An annuity can be a powerful tool for retirement planning, offering guaranteed income when you need it most. However, the world of annuities is complex, with numerous product types, features, and considerations that can make the buying process overwhelming. If you’re looking to purchase an annuity, we’ll walk you through everything you need to know about purchasing an annuity, from understanding the basics to making your final decision.

Annuity basics

An annuity is essentially a contract between you and an insurance company. You pay the insurer a lump sum or series of payments, and in return, the company agrees to make periodic payments to you, either immediately or at some future date. Think of it as a way to convert a portion of your savings into a guaranteed income stream.

The fundamental appeal of annuities lies in their ability to provide predictable income, making them particularly attractive for retirees who want to ensure they won’t outlive their money. Unlike other investments that fluctuate with market conditions, annuities offer a level of certainty that can provide peace of mind during retirement.

Types of annuities: Choosing your path

Understanding the different types of annuities is crucial to making an informed decision. Each type serves different needs and risk tolerances.

• Immediate annuities begin paying you within a year of purchase, making them ideal if you need income right away. You typically purchase these with a lump sum, and payments can start as soon as 30 days after your initial investment. These are most common among people who are already retired or nearing retirement.
• Deferred annuities, on the other hand, allow your money to grow tax-deferred until you’re ready to start receiving payments, which could be years or even decades in the future. During the accumulation phase, your money grows according to the terms of your specific annuity type.
• Fixed annuities offer guaranteed returns and predictable payments. The insurance company promises a specific interest rate for a certain period, protecting you from market volatility. Your principal is protected, and you know exactly what you’ll receive. However, the trade-off is potentially lower returns compared to market-based investments, and fixed payments may lose purchasing power over time due to inflation.
• Variable annuities allow you to invest in sub-accounts that function similarly to mutual funds. Your returns depend on the performance of these underlying investments, which means you bear the investment risk. While this offers the potential for higher returns, it also means your account value and future payments can fluctuate based on market performance.
• Indexed annuities represent a middle ground between fixed and variable products. Your returns are tied to the performance of a market index, such as the S&P 500, but with a guaranteed minimum return and a cap on maximum gains. You participate in market upside while having some downside protection.

Key features and riders

Modern annuities come with various optional features called riders that can enhance your contract for an additional cost. Understanding these options helps you tailor the annuity to your specific needs.

• Death benefits: Most annuities include a basic death benefit that pays your beneficiaries at least the amount you initially invested, minus any withdrawals. Enhanced death benefit riders might guarantee your beneficiaries receive the highest account value on any anniversary date or provide a stepped-up benefit based on investment performance.
• Income riders: Guaranteed lifetime withdrawal benefit (GLWB) riders ensure you can withdraw a specific percentage of your account value annually for life, regardless of market performance. These riders typically guarantee withdrawal rates between 4% and 6% annually, depending on your age when you begin withdrawals.
• Inflation protection: Some annuities offer cost-of-living adjustments that increase your payments over time to help maintain purchasing power. While valuable for long-term income planning, these features typically reduce your initial payment amount.
• Long-term care benefits: Certain annuities include provisions that double or triple your income payments if you require long-term care services, providing an additional layer of financial protection for healthcare expenses.

Financial considerations

The cost structure of annuities is more complex than many other financial products, and understanding these costs is essential for making an informed decision.

• Surrender charges: Most annuities impose surrender charges if you withdraw more than a specified amount (typically 10% of your account value) during the early years of the contract. These charges often start at 7-10% in the first year and decrease annually, eventually disappearing after 6-10 years. Understanding this surrender schedule is crucial, as it affects your liquidity.
• Management fees: Variable and indexed annuities typically charge annual management fees ranging from 1% to 3% of your account value. These fees cover administrative costs, investment management, and insurance features. Fixed annuities generally have lower explicit fees since the insurance company profits from the spread between what they earn on investments and what they credit to your account.
• Rider costs: Optional riders typically cost between 0.25% and 1.5% of your account value annually. While these features can provide valuable benefits, it’s important to understand their cost and evaluate whether the benefits justify the expense.
• Tax implications: Annuities offer tax-deferred growth, meaning you don’t pay taxes on gains until you withdraw money. However, withdrawals are taxed as ordinary income, not as capital gains. If you withdraw money before age 59½, you may face a 10% early withdrawal penalty in addition to regular income taxes.