Immediate vs. deferred annuities

• Immediate annuities begin paying out within a year of purchase, making them ideal for retirees who need income right away. You make a lump-sum payment and start receiving regular payments almost immediately. These are particularly useful for retirees who have accumulated savings but want to convert a portion into guaranteed income.
• Deferred annuities allow your money to grow for a period before payments begin, often years or even decades later. These are typically purchased during your working years as part of a long-term retirement strategy. The longer deferral period allows for more potential growth through compound interest or investment gains.

Fixed annuities

Fixed annuities provide guaranteed returns and predictable payments. The insurance company promises a specific interest rate for a certain period, and your payments are calculated based on this guaranteed return. This predictability makes fixed annuities attractive to conservative investors who prioritize capital preservation and steady income over growth potential.

The interest rates offered by fixed annuities are typically higher than those available from certificates of deposit or savings accounts, but they require you to lock up your money for longer periods. Fixed annuities also offer tax-deferred growth, meaning you don’t pay taxes on the gains until you start receiving payments.

Variable annuities

Variable annuities offer the potential for higher returns by allowing you to invest your premiums in various sub-accounts that function similarly to mutual funds. These sub-accounts might include stock funds, bond funds, or balanced portfolios. Your ultimate payout depends on how well these investments perform.

While variable annuities offer growth potential, they also come with market risk. If your chosen investments perform poorly, your account value and future payments could be significantly reduced. However, many variable annuities offer optional riders that provide minimum guaranteed benefits, though these come at additional cost.

Indexed annuities

Indexed annuities, also called equity-indexed or fixed-indexed annuities, offer a middle ground between fixed and variable products. Your returns are tied to the performance of a market index, such as the S&P 500, but with built-in protection against losses. These products typically offer a guaranteed minimum return while allowing you to participate in market gains up to a certain cap.

The appeal of indexed annuities lies in their combination of growth potential with downside protection. However, the participation in market gains is often limited by caps, spreads, or participation rates that can significantly reduce the upside potential compared to direct market investment.

Qualified vs. non-qualified annuities

• Qualified annuities are purchased with pre-tax dollars from retirement accounts like 401(k)s or IRAs. The entire amount withdrawn from these annuities is taxable as ordinary income since no taxes were paid on the original contribution.
• Non-qualified annuities are purchased with after-tax dollars. Only the growth portion of withdrawals is taxable, while the return of your original principal is not subject to additional taxation. This can provide more favorable tax treatment for some retirees.

Benefits of retirement annuities

Let’s take a closer look at how annuities can help you through your retirement:

Guaranteed income stream

• The primary benefit of annuities is the guarantee of lifetime income. This feature addresses one of the biggest fears in retirement: running out of money. With a lifetime annuity, you receive payments for as long as you live, regardless of how long that might be or how the markets perform.
• This guaranteed income can serve as a foundation for your retirement budget, similar to Social Security benefits. Knowing that your basic living expenses are covered by guaranteed sources can provide tremendous peace of mind and allow you to take more risk with other portions of your portfolio.

Tax advantages

• Annuities offer tax-deferred growth, meaning you don’t pay taxes on investment gains until you withdraw the money. This can be particularly beneficial if you expect to be in a lower tax bracket during retirement than during your working years. The ability to compound gains without the drag of annual taxation can significantly enhance long-term returns.
• For non-qualified annuities, the tax treatment of withdrawals can be favorable, as you typically receive a return of your basis (original investment) tax-free, with only the gains being taxed as ordinary income.

Protection from market volatility

• Fixed and indexed annuities provide protection from market downturns. While this might limit upside potential, it ensures that market volatility won’t devastate your retirement income. This protection becomes increasingly valuable as you approach and enter retirement, when you have less time to recover from significant losses.

Flexibility in payout options

• Modern annuities offer numerous payout options to match your specific needs. You might choose payments for a specific number of years, payments that continue for your lifetime, or joint-life payments that continue as long as either you or your spouse is alive. Some annuities also offer inflation adjustments to help maintain purchasing power over time.

Estate planning benefits

• Certain annuities can play a role in estate planning by providing death benefits to beneficiaries. Some products guarantee that if you die before receiving payments equal to your initial investment, the difference will be paid to your beneficiaries. This feature can help ensure that your annuity purchase doesn’t disadvantage your heirs.

Drawbacks and considerations

Of course, as with any financial products, retirement annuities aren’t ideal for everyone:

High fees and costs

• Annuities often come with complex fee structures that can significantly impact returns. These might include surrender charges for early withdrawals, annual management fees, mortality and expense charges, and fees for optional riders. Variable annuities tend to have particularly high fee structures, sometimes exceeding 3% annually when all fees are combined.
• Understanding all fees is crucial because they can erode returns over time. A product with high fees might need to generate significantly higher gross returns just to match the net performance of lower-cost alternatives.

Limited liquidity

• Most annuities have surrender periods during which withdrawals beyond a certain amount (typically 10% of the account value annually) are subject to surrender charges. These charges can be substantial, especially in the early years of the contract, sometimes exceeding 10% of the withdrawal amount.
• This limited liquidity means annuities are not suitable for money you might need for emergencies or unexpected expenses. The funds should generally be considered committed for the long term.

