Annuities Simple Guide for Retirees

Aug 7, 2020 07:45 AM ET
Annuities Simple Guide for Retirees

What is Annuity?

An annuity is a financial product. It pays a fixed amount to an individual and is mainly used as an income stream for retirees. These are contracts that are issued & sold by financial institutions. These institutes invest funds from different individuals. They help in reducing the risk of outliving the savings. The accumulation phase is the period between the funding of the annuity and the time when the payouts begin. As the payouts start, this contract is said to be in the annuitization phase. As this phase is reached, the product starts paying the annuitant. This paying out time can be a fixed period or the remaining lifetime of the individual as per the contract.

How do Annuities work?

There are different types of annuities. For example, fixed annuities work as they offer periodic payments in the amount agreed as specified in the contract. For example, if the contract states that the payout rate is 5% on $100,000 annuity, the individual receives $5000 each year as per the contract. Variable annuities work in a different way. Their payout rates vary and are dependent on how the investment portfolio is performing. The amount which the individual gets depends on the money which the portfolio loses or gains. Variable annuities are risky, but they are lucrative as they pay a lot more.

The Types of Annuities

Annuities are structured after considering several things. These include the duration or the time of payments, which is assured. The main purpose of creating annuities is to continue the payment for a long time so that either the spouse or the annuitant gets the amount, as long as the individual is alive. If not, these can also be structured in a way to pay funds for a fixed duration of time. This can be 10 years or 20 years, irrespective of the time, the annuitant lives.

Individuals can buy an annuity depending on their requirements. They can choose an immediate payment option or a deferred payment option, which depends on the retirement needs of the individual.

Immediate Payment Annuity - There are annuities that can start immediately after a deposit is made. This is a deposit of a big amount usually or else, it can be structured to provide deferred benefits. For instance, there is an immediate payment annuity where payments start immediately, after this payment of a lump sum amount is made.

Deferred Income Annuity – This type of annuity is just opposite to the immediate payment annuity. It is different as the payment does not start immediately after the first investment is made. The client mentions an age in the contract. This is the age; the client prefers to receive payments on behalf of the insurance company.

Fixed and Variable Annuities

Annuities can be structured as 

  • Fixed annuities – These provide periodic payments

  • Variable annuities – The owner receives more cash flows if the portfolio does well. If the portfolio does not do well, the owner receives smaller amounts. The annuitant does not receive a stable cash flow as in the case of a fixed annuity.

Variable annuities are risky as there is a chance of losing the principal amount. Certain features and riders are added to the annuity contracts, which let them function favorably like a hybrid-fixed variable annuity. The owners have the scope to benefit from an upside portfolio potential, as they enjoy lifetime minimum withdrawal benefits. This is often guaranteed in case there is a drop in portfolio value.

Why Should You Buy an Annuity?

Annuities are financial products with the objective of providing a guaranteed and stable retirement income. Immediate annuities are bought by individuals of any age with a large sum of money. You can buy an immediate annuity if you prefer to exchange this big amount for cash flows in the future. 

Why Should You Buy an Annuity
Annuities - Pros:

  • Stable Income - Annuities provide income for a lifetime. Individuals cannot outlive their income. This does not happen with traditional investments. Thus, it is a great option for retirees who look forward to a stable income after their retirement.
  • Tax-Deferred Status – The tax-deferred status is a major advantage as there is no need to make any payment on the maturity date. There is nothing to be paid unless the funds are withdrawn. Thus, owners have certain control over the tax paid.
  • Rates are Guaranteed – The payout on a fixed annuity is guaranteed for a certain time. Seniors who need a stable and predictable income, find fixed annuity a good option.

Annuities – Cons:

  • Fees - One of the major disadvantages is the hefty cost involved when compared with different mutual funds. Several of these annuities are sold by agents who charge a lot of money as commission. If buyers can purchase these directly from the insurer, it can help in saving money.
  • High Annual Expenses – Individuals need to pay a large sum of money as annual expenses. This can also be a lot more than the expenses incurred in case of an actively managed mutual fund. If anyone selects special riders for increased coverage, the expenses can be even more.
  • Poor Liquidity – There are several annuities which charge a surrender fee. This is incurred when the withdrawal is made the first time and within a few years of the contract. The surrender period can last between 6-8 years, though it can be longer.
  • Complexity – There are many buyers who agree that annuities are tough to understand. There are several riders and features which seem attractive and promising, but they come with hidden clauses that investors do not understand. They are complex and many investors do not completely understand what they are getting.

For several people and those who are not comfortable in managing an investment portfolio, any retirement annuity is a secure way to ensure that they have an income after their retirement. However, it is important to completely understand the contract before choosing to invest.

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