Annuities 101: Understanding the Basics Before Adding an Annuity to Your Retirement Plan
When people begin planning for retirement, one concern tends to rise to the top of the list:
“How can I make sure my money lasts?”
It is an understandable question. Retirement may last 20, 30, or even more years, and unlike a paycheck from an employer, retirement income must often be created from a combination of Social Security, pensions, investments, savings, and other financial resources.
Annuities are one financial tool that may be considered as part of that conversation.
However, annuities are not one-size-fits-all investments, and they can be complex. The SEC’s Investor.gov describes an annuity as a contract with an insurance company designed to meet retirement and other long-term goals, with the insurer agreeing to make periodic income payments beginning immediately or at a future date. Investor.gov
Understanding the basics can help you determine whether an annuity deserves a place in your retirement conversation.
What Is an Annuity?
At its simplest, an annuity is a contract between you and an insurance company.
You provide money to the insurance company through a lump-sum payment, a series of payments, or another permitted funding arrangement. In return, the contract can provide benefits that may include tax-deferred growth, death benefits, and, depending on the contract, a stream of income.
Annuities generally fall into two broad timing categories:
- Immediate annuities begin making income payments relatively soon after purchase.
- Deferred annuities allow money to accumulate before income payments begin.
FINRA explains that annuities may be fixed, variable, or indexed, and that different types have different risks, potential rewards, fees, and features. FINRA
That distinction is important because the word “annuity” alone does not tell you enough about the actual product.
Fixed, Variable, and Indexed Annuities
A fixed annuity generally provides a minimum guaranteed interest rate during the accumulation period, with the insurer determining the applicable rates under the contract. Investor.gov notes that fixed annuities can also provide a set amount of periodic payments for a specified period or potentially for life.
A variable annuity works differently. The contract generally offers investment options, often mutual-fund-like portfolios, and the contract value can rise or fall based on the performance of those investments. Investor.gov emphasizes that variable annuities also include insurance features and tax-deferred treatment, but they come with additional costs and investment risks.
An indexed annuity ties interest-crediting, in whole or in part, to the performance of a market index under the terms of the contract. However, the details matter considerably because different contracts use different methods for calculating interest, including participation rates, caps, spreads, floors, buffers, or other provisions.
This is one reason FINRA describes indexed annuities as products that can be difficult to compare. FINRA
Why Do People Consider Annuities?
One reason is the desire for predictable retirement income.
A retiree may have substantial assets but still worry about converting those assets into reliable income. Depending on the type of annuity and the contract provisions, an annuity may provide a stream of payments for a defined period or for the rest of an individual’s life.
That can address one of retirement’s most difficult risks: longevity.
You cannot know exactly how long you will live.
If you retire at 65, you may need income for another 20 years. You may need it for 30 years. One spouse may live considerably longer than the other.
Creating a retirement income strategy therefore requires thinking beyond investment returns. It requires considering how long the income needs to last.
Tax Deferral Can Be Helpful, But It Is Not the Whole Story
Annuities can provide tax-deferred growth, meaning you generally do not pay federal income tax on investment gains inside the contract until taxable distributions occur.
But tax deferral should not be viewed in isolation.
Investor.gov points out that retirement accounts such as IRAs and employer-sponsored 401(k) plans may already provide tax advantages, meaning investors should consider whether the additional features and costs of an annuity are appropriate for their circumstances.
The question is not simply, “Is this tax-deferred?”
The better question is, “What job is this financial product supposed to accomplish in my overall retirement plan?”
Understand Fees, Surrender Charges, and Liquidity
This is one of the most important parts of evaluating an annuity.
FINRA cautions that annuities can be complex and costly, and investors should understand fees, expenses, surrender charges, and optional riders before purchasing a contract.
Depending on the product, charges may include administrative expenses, investment expenses, insurance-related charges, rider costs, and surrender charges for withdrawing money during a specified period.
Liquidity is particularly important for retirees.
