Many people aren’t familiar with the concept of an annuity, and for those who are, a number of them may question whether annuities are a good investment in their financial future. In times of economic turbulence, consumers may be hesitant to put their money into any financial product, let alone something they have a limited understanding of.
A 2020 study by LIMRA’s Secure Retirement Institute found that 75% of consumers failed to answer at least 7 of 10 annuity related questions correctly, with more than 40% of respondents unable to answer any of the questions. That same study found that the higher a respondent’s score was on the survey, the greater the likelihood was that they would have a positive view of annuities.
What to make of this? Annuities are a mystery to many consumers, but when that mystery is clarified and the product is better understood, consumers are generally interested in adding annuities to their financial planning strategy.
With that in mind, let’s take a look at some of the benefits of an annuity, debunk some annuity myths and clear up some of the misconceptions around this product.
What Is an Annuity?
Let’s get this one out of the way up front. I’ve written about this before, but annuities are not equity investments — like investing in the stock market. Rather, annuities are insurance products, contracts between an annuitant and an insurer. There are different types of annuities, but the basic concept is you pay an insurance company, either over time via premiums or in a lump sum, to fund the annuity. At a given time (immediate or deferred), the annuity begins to pay you, providing you with a guaranteed, reliable source of income.
Annuities vs. 401Ks
When most people think of retirement planning, the savings vehicle that most commonly comes to mind is a 401K. However, there are a few key differences between these two retirement planning tools.
One difference between the two is that when you start to withdraw your funds, a 401K has a limit — what you’ve contributed plus any investment earnings — whereas an annuity will continue to pay out as long as you live (and possibly beyond, depending on the type of policy you purchase).
Additionally, 401K contributions are limited each year, although most people don’t reach that maximum contribution. Conversely, depending on suitability and product restrictions, contributions to an annuity are much less restrictive.
That’s not to say that these two planning vehicles are mutually exclusive. Many financial professionals will recommend contributing as much as you can to a 401K, because it has a higher growth potential or because you may benefit from a matching employer contribution that can significantly impact your savings potential. However, the two can work together as part of a balanced retirement strategy and give you diversity in both risk and benefits.
Annuities vs. Life Insurance
Although annuities and life insurance are both insurance products, they serve opposite purposes. An annuity is intended to pay you a fixed amount on a regular basis for your lifetime. Its purpose is to protect you financially if you live a long life, providing a guaranteed source of income so you can’t outlive your funds. The purpose of life insurance, on the other hand, is to provide financial security for your loved ones in the event of your early death.
Both are important — you want to be prepared in case of either an early death or a long life.
What Happens When You Die?
Annuities generally pay out until the annuitant dies (or the annuitant and his or her spouse, for a joint annuity). There are different ways you can structure the payment to last beyond the original annuitant’s life, however.
One option is a life with period certain annuity. This annuity type will pay out the guaranteed amount for the duration of the annuitant’s lifetime, with a guaranteed payout period. For example, if you have a life and 15 years certain annuity, the payments are guaranteed for at least 15 years. If the annuitant (or both, in case of a joint annuity) dies 2 years into the payout period, his or her beneficiaries will receive the remaining 13 guaranteed years of payments.
Who Should Buy Annuities?
First of all, the best recommendation on whether annuities are a good investment in your future in retirement should come out of a conversation with a financial professional who understands your unique planning goals and situation.
With that said, a common recommendation is that annuities become more appealing the closer you are to retirement. Because they don’t offer a high rate of return, a younger individual with a longer investment time horizon may be more interested in equity investments that offer a chance for greater upside.
Still, there may be a place for annuities in a retirement strategy even for retirement planners who still have decades of their careers ahead of them, depending on the annuity type being considered. Deferred annuities offer the ability to put away funds for the future over a long period, letting you benefit from growth over that timeframe until you are ready to annuitize the policy and begin receiving payments. Because pensions are increasingly uncommon and Social Security is facing uncertainty of its own, having the certainty of an annuity in your retirement strategy can provide a lot of peace of mind at any age.