What is an Annuity?

An annuity is a type of financial product, typically sold by insurance companies. Some people use annuities to help establish and manage income in retirement. There are different types of annuities, some of which have variable payout periods or fixed payouts.

 


Jump to learn more about annuities:

Annuity considerations | Annuity benefits | Annuity risks

 


Why buy an annuity?

When it comes to saving for retirement, you might consider an annuity if you’re concerned that:

  1. You might lose money in a market downswing or
  2. You could outlive your savings

Annuities can help protect against both these risks by providing guaranteed retirement income. With a particular kind of annuity, called a deferred income annuity (DIA), you can decide when you want to start receiving payouts from the annuity, whether that's two years from now or 40.

 


What are the potential benefits of a
deferred income annuity (DIA)?

  1. Winning the insurance game. When you start to draw down the income from your DIA, you will receive payments over the course of your lifetime (or your life and the life of a beneficiary) – guaranteed. Furthermore, a DIA is not variable. This means that, while you won’t make additional money when the market does well, you also won’t make less money if the markets take a turn. Instead, the insurance company takes on the investment risk.
  2. Tax advantages. Normally, when you turn 70 ½, you’re required to take minimum distributions from your 401(k) and/or individual retirement account (IRA). What’s more, these required minimum distributions (RMDs) count as taxable income. But new tax rules generally state that you can spend up to 25% of your retirement account value (or up to $125,000) to purchase a DIA. And you can exclude that amount from the portion of your savings that is subject to the RMD rules, thus potentially providing tax savings in the near term.
  3. Put more in, get more out. The longer you wait before starting to take payments from the annuity, the higher each individual payment will be, because it has a longer time to grow. Plus, having a guaranteed income stream also helps you to plan your other withdrawals accordingly. For example, if you purchase an annuity at age 60 and defer until you’re 80, you’ll have time to spend down other income and can eventually receive a higher payment from your DIA.

 


What are the potential risks of a deferred income annuity (DIA)?

  1. Losing the insurance game. While annuities are designed to protect against outliving your retirement savings, the opposite scenario (dying before you begin to receive payments from the annuity) is obviously the biggest risk. While there are annuities that allow you to designate a beneficiary to “inherit” those payments, such features may cost extra.
  2. Illiquidity, inflation and insolvency. Annuities are relatively illiquid, meaning it’s hard to get your money out. In addition, some annuities (typically those with fixed, as opposed to variable, payments) do not protect against inflation. Finally, there is also the credit risk that the insurance company will have ceased operations when your annuity payments are due.

 


There are pros and cons to every retirement savings strategy, and annuities are no different. That’s why you may find that using a combination of retirement savings products offer the best strategy for generating retirement income later in life. It all depends on your goals, tax status, other sources of income, how long you expect to be retired, and so on. It can be a lot to manage, so we recommend talking it over with your financial planner.