If you need access to a significant portion of your money shortly after purchasing an annuity, a contract with a lengthy surrender period may not be appropriate for that purpose.
FINRA notes that some variable annuities can have surrender periods of eight years or longer. FINRA
The lesson is simple: never evaluate an annuity solely by looking at the promised benefit. Understand the cost and the restrictions attached to that benefit.
Guarantees Depend on the Insurance Company
Another important point is that an annuity is an insurance contract.
Investor.gov explains that an annuity’s obligations depend on the financial strength and claims-paying ability of the issuing insurance company. Annuities are not guaranteed by the FDIC, SIPC, or another federal agency. Investor.gov
That means the financial strength of the insurance company matters.
When evaluating an annuity, it is appropriate to consider not only the product features but also the issuing company’s financial strength and the applicable state insurance protections.
Be Careful When Replacing an Existing Annuity
If someone suggests exchanging an annuity you already own for a new annuity, slow down and compare the contracts carefully.
FINRA specifically warns that an exchange may create new surrender periods, additional costs, higher fees, or the loss of valuable existing benefits. The fact that a transaction can qualify for a tax-deferred Section 1035 exchange does not automatically mean the exchange is financially beneficial. FINRA
In other words, tax treatment should not be the only reason to make an exchange.
The new contract should be evaluated on its actual benefits, costs, guarantees, liquidity, investment options, and suitability for your goals.
Five Questions to Ask Before Buying an Annuity
Before signing an annuity contract, consider asking:
- What specific retirement problem is this annuity designed to solve?
- What income or other benefits are guaranteed, and under what conditions?
- What are all of the contract’s fees, charges, and surrender provisions?
- How much access will I have to my money if my circumstances change?
- What would I give up if I chose a different retirement-income strategy?
Those questions can lead to a much more productive conversation than simply asking about the interest rate or projected return.
Annuities Are a Tool, not a Complete Retirement Plan
At SF Financial Services, our approach is centered on the broader retirement picture.
Barbara Swiatek founded SF Financial Services and has spent more than two decades helping individuals and families plan for retirement. Our approach emphasizes personalized planning and its Financial Endurance Plan, with a focus on helping families pursue retirement with greater clarity and confidence.
That philosophy is especially relevant when discussing annuities.
An annuity may be an appropriate tool for one person and a poor fit for another. The answer depends on the person’s income needs, assets, tax situation, liquidity requirements, risk tolerance, longevity considerations, and overall retirement objectives.
We discuss many of these questions through Retire Financially Fit, Barbara’s radio show and podcast, which provides educational conversations about retirement strategies and protecting retirement assets. SF Financial Services
The goal is not to find a financial product that sounds attractive in isolation.
The goal is to build a retirement strategy in which every component has a purpose.
The Bottom Line
Annuities deserve a thoughtful place in the retirement-planning conversation because they can provide features that other financial products may not, particularly when the goal is to create a predictable stream of retirement income.
But they also involve contracts, costs, restrictions, insurance-company considerations, and features that can be difficult to understand.
Before purchasing an annuity, make sure you understand not only what you are getting, but also what you are giving up.
Retirement is too important to build around a product you do not fully understand.
A good retirement-income strategy starts with your goals, your needs, and your complete financial picture. The products come after the plan—not the other way around.
This article is for educational purposes only and does not constitute individualized investment, tax, Social Security or legal advice.
Investment advisory services offered through Brookstone Wealth Advisors, LLC (BWA), a registered investment advisor and an affiliate of Brookstone Capital Management, LLC. BWA and SF Financial Services are independent of each other. Insurance products and services are not offered through BWA but are offered and sold through individually licensed and appointed agents.
Index or fixed annuities are not designed for short term investments and may be subject to caps, restrictions, fees and surrender charges as described in the annuity contract. Guarantees are backed by the financial strength and claims paying ability of the issuer. Please refer to our firm brochure, the ADV 2A Item 4, for additional information.