Why Annuities Can Be a Strong Retirement Tool

Low interest rates hurt payouts now, but annuities retain appeal for providing secure retirement income.

By + More

Be honest. When you see the word "annuity," does your brain quickly look for an escape route to a more enjoyable topic? That's OK. I won't take it personally. And annuities can be tough sledding. But properly understood and used, annuities can be a great addition to a retirement plan. So, arm yourself with your favorite caffeinated beverage, and let's take a tour of Annuityville. Much of the information here was obtained via reports and interviews from experts at the Insured Retirement Institute and another trade-supported organization called LIMRA.

[Find top-rated Mutual Funds and ETFs.]

In many respects, Social Security payments are like an annuity, although one that has very attractive cost-of-living increases. A lot of folks would like to have more retirement income that is that safe. Low interest rates have made it hard for insurers to provide attractive payment guarantees on products sold today. Even so, annuities are receiving a lot of attention. What should you be looking for?

The first thing to understand is that annuities are essentially contractual obligations from insurance companies. In exchange for funds you provide to the insurer, which are paid into the product during what is called its build-up phase, you are provided certain things that are spelled out in your annuity contract. The most basic promise is the insurer's commitment to make regular payments to you. This is known as the annuitization phase of the product. The payments begin at a specified time and usually last for the rest of your life or, depending on the specifics of your annuity, the rest of your spouse's life as well.

Second, money put into an annuity contract can grow tax-free until funds are withdrawn. If funds are withdrawn during the build-up phase, or because the annuity has been terminated early, it is assumed that any earnings that have accumulated in the annuity are withdrawn first, and taxed as ordinary income. Assuming the annuity was funded with post-tax dollars, the return of those initial funds is considered a return of principal (remember, this is an insurance product) and is not taxed. Once regular payments have begun in the annuitization phase, they are treated as a blend of earnings and return of principal, and taxed accordingly.

When you purchase an annuity, the size of the ultimate payments you will receive depend on several basic factors: how much money you're putting into the contract, how old you are, and how far off the beginning date is for payments to begin. The insurer knows, on average, how long you're going to live. And it also knows how much money it expects to earn from the funds you've placed into the annuity contract. The amount of money it's willing to pay you is thus a calculated bet on its part. And, yes, it's a bet where the odds are tilted in favor of the insurer, which is trying to make a profit on the transaction.

[See 3 Ways Low Interest Rates Hurt Seniors.]

Annuities can be bought and activated right away or over time. In the case of an immediate annuity, the insurer's stream of payments begins right after it has received your money. In a deferred annuity, the payments don't begin until a future date specified in your agreement. You can fund an annuity with a single, lump-sum payment or with periodic payments.

A fixed annuity provides you the promise of fixed payments over time. A variable annuity (VA) places your money into investments that you can control. Most often, those investments are in mutual funds. Your subsequent VA payments will be influenced by the performance of your investments. There also is a type of fixed annuity known as an indexed annuity. It provides you performance guarantees that are linked to the gains in a common index, such as the S&P 500 index. You would be able to enjoy some of the upside of having your funds invested in the stock market, but you wouldn't need to actively manage these investments.

In the most basic of annuities, the insurer promises to pay you a specified amount of money, beginning at a future date, for the rest of your life. When you die, any money you've placed in the annuity contract belongs to the insurer, not to your estate. Clearly, if you live for a short time, the insurer does very well on the contract. If you live for a very, very long time, the insurer doesn't fare so well. That's the basic bet.

[See Is Retirement Advice Biased Against You?]

Most people, however, want more than this basic promise. They may, for example, want the insurer to make annuity payments to them or their heir for at least a minimum amount of time. If that time is, say, 10 years, then their estate gets those payments should the contract owner die before receiving 10 years of payments. Often, one spouse wants to make sure that annuity payments continue for his life and, should he die, for the remaining life of his spouse as well. Lots of annuity contracts include that provision.

Many contracts for investment-linked annuities also offer guarantees that, regardless of market performance, you will always receive back at least the amount of your premium payments into the annuity.

Guaranteed benefit provisions and other product enhancements aren't free and are reflected in a combination of higher purchase costs and reduced benefits. Some annuities also carry steep fees for ending the contracts in their early years.

If you don't know these trade-offs and are not sure you can make an informed purchase decision, either avoid annuities or work with an investment adviser.