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Annuities are long-term investment products that provide a guaranteed regular income during one’s retirement, or during the period in which the annuity is held. Typically sold by insurance companies, annuities provide stability, peace of mind, and protection against outliving your money.
Nearly half of all U.S. investors own annuities—in fact, 48% claim to currently own or that they have previously owned an annuity. By comparison, only about 45% say they own mutual funds. Even if they come at a higher cost, millions of Americans will take the benefits of annuities over the risks inherent in stocks, mutual funds, and other equities.
But what are the benefits of annuities, beyond those already mentioned? To help bring you up to speed on this refreshingly boring, low-risk asset class, we’ve put together a comprehensive guide to annuities. In this article, we will explore the reasons why retirees and soon-to-be retirees might want to diversify their retirement portfolio with an annuity.
Annuities 101: What Is An Annuity?
Technically, an annuity isn’t an investment; at least not by the traditional definition. Since the returns on fixed annuities are predetermined by an annuity contract, they don’t carry market risk. Rather, the main risk involved (i.e., what makes it an investment and not merely a product) is the risk of dying prematurely and not realizing the full value of the annuity.
In the absence of pensions and adequate social security coverage, annuities fill the need for regular income payments during one’s retirement. Annuities are purchased from an insurance company; that is, unless they are secondary market annuities, which are controversial investment products purchased from a factoring company in the aftermarket.
An annuitant (i.e., the annuity “investor”) purchases an annuity contract for a lump sum upfront in exchange for a series of annuity payments paid out in monthly installments. Therefore, the annuitant agrees to pay $X right now, under the condition that they are paid $Y per year for the rest of their life.
As an insurance product, the overall expected value of an annuity is negative. For example, most consumers lose money on auto insurance, but they’re paying for an important service in the event of a car accident. The same is true of annuities—you’re paying for protection from outliving your retirement savings, or from enduring a recession during your retirement.
The Benefits of Annuities
Now that we know the basic structure of annuity investments, let’s take a look at why an investor (and especially a retirement investor) might be interested in purchasing one. Below, we’ve listed some of the main benefits of annuities and provided our own commentary on whether these reasons are compelling or not.
Steady Retirement Income
The most obvious benefit of annuities is that they provide structured payments during one’s retirement, a period in life where regular income can be hard to come by. An annuity provides supplemental income that can provide much-needed peace of mind during your golden years. This way, you won't have to worry about how to cover expenses when you're no longer working.
Tax-Free Retirement Growth
Money contributed to an annuity is tax-deferred. Like a traditional IRA or 401(k), you won't owe money on your annuity contributions until you start receiving payments in your retirement. However, it's possible to buy an annuity through a Roth IRA to enjoy a completely tax-free income stream later in life.
Freedom & Flexibility
Unlike normal tax-advantaged retirement accounts like 401(k)s and IRAs, annuities don't have mandatory withdrawals. In other words, you aren't forced to start taking distribution payments at the age of 72—instead, you can start taking distributions whenever you please.
Also, there aren't any contribution limits imposed on annuities. Whereas IRAs are capped at $7,000 per year if you're 50 years of age or older, annuities do not have restrictions on the amount of after-tax money you contribute.
In many cases, annuities include insurance in the case of the annuitant's death whereby payments are contributed to one's next-of-kin or designated secondary beneficiary. In other words, you can rest assured that your annuity will continue to payout to an appointed individual, often a family member, even in the event of your premature death.
Whereas fixed annuities offer guaranteed rates of return, similar to Treasury securities or municipal bonds, variable annuities are tied to the performance of an underlying asset. Usually, variable annuities are tethered to an index fund or mutual fund whose values fluctuate over time. There exists considerable debate regarding whether variable annuities are worth the risk for retirees.
When buying a variable annuity, there are many underlying funds you can choose from that can be tailored to your individual risk preferences. For example, more risk-averse investors can choose an annuity tied to the S&P 500 (0.83 Sharpe ratio), while those who prefer a more risky investment strategy might opt for the Vanguard Growth ETF (1.17 Sharpe ratio).
To better illustrate the important differences between a variable and fixed-rate annuity, we've provided a table below.
|Fixed Annuity||Variable Annuity|
|Rate of Return||Fixed interest rate, predetermined in advance and specified in the annuity contract||Fluctuates depending on performance of underlying funds; potential for higher returns as well as losses|
|Registered as Security||No||Yes|
|Associated Risks||Locked-in long-term rates; opportunity cost of a low-return asset||Market risk of underlying assets to which the annuity is tied|
|Best Suited For||Low-risk retirement investors seeking income security||Higher-risk retirement investors willing to assume greater risk for greater potential reward|
Living Benefits Options
One of the lesser-known benefits of annuities is that they often include a living benefit option, which is a form of principal protection offered for a fee. If you purchase a variable annuity, market risk factors into your payouts. However, a living benefit option can protect against negative market effects on your annuity's performance.
There are three main types of living benefit options that can provide downside protection in case your annuity's value declines. You can think of these as a form of insurance to offer a guaranteed minimum income in case the market takes a turn for the worst. There are three main types of living benefit options, which are as follows:
- Guaranteed Lifetime Withdrawal Benefit (GLWB): An optional rider that provides a minimum level of lifetime income that can rise depending on market performance.
