For many people, a 401(k) will not provide enough income to make ends meet during retirement. For this reason, you should consider alternative investments, whether that means other tax-advantaged accounts or unique products such as annuities.
A way to secure guaranteed income during retirement, annuities are contracts sold by insurance companies that provide regular installments based upon the initial agreement. An annuity can act as a supplement to Social Security and serve as the backbone of any retirement plan, especially since these contracts can provide guaranteed income for life. However, annuities can be complicated products, so you should understand the different types available before making a purchase.
The Difference between Fixed and Variable Annuities
The first major division in annuities is between fixed and variable versions of the product. As the name implies, a fixed annuity guarantees a specific payment at the agreed-upon date, which could be immediate or in the future. Insurance companies usually invest money from fixed annuities in safe products such as highly rated corporate bonds and Treasury securities.
A fixed annuity offers safe and predictable income for life, which is attractive for someone in retirement. Annuities are like private pensions in the sense that they provide a guaranteed income for as long as you live. However, you may sacrifice the chance of securing a high payout, unless the contract offers increasing income over time. The low returns with a fixed interest rate annuity can even be less than inflation, like a bank CD, which means that you will lose purchasing power. At the same time, some annuities take inflation into account, and offer increasing income streams over time, but you may need to pay extra for this sort of product. These options are best for someone with a low tolerance for risk, or for someone who wants a certain portion of their accumulated capital to not be at risk in a market crash.
With a variable annuity, the insurance company will invest in a portfolio of various mutual funds that you choose. Then, the account grows depending on the performance of those investments. The size of the payout depends on the amount of growth achieved. The variable annuity payouts can themselves be fixed, depending on performance, or vary according to the market. If you choose a variable annuity, you are accepting a certain amount of risk for the chance of a larger payout down the road. If you are familiar with mutual funds and their risks, this can prove a wise investment. However, the risk could also mean that you end up losing money in the long run, just as you would with mutual funds at risk in the markets.
How to Decide between Immediate and Deferred Annuities
The other major division in annuities is between immediate and deferred products. Immediate annuities start payments once the product has been purchased, whereas deferred annuities start at an agreed-upon date. Both of these products can be either fixed or variable. With immediate annuities, the payouts begin once the lump sum is made, so they are ideal if you are already retired or plan to stop working very soon. However, there is a tradeoff for starting payments immediately. Most importantly, the money will not have time to grow as much once it is invested, which is most important when purchasing a variable annuity.
Deferred payments give the money time to grow in the account. The earnings from investments accumulate on a tax-free basis, much like with an IRA or 401(k). If you have a variable annuity, this could equate to a significant sum and a large payment in the future. However, you also run the risk of losing money. If you have a very long time between purchasing the annuity and starting payments, you can mitigate this risk since the recovery of the accounts is possible. The amount of time that the account is allowed to grow is known as the accumulation period. A lower cost alternative to the variable annuity is a “fixed index annuity”, which offers full principal protection at all times in exchange for potentially lower returns from various index choices. In other words, you give up some of the upside that the variable annuity offers, but you never have a negative year, and thus don’t need to face what could be a multi-year period of recovery.
The Other Points to Consider When Purchasing an Annuity
Beyond these basic breakdowns, you will need to consider several other points when purchasing an annuity. For example, the duration of payments is not always the same. While some annuities will pay out for 10 or 15 years, others offer lifetime payments, which is usually the best choice for retirees. However, a longer payout period means smaller payments overall. You will also need to think about spousal coverage. If you are married, you will likely want an annuity that lasts not just the length of your life, but also that of your spouse—this is called a joint and survivor annuity. While the payment is lower with this option, both parties remain covered, regardless of how long one or both of the parties live.
The other point to consider when purchasing annuities is that they are paid out through the insurance company, which means that you will stop receiving payments if the company fails. For that reason, you need to do your due diligence and make sure that you are choosing a company that is likely to be around once you start receiving payments. This risk is most significant with deferred annuities, as they can sometimes be planned to start decades in the future. If the insurance company no longer exists at that point, you will have lost out on the lump sum that you initially paid for the annuity and not receive any payments. Historically, insurance companies rarely fail, and are generally much more conservatively managed than banks. In fact, unlike banks that may lend out many times their deposit base in risky loans ( fractional reserve lending), the insurance company does not make loans, and therefore has no leverage to worry about. The vast majority of an insurance company’s holdings are in bonds, rather than real estate or loans, like a bank. You may want to consult with a financial professional when purchasing an annuity to make sure you are making the right choice for your situation.