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.
However, you can plan for this so-called longevity risk by purchasing an annuity, which can provide guaranteed income for the rest of your life.
HOW DO ANNUITIES WORK?
An annuity, in a most basic sense, is a contract between you and an insurance company. Annuities come in two basic versions: income annuities and deferred annuities. Both annuity types help to add some certainty to your financial planning and generally come with guarantees that you won't get with market investments.
When you buy an annuity, you make a large, single premium payment or payments over time. Then, at some point in the future, you have the option to annuitize payments, which is when the insurer starts making guaranteed income payments to you. With income annuities, you can choose to have payments begin immediately (an immediate income annuity) or have the payment start date deferred for decades (a deferred income annuity). Neither immediate nor deferred income annuities have an accumulation period, so they do not increase in value. Many annuities offer features that allow for payments to last for a certain period, or through the life of the annuitant.
Whether you’re in retirement or still saving for retirement, an annuity may take a little risk out of your long-term financial plan.
How a deferred annuity works: Deferred annuities have two phases: the growth period, known as accumulation, and the payment period, often referred to as the annuitization phase.
There are two types of deferred annuities – variable and fixed. Deferred fixed annuities accumulate value based on a fixed interest rate. In a deferred variable annuity, your premium payment is invested in one or more sub-accounts, which are investment funds for you to choose from. The annuity value is determined by the performance of those subaccounts.
For those looking for potentially higher returns and willing to accept higher risk, a deferred variable annuity might be appropriate. The rate of return varies based on the investments that you choose. Variable annuities typically offer numerous investment options, can help diversify a retirement portfolio and can be allocated according to your risk tolerance level. The performance of variable funds is not guaranteed and can fluctuate, and there is risk that you may lose money. Deferred variable annuities also offer a death benefit.
An indexed annuity has features similar to a variable annuity. Rather than choosing investments your returns are hinged to an equity-based index, such as the S&P 500. However, how that index is tracked depends on the methods used by the insurance company. Also, different companies may cap the amount of interest you can earn in an indexed annuity or put in a floor to limit potential losses.
Pay attention to: For all annuities, distributions may be subject to ordinary income tax. You’ll also want to pay attention to fee structures and withdrawal or surrender charges. In most cases, you’ll be charged a 10 percent penalty if you withdraw money from your annuity before reaching age 59-1/2.
A deferred annuity may be a good option for: Younger savers who are maxing out their contributions to other retirement accounts and want to continue building and growing their tax-deferred nest egg.
How an income annuity works: An income annuity is designed to generate guaranteed payments. There are immediate income annuities that provide an income stream typically starting within 12 months, and there are deferred income annuities where the start date of the income stream can be deferred up to several decades. Income annuities are typically purchased with a lump-sum payment; however, some income annuities also allow for additional premium deposits.
If you go with an income annuity option, your periodic payments will never change. They will typically be invested in the insurance company’s general fund.
Pay attention to: One of the big concerns people have when buying an annuity is that the insurance company will keep all their money if they die right away.
Income annuities have no cash value. Once issued, this annuity cannot be terminated (surrendered), and the premium paid for the annuity is not refundable and cannot be withdrawn. As with deferred annuities, a 10 percent IRS penalty may apply if distributions are taken before age 59-1/2 and distributions may be subject to ordinary income tax.
Ideal for: Risk-averse retirees, or people very close to retirement, who want to convert a lump sum of cash (perhaps a portion of money that you have invested over your lifetime) into a guaranteed stream of income for the rest of their lives, or for a specified timeframe.
If you’re in retirement, saving and growth likely take a backseat to a focus on generating reliable, predictable income. For a retiree, an income annuity could 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.
ONE FINAL CONSIDERATION
You should also consider the financial strength of the company you purchase the annuity from. An annuity is only as good as the company’s ability to guarantee its financial commitment to you. You want to buy an annuity from a company that has an excellent financial strength rating and one that will be around for many more years (Northwestern Mutual, for example, has been in business for 160 years and counting and has been awarded the highest financial ratings in the industry*).
If you’re interested in learning more about how an annuity might fit into your overall plan, a financial pro can discuss what the best options are for you.
*Northwestern Mutual has the highest financial strength ratings awarded to any U.S. life insurer by all four of the major rating agencies: A.M. Best Company, A++ (highest), April 2018; Fitch Ratings, AAA (highest), June 2018; Moody's Investors Service, Aaa (highest), January 2018; S&P Global Ratings, AA+ (second highest), June 2018. Third-party ratings are subject to change. Ratings are for The Northwestern Mutual Life Insurance Company and Northwestern Long Term Care Insurance Company. Third-party ratings are a measure of a company’s relative financial strength and security but are no reflection on the safety or performance of the variable funds.