- Guaranteed Minimum Accumulation Benefit (GMAB): An optional rider that guarantees a minimum value after a defined accumulation period, typically 10 years.
- Guaranteed Minimum Income Benefit (GMIB): A clause that, after the annuity is annuitized, guarantees a minimum payment amount on a regular basis regardless of market conditions.
In short, all three of the living benefit options listed above allow variable annuities to have some fixed elements. In other words, they help minimize risk in an otherwise riskier retirement asset.
How Safe Are Annuities?
Annuities are often heralded as one of the safest and most secure investment options for retirees. This is because fixed annuities (although they have their share of pros and cons) offer guaranteed rates of return, similar to Treasury bonds. Therefore, no matter the conditions of the market, the annuity holder will always receive a predetermined payment amount at regular intervals.
In short, the answer is yes, annuities are indeed safe. Annuities are one of the safest investment options (or insurance products, depending on your perspective) available to retirement investors. Although fixed annuities often have low upside potential when compared to stocks and mutual funds, they do not have the same downside risks as these more risky assets have. Furthermore, they are impervious to the effects of recessions, unlike regular equities.
In good market conditions, fixed annuities tend to underperform while, in a down market, they overperform. On the whole, a fixed annuity provides safe and secure retirement income that pays out steadily over the course of one's retirement, without the retiree having to worry about the conditions of the market.
IRA Annuity: What Is An IRA Annuity Account?
Traditionally, IRAs and annuities were thought of as competing investment vehicles. Either you invested in a tax-advantaged retirement account, like an IRA, or you purchased an annuity, since they serve similar purposes for a retiree. However, this is no longer the case, since it's possible, and often advantageous, to purchase an annuity through an IRA.
An IRA annuity account is a type of annuity purchased with after-tax IRA funds. If you own a self-directed IRA account you can purchase an annuity with the funds already contributed to your IRA. If you have a Roth IRA, your annuity payments will be 100% tax-free at the moment of withdrawal, which can save you thousands of dollars over the lifetime of the annuity.
Note that brokerage IRAs, such as those offered by Vanguard, Fidelity, or Charles Schwab, cannot typically invest in annuities. Rather, alternative investment products or insurance products, such as fixed annuities, can only be purchased through an IRA if the IRA is self-directed (i.e., not limited by a brokerage regarding the assets in which it can invest).
Choosing the Right Annuity Product for You
Not all annuities are exposed to the same level of risk, and not all annuities have the same potential for reward. Ultimately, once you've decided to invest in an annuity, the next decision becomes whether you want to invest in variable rate vs. fixed annuities. The annuity product you choose will depend on your appetite for risk.
If you absolutely must receive regular, guaranteed payments of a predetermined amount (and cannot afford to have certain months slip under this threshold), then there is no doubt that a fixed annuity is right for you.
On the other hand, a variable annuity is a better option for those who want more upside potential while also being able to afford the odd loss here and there.
Although they come at the cost of higher fees, a living benefit option is an optional rider that can be added to variable annuities to make sure your income payments never drop below a certain minimum threshold. Therefore, we find that variable annuities with living benefit options are the best middle-ground solution for investors looking for upside potential while limiting overall risk.
Are Annuities Insured?
Yes, annuity products are technically insured, although not in the traditional sense. Since annuities are sold by insurance companies themselves, they are backed by state guarantors and guaranty associations that ensure annuitants are paid if the insurance company defaults.
Although annuity products are not insured by the federal government (i.e, the FDIC), they are backed by 50 state-level guaranty associations which are authorized to provide at least $250,000 to customers if the annuity provider cannot meet their contractual obligations.
The Bottom Line on Annuities
Retirees with a steady pension or other stable sources of retirement income would probably find an annuity redundant. Since their main benefit is to provide income assurance during retirement, annuities are almost exclusively purchased by those who aren't part of a pension plan or don't expect to generate steady cash flow after they stop working.
These days, only 4% of private sector workers have a defined contribution pension, down from about 60% only 40 years ago. Even those unionized industries that offer employee pension plans have been largely scaled down and clawed back in recent years.
Since so many Americans can no longer rely on pensions during their retirement, annuities are becoming more and more popular. Basically, they allow retirement planners to take control of their financial future by trading upfront cash now for a guaranteed lifetime income.
Even those who have adequately saved for their retirement might find that they outlive their savings, or come close enough to cause them serious distress during their retirement years. In situations such as these, annuities provide critical peace of mind. After all, you're supposed to enjoy the fruits of your labor during retirement, not worry about overspending.
Purchase an IRA Annuity Today for Lifelong Peace of Mind
Outliving your retirement savings would be disastrous, and could have lasting impacts on the financial security of your family. Fortunately, there’s protection available to retirement investors. Fixed annuities provide critical income assurance for the entirety of the annuitant's life; variable annuities do the same, only with higher margins of risk and reward.
If you think that an annuity is right for you, consider purchasing one through a Roth IRA. This way, you can benefit from 100% tax-free income during your retirement. Uncle Sam already took so much of your income during your working years, don't give him an opportunity to take any more.
The benefits of annuities for retirement investors are virtually endless. After all, there's nothing more valuable than peace of mind during your golden years. To get started investing in annuities in a tax-advantaged environment, check out our list of self-directed retirement accounts today.