What is an Annuity? And Could it Be Part of Your Retirement Strategy?

Ah, annuities: the product the financial services industry loves to hate. But are the hard feelings warranted? Let’s breakdown why annuities got so bad a rap and whether today’s products deserve fresh consideration.

First, what is an annuity?

Annuities are a long-term investment designed to deliver a fixed income stream for a set period of time. You provide money to a financial institution—either in payments or a lump sum—during what’s called an accumulation phase. Down the line, when your investment reaches the annuitization phase, you’ll begin to receive payments. Annuities can be structured in a number of ways—for example, to pay out income for a set period of time, or for the duration of your or your spouse’s life.

The Good, the Bad, and the Ugly

Commercial annuities made their debut in the early 1800s, but that wasn’t the first time the idea was introduced. The Romans used annuities to compensate their military, using what we know today as a Single Premium Immediate Annuity (SPIA). In a SPIA, your investment is converted into a fixed, usually monthly payment, doled out over a set period of time, or for a lifetime. This is the structure of what debuted in the 1800s. It’s simple, easy to understand and largely regarded as “good” for retirees seeking a steady stream of income they can’t outlive.

Now for the “bad.” Over time, annuities became increasingly complex and comparison shopping became more difficult. Fees increased and so too did the upfront investment. Surrender charges made it hard for consumers to cash in. What was once “good” turned “bad.”

So, what’s the “ugly”? Some annuities started charging annual fees as high as 4% and introduced surrender penalties that lasted over 15 years. While these unfavorable terms weren’t true of all annuities, it’s easy to see why the product as a whole got a bad rap.

If it Ain’t Broke…

Remember the SPIA we mentioned before? The original model for annuities needed no improvement. Today, it reminds us of an important tenet of shopping for annuities: simple is best.

Annuities can be a good choice again for dependable income in retirement.  Here’s what to know when evaluating your options:

Returns

Fixed annuities are comparable to CDs. They can have a fixed rate of return or a range tied to market performance with ceilings and floors. The appeal is that most fixed annuities have no risk of loss to your principal.

Tax Advantages

Unlike CD interest or stock dividends that are taxable each year, annuity interest is tax deferred. It gets added to your principal, so you benefit from growth on your untaxed gains. You don’t pay taxes until you take that money out.

Length

Annuities are similar to CDs or bonds—you can choose different terms (1 year, 10 years, etc.). Also, like CDs and bonds, if you terminate before the term, you could forfeit some of your returns or pay a penalty. However, unlike CDs and bonds, many fixed annuities allow up to a 10% draw of the account value every year without any penalty.

Commissions

Planners who sell annuities are paid a commission from an insurance company, just like financial advisors or banks selling CDs, bonds, and mutual funds. However, with annuities, the insurance company pays the planner directly. The money does not come out of your annuity. But, when a financial advisor sells you certain mutual funds, the commission comes out of your account and your balance goes down on day one.

Do Annuities Have a Place in Your Retirement Plan?

Most annuities are reliable, conservative and part of many middle- and upper middle-class retirees’ investment plans. Most retirees don’t have millions to make market gambles with; they want safe and predictable options in retirement. Annuities can provide just that.

Before making your decision, it’s always wise to consult with an experienced retirement planner who can help you evaluate whether an annuity could be beneficial to your overall retirement strategy. Need a good team? Talk with one of our planners.