable component. The fixed portion would earn a set interest rate and would have a no risk exposure. The other portion would be invested in subaccounts according to your risk tolerance and would have both growth and risk exposure.
A hybrid strategy lets you achieve multiple goals and create a comprehensive strategy. You can get a guarantee of principal on a portion of your funds and then use other funds for growth potential and as a hedge on inflation. There are multiple types of hybrid annuities designed to meet a wide range of goals. A financial professional can help you choose the type that’s best for your needs and objectives.
E. Optional Deferred Annuity Benefits
Many people choose to use deferred annuities so they can take advantage of an optional benefits. These optional features, known as riders, enhance an annuity’s protection or benefits. They can be used to create income, protect your principal, or even pay for long-term care. Below are a few of the most common deferred annuity riders:
Long-Term Care Waiver
As discussed earlier, most deferred annuities have a surrender period. This is a period of several years at the beginning of the policy in which you may pay a penalty if you withdraw too much money in any given year.
Surrender penalties aren’t an issue if you don’t withdraw money during the surrender period. However, they could present a challenge if you face an emergency during that time and need to access your money. For example, you could face significant costs for long-term care, either by moving into an assisted living facility or hiring an in-home health aide.
Fortunately, most deferred annuities offer something called a “nursing home waiver.” This is a benefit that allows you to take withdrawals or even surrender your contract without paying surrender penalties if the money is needed to pay long-term care costs. This feature often has no extra charge attached to it and is widely available on many deferred annuity contracts.
Guaranteed Principal Protection
Fixed annuities and fixed indexed annuities have inherent principal protection guarantees. They pay interest and have no market risk exposure, so there’s no danger in losing money to market volatility. However, the same isn’t true of variable annuities. They may offer greater growth potential, but there’s also risk of loss.
However, many variable annuities offer an optional benefit in which you can guarantee your principal over a certain period of time, such as five or ten years. You pay an annual fee each year out of your contract value. If your contract value is less than your original principal at the end of the guarantee period, the annuity company makes up the difference.
This benefit could be helpful is you want the growth potential of a variable annuity, but are concerned about the risk. However, be sure to consider how the fees may impact your performance over time. Also consider whether a fixed annuity or fixed indexed annuity may better help you achieve your goals.
Guaranteed Minimum Income Benefit
Perhaps one of the most popular types of annuity benefits is the guaranteed minimum income benefit, also sometimes known as a guaranteed minimum withdrawal benefit. This optional feature gives you the benefit of guaranteed lifetime income without tying up your assets in an immediate annuity. You can find this feature on most variable and fixed indexed annuities.
In a guaranteed minimum income benefit, the insurance company gives you an allowable annual withdrawal amount, usually stated as a percentage of your premium or contract value. As long as you never exceed that withdrawal amount in any given year, the income is guaranteed for life, no matter how long you live or how the market performs. Even if market performance drains your entire contract value, the annuity company will continue to pay the guaranteed income.
Many people purchase annuities specifically for this type of guaranteed benefit. It gives you a base level of guaranteed retirement income that you know you can count on, know matter how long you live. You also have the opportunity to grow your contract value over time and possibly even increase your income.
An annuity could be a helpful and effective planning tool for your retirement. You can use an annuity to maximize the power of tax-deferral, guarantee your income, or simply achieve low-risk growth.
You should choose an annuity based on your unique goals, needs, and concerns. If you aren’t experienced with annuities, you may find the wide range of choices to be a bit overwhelming.
At America’s Annuity, we can help you determine if an annuity is right for you and which one best fits your goals. Contact us today. We welcome the opportunity to help you achieve an enjoyable and financially secure retirement. Let’s connect soon and start the conversation.