Rising interest rates are making annuities more appealing to investors. In fact, annuity sales are breaking previous records, which were set back in 2008 during the Great Recession. Annuities, which can provide income for retirement, are also becoming an option for workers when their employers don’t offer pensions.
In the second quarter of 2022, total annuity sales in the U.S. surged by 22% to reach $77.5 billion, as reported by LIMRA, a financial services trade association. These figures mark the highest quarterly sales since LIMRA started tracking annuity sales in 2014. This amount is $9 billion more than the previous record achieved in the fourth quarter of 2008.
While annuities are gaining popularity once again, the concept behind them has ancient roots, dating back to early Rome. In those times, people would make a lump-sum payment to an arrangement called an ‘annua’ in exchange for yearly income payments throughout their lives.
Modern-day annuities are more complex than their historical counterparts, despite retaining the same name, and they aren’t suitable for everyone. Before you consider an annuity, it’s essential to grasp some fundamental concepts, such as what annuities are, the options they offer, and how secure your investment will be.
Let’s explore these questions and more in the following sections:
What Is an Annuity?
An annuity is like a financial agreement you make with an insurance company. Here’s how it works: You give them some money, and they use it to invest for you. The good part is that your money grows without getting taxed right away.
Now, here’s where it gets interesting: At a later point, depending on the terms of this agreement, the annuity can start paying you regular income. This income can last for a specific period or even your whole life. So, annuities act as a kind of safety net to make sure you don’t run out of money, even if you’ve used up all the money you initially put in.
If you have a lifetime annuity and live a really long time, you might end up getting more money in total than what you originally invested. But keep in mind, there’s also a chance you might not live long enough to recoup all your investment, depending on how the annuity is set up.
Annuities come in different flavors, depending on how you buy them and how your money grows over time. You can also add extra features to customize them, which are called “riders.” For instance, you could add a long-term care rider, which means you get more money if you need long-term care. Or, there could be a rider that makes sure your loved ones get the money if you pass away before receiving it.
But, there’s a catch with these riders – they usually cost you some extra money. So, if you choose to include them, your regular income payments might be a bit smaller.
In some cases, instead of regular income, an annuity might just give you a lump sum of money on a specific date.
Understanding the concept of retirement annuities
When you turn your annuity balance into regular income, it’s called “annuitization.” However, you don’t always have to do this. You can choose to keep your money invested in the annuity for as long as you want. In this case, you might have the option to take out money in one go or decide who gets the money when you’re no longer around.
Now, if you decide to go ahead with annuitization, the amount of income you’ll receive is figured out based on a few things:
- How much money you’ve built up in your annuity: This includes the total amount you’ve put in over time.
- How your money has been invested: Depending on how well your investments have done, this can impact your income.
- How long you want to receive income: You can set it up so you get paid for the rest of your life or for a specific number of years, like 20.
- Any extras you’ve added: If you’ve added features like an inflation adjustment, it can also affect how much you get.
So, annuitization is like turning on a money faucet, but how much water (or income) comes out depends on a few factors.
People choose to get annuities mainly for two big reasons: tax benefits and guaranteed income.
- Tax Benefits: The money you put into your annuity can grow in two ways – it can either earn a set interest rate or go up and down with your chosen investments. The cool part is that any money you make in there doesn’t get taxed right away. It’s a bit like a 401(k) where you only pay taxes when you start getting the cash from your annuity.
- Guaranteed Income: Once you decide it’s time to get regular income from your annuity (we call this “annuitize”), the insurance company has to stick to the deal. They’re legally bound to send you those income payments. Even if the insurance company hits a rough patch and goes bankrupt, there’s a safety net. Your state has a guaranty association that should cover at least $250,000 of your annuity payments. But keep in mind, the exact rules can vary from state to state, so it’s a good idea to check with your state to know exactly how it works for you.
Some doubters say that despite the advantages, annuities can be a bit of a letdown due to their complexity and costs.
Here’s the deal: When you want to turn a chunk of money into regular income with an annuity, insurance companies use tricky math. This can make it pretty tough to figure out how much you’re actually making on your investment.
Plus, annuities often come with a bunch of different fees, like administration fees, investment fees, commissions, and more. All these fees can really pile up. In fact, they might eat up more than 3% of your money every year, especially if you need to take some cash out or cancel your annuity early.
Types of annuities
There are different types of retirement annuities to choose from, and here are five common ones:
- Immediate Annuity: With an immediate annuity, you start by putting in a lump sum of money. Within a year, you begin receiving regular payments.
