What Are Annuities Anyway?

By Hightower Westchester on January 31, 2022

As people are living longer, one of the biggest concerns they have is outliving their assets or income needs. For many, pensions are a thing of the past and the viability of social security in the future is up for debate.  So, what can you do?  Some people are turning to the private sector and considering annuities to supplement their cash flow needs.

What exactly are annuities? Quite simply they are an insurance contract that provide people with an income stream during retirement. You, the consumer, deposit a certain amount of money with the insurance company which invests that money that in turn, will get paid to you in specific intervals over a specific period of time.   So, depending on how the annuity is structured, it provides someone with a fixed income stream over the course of their lifetime or for a fixed period of time.  Annuities can be complex vehicles and the fees can vary so anyone purchasing an annuity should seek additional guidance before doing so.

Annuities can be optimized for income or long-term growth. The majority of the time they are a longer-term vehicle that is used to diversify and mitigate longevity risk.

There are two basic annuities, immediate or deferred. The option that is appropriate for you should be determined based on your financial goals.

Immediate Annuity: If you need income right away, then you would choose this option. This works similarly to a pension plan. You pay a lump sum of money to the insurance company and in return you receive a guaranteed stream of income for the duration of the contract. There are different types of immediate annuities to choose from so you should do your research to make sure you know all the different options offered.

Deferred Annuity: If there is a specified timeframe in which you need money then the deferred annuity is the desired option. With a deferred annuity, the income payments are delayed for at least a year, but you can delay payments for longer than 10 years if you’d like, giving your investment more time to grow which could mean larger payments in the future.  With deferred annuities, the funds grow tax-deferred until withdrawn. Once funds are taken out, the appreciation, which most of the time comes out first, is taxed as ordinary income.

There are three types of deferred annuities: fixed, variable and indexed.  Here is a summary of their features:

Fixed Annuity: This option has the least risk and the most predictability, so it’s suited for conservative investors. These annuities provide the consumer with a guarantee from the underlying insurance company that their contribution will earn a specific rate of interest during the accumulation phase. During the accumulation phase, the interest in your account is tax-deferred. Upon maturity, you have options. You can take out a new annuity, annuitize the contract, or leave the annuity with the insurance company which will provide a different rate of interest for the new contract.  Some of the cons of fixed annuities: fees and/or internal expenses, returns tend to be low, loss of flexibility, and penalties for early withdrawals.

Variable Annuity: Has more risk and the potential for higher rewards.  Variable annuities are invested in various investment vehicles and the interest rate is tied to an investment portfolio. The payout on these annuities can increase if the portfolio does well, but they can decrease if the investment loses money.  Variable annuities also offer certain insurance features, at a cost, such as the ability to make a certain number of withdrawals per year or a stepped-up death benefit. Variable annuities are also tax-deferred meaning you only pay taxes on the income and the investment gains when you start withdrawing your money.  This type of annuity is not optimal for someone looking for a fixed rate of return or fixed payout. Some of the cons of variable annuities: high fees, can generate significant taxes, and are very complex.

Indexed Annuity:  These annuities have characteristics of both fixed and variable annuities.  It’s a way to balance risks and rewards as they have lower risk than variable annuities and higher income potential than fixed annuities. Index annuities pay an interest rate that is tied to a specific market index, think the S&P 500.  As a result of this, an indexed annuity can rise higher than a fixed annuity but there can be limits set on the potential gain. There are also minimum rate guarantees for when the specific market index declines. These are more complex vehicles with potentially longer lockup periods and higher costs. Some of the cons of indexed annuities: high sales commissions, complicated contracts and regulations, potential for lower returns, penalties for early withdrawal, and interest cap rates.

One not previously mentioned benefit of annuities is there are no annual contribution maximums so if you’re a high-income saver that has reached their annual maximum contribution for your 401(k), this is another potential tax-advantaged vehicle for you to save for your retirement.

For some the word annuity creates a negative connotation whereas for others it is a means to an end.  As with any investment vehicle, it comes down to defining one’s goals and objectives to make sure it is something that fits in the overall financial roadmap. The insurance landscape is ever changing so we highly recommend seeking professional advice to understand the pros and cons of these investment vehicles.

Roman Ciosek – Managing Director, Partner – Hightower Westchester

914.825.8633 – rciosek@hightoweradvisors.com