What are annuities?

Saving for retirement is one of the most important money moves you can make. After all, it can be tough to live off of Social Security payments alone. For example, the average Social Security retirement benefit for January 2024 is estimated to be $1,907, according to the Social Security Administration, which may not be enough to cover all your expenses during retirement. And, with questions surrounding the long-term viability of the Social Security system, it makes sense for most people to start saving and investing for retirement as early as possible. 

But while it's imperative to have a solid plan in place for your finances after you stop working, traditional options, like a 401(k) or individual retirement account (IRA), aren't the only way to ensure financial security during retirement. If you're approaching retirement age and want to ensure a steady stream of income for your golden years, you may also want to consider an annuity. 

What exactly is an annuity, though, and is it a good investment choice for your situation? Below, we'll take a closer look at how annuities work and what the potential pros and cons are of opting for one during retirement.

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What are annuities?

An annuity is essentially a contract between you and an insurance company in which you make an upfront lump sum payment or series of payments to the insurer. In return, the insurer agrees to make periodic payments back to you, either for a specific number of years or over your lifetime.

Annuities are a popular retirement option because they provide a steady source of income after you stop working, whether it's for a specific period or the rest of your life. And, annuities are also tax-deferred, which allows you to avoid paying income tax as they grow. 

Main types of annuities

There are several different types of annuities, but they generally fall into two main categories: deferred annuities and immediate annuities.

Deferred annuities

With a deferred annuity, your initial investment is allowed to grow tax-deferred over time before you begin taking withdrawals as income. This lets you take advantage of compound growth and is helpful if you are still in your working years but want to supplement other retirement accounts.

Deferred annuities generally come in two key forms:

• Fixed annuities: These types of annuities provide predetermined periodic payments based on your premium amount and the going interest rate from the insurer.
• Variable annuities: Variable annuities generally allow you to allocate your premiums across investment portfolios, so your eventual payments can fluctuate based on those investments' performance.

Immediate annuities

An immediate annuity starts providing income payouts right after you make your initial lump sum investment. This type of annuity can, in turn, be useful if you have a specific lump sum, like the funds from a 401(k) rollover, and need income immediately in retirement.

The payout terms for immediate annuities can vary based on factors like your life expectancy. For example, you'll receive higher payments with a fixed period certain annuity versus a lifetime annuity.

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Advantages of using an annuity for retirement planning

So why would you want to consider an annuity for retirement planning? Here are a few key advantages:

Guaranteed income stream

With most types of annuities, especially fixed annuities, you are guaranteed to receive a specified income payment amount on a regular schedule. This can provide invaluable peace of mind as you'll know that you have money coming in to cover basic living expenses during retirement.

Tax-deferred growth

Any earnings on your annuity investment are allowed to grow tax-deferred until you begin taking withdrawals as income in retirement. This gives you a head start over taxable investment accounts.

Potential for lifetime income

If you select a life annuity, you can receive payments for as long as you live, even if you live longer than the average life expectancy. This protects against the risk of outliving your assets.

Disadvantages of using an annuity for retirement

But while annuities can be a smart option to consider, they also come with some drawbacks:

Upfront costs

Annuities typically charge administrative fees, fund management fees for variable annuities and potentially surrender charges if you make early withdrawals. These fees can add up quickly, so it's important to factor them in when making a decision.

Less liquidity

Once you've established an annuity, your money is committed for a set period or until you start taking income. 

Lower investment returns

The stability of the guaranteed income stream provided by annuities comes at a cost. When you purchase an annuity, the tradeoff is potentially lower overall investment returns compared to other retirement accounts.

No control over the principal

With a life annuity, in particular, you eventually spend down the entire original investment amount you contributed. At the end of your life, the insurance company keeps what remains.

The bottom line

For many retirees, using a portion of their savings to purchase an annuity and create a guaranteed baseline income can make sense as part of an overall diversified retirement strategy. However, annuities likely shouldn't be your only retirement income source. A balance of income streams and growth opportunities is ideal. And, as with any major financial decision, it's crucial to understand all the fine print and terms of an annuity contract. It's also smart to make sure you're comfortable with any fee structures, income start dates or other restrictions to ensure an annuity matches your retirement goals and fits well within your broader financial plan.