Complexity

• The annuity market offers hundreds of products with varying features, benefits, and restrictions. Understanding the specific terms of any annuity contract requires careful study of lengthy prospectuses and contracts. Features like participation rates, caps, spreads, and various rider options can make comparison shopping challenging.

Inflation risk

• Fixed annuities provide predictable payments, but these payments typically don’t adjust for inflation. Over long retirement periods, the purchasing power of fixed payments can be significantly eroded by inflation. While some annuities offer inflation adjustments, these typically come at the cost of lower initial payments.

Opportunity cost

• The guarantees provided by annuities come at a cost. The insurance company needs to make a profit and maintain reserves, which means the returns offered by annuities are typically lower than what you might achieve through direct market investment over long periods. This opportunity cost can be significant, especially for younger investors with long time horizons.

Who should consider annuities for retirement

• Risk-averse retirees: Individuals who prioritize capital preservation and predictable income over growth potential may find annuities appealing. If market volatility causes you significant stress or if you prefer knowing exactly what your income will be, annuities can provide valuable peace of mind.

• Those lacking guaranteed income: If your retirement income will come primarily from 401(k) accounts, IRAs, and other market-based investments without significant pension or Social Security benefits, annuities can provide the guaranteed income foundation that these other sources lack.

• Longevity concerns: If you have reason to believe you’ll live longer than average—due to family history, lifestyle, or health factors—the lifetime income guarantee of annuities becomes more valuable. The insurance company assumes longevity risk, which is particularly beneficial for those who might outlive normal life expectancy.

• Estate planning needs: For individuals with specific estate planning goals, certain annuity features might be valuable. This could include death benefits that guarantee a minimum payout to heirs or the ability to transfer annuity contracts to beneficiaries.

Who should avoid annuities for retirement

• Young investors: The benefits of annuities are often not worth their costs for younger investors who have decades until retirement. The guaranteed returns offered by annuities are typically much lower than historical stock market returns, and younger investors have time to ride out market volatility.

• Those needing liquidity: If there’s a significant chance you’ll need access to your invested funds before the surrender period expires, annuities are not appropriate. The surrender charges and restrictions can be costly if you need the money for emergencies or other purposes.

• High-net-worth individuals: Wealthy individuals who can self-insure against longevity risk might not need the guarantees provided by annuities. If you have sufficient assets to generate income for any reasonable lifespan, the costs and restrictions of annuities may outweigh their benefits.

Timing your annuity purchase

The timing of annuity purchases can significantly impact their value.

• Interest rates play a crucial role in determining the payments offered by immediate annuities and the guaranteed rates for fixed deferred annuities. Purchasing during periods of higher interest rates can lock in better terms for the life of the contract.
• For immediate annuities, waiting until later in retirement can result in higher payment amounts due to shorter life expectancy, but this strategy involves the risk of declining health or cognitive ability affecting your decision-making capacity.
• Market conditions also matter for variable and indexed annuities. Purchasing during market downturns might provide better long-term value, while buying at market peaks could limit future growth potential.

Integration with overall retirement strategy

Annuities work best as part of a diversified retirement strategy rather than as standalone solutions. Financial planners often recommend the “bucket” approach, where different portions of retirement assets serve different purposes. Annuities might fill the “safety” bucket, providing guaranteed income for basic living expenses, while other investments handle growth and inflation protection.

The decision of how much to allocate to annuities depends on your total retirement assets, other guaranteed income sources like Social Security and pensions, risk tolerance, and personal preferences. A common approach is to ensure that guaranteed income sources cover basic living expenses, with the remainder invested for growth and flexibility.

Final thoughts

Choosing whether to purchase an annuity requires careful evaluation of your specific situation. Consider working with a fee-only financial planner who can provide objective advice without sales commissions affecting their recommendations.

Key questions to ask yourself include:

• How much guaranteed income do I need?
• How important is liquidity to me?
• What is my risk tolerance?
• How long do I expect to live?
• What other guaranteed income sources do I have?

Compare multiple products from different companies, focusing not just on promised returns but on the financial strength of the insurance company, fee structures, and contract terms. Remember that the cheapest option isn’t always the best, but the most expensive isn’t necessarily better either.

The key to successfully incorporating annuities into retirement planning lies in understanding your specific needs, carefully evaluating products, and using annuities as part of a broader, diversified strategy rather than as complete solutions. When used appropriately, annuities can provide valuable peace of mind and financial security during retirement years.

Pave the way with Stone Street

Do you need upfront money for any of the following?

• Annuity
• Structured Settlement
• Inherited Annuity
• Assignable Annuity

If so, selling your payments for a lump sum may be the right option for you. We will work with you one-on-one so you get the sale option that best fits your needs:

• One-on-one consultation.
• Customized solution just for you.
• Customer service you can count on.

Call us at 866-416-5118 to talk about your financial needs and what annuity payments you have coming to you. We’ll do the hard work and handle the rest of the process!*

*Stone Street is a purchaser of future payment streams. Stone Street does not provide financial advice.