According to Northwestern Mutual’s 2018 Planning and Progress Study, 66 percent of the roughly 2,000 Americans surveyed worry they’ll eventually outlive their retirement savings.
The good news is that there’s a way to plan financially for this so-called longevity risk: an annuity, which can provide guaranteed income for the rest of your life.
HOW DO ANNUITIES WORK?
Annuities are typically a way to add some certainty to your financial planning — whether you’re saving for retirement or in it — as they generally come with features and guarantees that you won’t get with investments.
While there are many different types of annuities, they basically all fall into two categories: annuities that help you accumulate funds for retirement and annuities that provide guaranteed income in retirement. Here’s how each works.
SAVING FOR RETIREMENT
If retirement is still decades away, it’s important to take advantage of both time and compound interest. For younger savers, an accumulation annuity makes it possible to harness the power of compounding interest on a tax-deferred basis and help ensure you’ll have income later in retirement.
How an accumulation annuity works: There are two main types of annuities to help you accumulate funds for retirement. The first is a fixed annuity. With a fixed annuity, the money that you contribute grows at a guaranteed rate. If you’re interested in participating in the market, you could choose a variable annuity, which allows you to invest in sub-accounts that can be tied to the market.1
Ideal for: Anyone who is saving for retirement and looking for additional tax-advantaged options outside their 401(k)s or IRAs. Money you put into an accumulation annuity grows tax-deferred.
Pay attention to: While you can withdraw your money from annuities that help you accumulate funds for retirement, there may be cases where you will owe penalties or fees to do it. You will owe a 10 percent penalty if you withdraw money from your annuity before reaching age 59-1/2 (that’s an IRS rule, it also applies to your traditional IRA or 401(k)). There may also be a surrender charge for the annuity itself. These charges are similar to the way charges may be assessed if you withdrew money from a CD too early. Annuities may also come with additional benefits, but at a cost. Some companies may offer a death benefit that will pay your beneficiaries a guaranteed amount of money if you pass away, for example.
Once you’re in retirement, saving and compounding growth likely take a backseat to a focus on generating reliable, predictable income. For a retiree, an income annuity can be an effective tool to hedge the risk of outliving your savings, and ensure you’ll always have some money coming in the door throughout retirement.
How an income annuity works: There are several kinds of income annuities, but the basic principle is the same: an income annuity will make regular payments to you for the rest of your life — no matter how long you live. Immediate income annuities are designed to begin paying out immediately after you purchase the annuity. Deferred income annuities are designed to begin paying out a few years down the road, after the deferral period. Once the deferral period has passed, the payments begin and will continue for a period of time or the rest of your life. Like immediate income annuities, these involve paying an insurance company a lump sum (or sometimes a series of payments over time. However, the benefit of the growth during the deferral period is that future income payments will be higher than what you would get by spending the same amount to buy an immediate income annuity when you retire. Income annuities are most often purchased with a lump sum payment, but some deferred income annuities allow you to put money in over time. Some income annuities have payments that will remain the same forever. Others can be indexed to increase with inflation. In addition, some companies offer income annuities that are eligible to earn dividends, which can increase the amount that’s paid to you over time.
Ideal for: Retirees, or people approaching retirement, who want to convert a lump sum of cash (perhaps a portion of money invested over a lifetime) into a guaranteed stream of income for the rest of their lives.
Pay attention to: One of the big concerns people have when buying an income annuity is that the insurance company will keep all their money if they die right away. However, many income annuities offer features that guarantee payments will last for a certain amount of time, or guarantee that your beneficiary will get the remaining balance of your payment if you die early.
ONE FINAL CONSIDERATION
You should also consider the financial strength of the company you purchase the annuity from — especially for income annuities, as income payments could last long into the future if you live a long time. You want to buy an annuity from a company that has an excellent financial rating and one that will be around for many more years (Northwestern Mutual been in business for 160 years and counting and continues to have the highest financial strength ratings awarded to any U.S. life insurer by all four of the major rating agencies).
If you’re interested in learning more about how an annuity might fit into your plan, a financial advisor can discuss what the best options are for you.
Annuities are contracts sold by life insurance companies and are considered long-term investments that may be suitable for retirement. Income annuities (either immediate or deferred) have no cash value and once issued they can’t be terminated (surrendered). The original premium paid is not refundable and cannot be withdrawn.
All guarantees associated with annuities and income plans are backed solely by the claims-paying ability of the issuer.
1All investments carry some level of risk, including potential loss of principal. Withdrawals from variable annuities may be subject to ordinary income tax, a 10 percent IRS penalty if taken before age 59 ½, and contractual withdrawal charges.