- Deferred Annuity: A deferred annuity gives you the flexibility to decide when you want to start receiving income from it. You can pay the premiums all at once or in several payments. Most deferred annuities also let you make occasional withdrawals if you need some cash but aren’t ready to start getting regular payments.
- Fixed Annuity: In a fixed annuity, your money grows at a set, guaranteed interest rate. However, the terms of this guarantee can differ. Some annuities guarantee the rate for just the first year, while others guarantee it for the entire time your contract is in place.
- Variable Annuity: With a variable annuity, your growth depends on how well the investments you choose perform. These investments, known as sub-accounts, are similar to mutual funds. So, your income from a variable annuity can vary based on how these investments do.
- Lifetime Annuity: A lifetime annuity doesn’t have a predetermined end date for income payments. Instead, you keep getting paid for as long as you live. These annuities usually offer lower payouts compared to term-based annuities because the insurance company takes on the risk that you might live longer than they initially estimated.
These different annuity types can overlap. For instance, you have the option to buy a single annuity that is both deferred and variable. If you choose to start receiving payments, you can set them up to continue either for the entirety of your life or for a fixed period, like 20 years.
Annuity Payouts: Single Life vs. Joint Life
When it comes to annuity payouts, you have a choice between two options: single life or joint life.
If you opt for a single-life annuity, you’ll receive the highest annual payout. However, there’s a catch – the payments stop once you pass away, even if your spouse is still alive.
On the other hand, if your spouse depends on that income as well, it might be wiser to go for a slightly lower payout that continues for both your lifetime and your spouse’s. Some annuities also come with guarantees that ensure payments for a specific number of years, even if both you and your spouse happen to pass away during that time frame.
Annuity Payouts: Men vs. Women
When you have an annuity that pays you income for the rest of your life, the amount you get depends on how long you’re expected to live.
So, if you start getting annuity payments when you’re older, you’ll generally get more money each time because you’re expected to live for a shorter time.
Some folks choose to split their annuities into different parts. They invest some money in the beginning of retirement to cover their expenses, and then later on, they put in more money to get bigger payments. This can also help you take advantage of better interest rates because each time you add more money, it gets the current interest rate.
Now, here’s the twist: Men usually get higher payments from their annuities that pay for life. That’s because, on average, men tend to live for a shorter time than women. Since they’re expected to receive payments for fewer years, each payment is a bit larger.
Cashing Out Your Annuity Early comes at a cost
When it comes to taking your money out of a deferred annuity early, there are some costs involved. Even though deferred annuities allow you to cash out whenever you want, you won’t get back everything you put in right away. There’s a fee called a “surrender charge” that you’ll have to pay, and it usually starts at around 7% to 10% of your account balance in the first year.
But don’t worry, this fee gradually goes down every year and disappears completely after about seven to ten years. If you decide to take your money out before you reach the age of 59 and a half, there’s another charge you’ll face – an “early-withdrawal penalty” of 10%. So, it’s a good idea to plan your withdrawals carefully to avoid these extra costs.
Alternatives to annuities
If you’re looking for a reliable source of income that doesn’t involve the fees and complexities of annuities, there are some other choices to consider. Two good options are Social Security and dividend stocks.
- Social Security: Alongside annuities, Social Security is one of the few ways to secure income that will last for your entire life. Your Social Security payout is figured out based on your earnings history. But here’s the thing – you can actually influence the amount, even as you approach retirement. For instance, you could boost your income in the final years of your career to increase your Social Security benefit. Another smart move is to wait a bit before collecting Social Security because this can also result in a higher benefit.Compared to annuities, Social Security has a significant advantage – there’s no upfront cost. If you decide to delay your retirement and increase your Social Security benefit, you might miss out on some immediate income. However, this doesn’t come at the expense of your savings.
- Dividend Stocks: Another option to consider for lifelong income is dividend stocks. But keep in mind, it’s not a guaranteed income source. Companies always have the option to reduce, suspend, or even eliminate their dividends.The good news is that some dividend-paying stocks are more dependable than others. There are companies known as “Dividend Aristocrats®” (the term Dividend Aristocrats® is a registered trademark of Standard & Poor’s Financial Services LLC) – these are businesses that have consistently paid and increased their dividends for 25 years or more. Additionally, there’s a group called “Dividend Kings” who’ve been raising dividends for 50 years or longer.While Dividend Aristocrats and Dividend Kings can’t guarantee dividends, they are typically less likely to cut them. If you’re willing to accept a bit of risk, these stocks can be suitable for generating retirement income.Compared to annuities, dividend stocks come with more uncertainty, but they also offer greater income potential. You not only receive dividends but also have the potential for your stocks to increase in value over time.
