People have a wide range of different vehicles available to them when it comes to saving and investing for retirement. One of the more complex options that individuals tend to overlook is annuities. An annuity is an insurance product that can be used for steady, predictable income during retirement. Individuals invest in an annuity with an agreement about when payments for it will be received in the future. The income from an annuity may come monthly, quarterly, annually, and even in one lump sum depending on the agreement that is made. The size of each payment depends on several different factors, including the desired repayment period.
Through an annuity, investors can choose to receive payments for the remainder of their lives or only for a set period. The decision affects payout totals, as does the type of annuity. A fixed annuity provides guaranteed payments, while a variable annuity pays an amount that is dependent on the performance of underlying investments. The downside of annuities is the high expense, which is one reason why many people steer away from them. Ultimately, however, they can prove to be a great choice for many people provided that they do their research and ensure that the investment will work well with their individual situation.
How Exactly Does An Annuity Work?
While the idea behind annuities is simple, these contracts tend to be highly complex. In the most basic sense, an annuity is a contract with an insurance company to bear the risk of investment. You can pay for annuities in a lump sum or through a series of payments during what is called the accumulation phase. When the annuity begins to pay you back, this is called the payout phase. Payout can start immediately, or it can be delayed for years or decades. One example of an annuity that virtually every American depends on is Social Security. You transfer risk to the Social Security Administration, and in return you receive payments based on how much you paid into the system.
While the federal government guarantees Social Security, insurance companies back traditional annuities. A guaranteed payment is only as secure as the insurance company taking the payment. This fact also means that there is some risk involved in annuities. While the risk in variable annuities is inherent, even fixed annuities can prove problematic if an insurance company grows unstable. Individuals should make certain that they invest with respectable and dependable organizations in order to reduce this risk, especially since most individuals use annuities to provide guaranteed income in retirement.
What Are the Benefits of Annuities for Retirees?
Perhaps the greatest benefit of making annuities part of a retirement portfolio stems from research undertaken by Mark Warshawksy, Robert Veres, and John Ameriks. They found that annuities reduced portfolio failure rates across the board. In other words, annuities help to protect you against running out of money in retirement. While this means the most when viewed through the framework of longevity, it is worth pointing out that this vehicle had benefits across the spectrum. At the same time, this benefit is a double-edged sword, because the same researchers found that annuities can also limit the potential upside of investment by decreasing overall gains. Thus, while annuities provide some stability, they do so at a price, as the money could be invested in riskier vehicles with higher potential returns.
Another benefit of annuities has to do with legacy. Most people assume that annuities decrease legacy since payments are limited, but this is not the case. A study found that annuities actually help people to spend less of the asset during retirement, particularly if they live a long life. This fact translates to a greater legacy for the heirs. Part of the reason behind this is the liquidity of an annuity, which is not the same for other types of retirement investments. While no investment portfolio should have only annuities, knowing that a deposit of cash is coming on a specific date makes it less necessary to dip into other vehicles that take a long time to turn into cash.
Who Would Not Benefit from An Annuity?
Not everyone needs an annuity in their retirement portfolio. Most notably, people who are not concerned about running out of money during retirement would not benefit greatly from an annuity since the money could be used for an investment with a bigger payoff. Also, people who feel like they receive a sufficient fixed income from Social Security may not need to necessarily focus on adding to that fixed income. The other consideration is life expectancy. Individuals with serious health conditions will not get the most from an annuity, of which much of the value derives from longevity. However, people with these conditions who want to make sure a spouse is provided for may benefit immensely from annuities. At the end of the day, individuals also need to think about diversification. Without a lot of money to invest, annuities should not be high on the priority list. Even with a decent nest egg, no more than 25 percent of total savings should be placed in annuities, according to most financial professionals.