As you begin to plan for income in retirement, you may start to hear about annuities. These products can provide a “guaranteed” income stream for a period of time, making them a helpful tool for retirement planning. 

In our experience, annuities tend to be one of the most misunderstood products available to help folks nearing retirement. Part of this comes down to how the products are sometimes marketed. Additionally, annuities have seen significant growth in the past decade—with new products (that carry new benefits and risks) hitting the market.

It’s never been more important to understand how annuities work, the differences between the various product types, and the benefits and risks associated with each. This high-level understanding, combined with professional guidance, can help you assess whether an annuity makes sense as part of your broader financial and retirement plan.

What is an annuity?

Unlike mutual funds or ETFs (which are considered investment products), annuities are actually contracts with insurance companies. The basic structure is: You make an upfront payment (either a lump sum or a series of payments) and the insurance company promises to make a series of payments at regular intervals for a set period of time in the future.

So, what does that mean, practically speaking? Let’s consider an example.

Jake is getting close to retirement and wants to figure out a budget—so wants to create a consistent income stream that resembles his working paycheck. He has significant retirement savings, so he decides to purchase a fixed annuity for $500,000, with payments starting in six months. The payments are set at $2,500 a month (or $30,000 annually) for the rest of his life.

• If Jake lives for 20 years, those payouts would total about $600,000.
• If Jake lives for another 30 years, he would receive about $900,000 in monthly payments.
• If Jake dies young—10 years after retirement—he would have received about $300,000 in payments.

This scenario starts to highlight some of the pros and cons of annuities, and you may start to see why insurance companies have created new products to address consumer needs. For instance:

• If Jake dies young, he essentially forfeits $200,000 (in simplified terms). He might want an annuity with an income guarantee (ensuring he receives his principal back). However, this might impact the amount of his monthly payments or the terms of the contract.
• Jake’s payments are fixed; inflation usually grows at 2-3% a year, meaning his payments may effectively buy less over time. Jake might want an inflation-adjusted annuity, but again, this would change the terms of the product and add more fine print to the mix.

With this example, and these first few considerations in mind, let’s dig deeper into how annuities work, before diving into various types of annuities that might address some of the concerns outlined above.

How annuities work

To help you understand how we might use annuities strategically as part of a retirement income plan, it’s helpful to understand how they work, broadly speaking. 

1. You pay a premium to purchase an annuity. This is either a lump sum or series of installments. Your money is then pooled together with other purchaser premiums.

Note: There’s often a period where you can forfeit your annuity policy in order to recoup some of your principal investment. Terms will vary by policy.

2. The insurer does a lot of math. Insurance companies employ thousands of actuaries to look at everything from market conditions to life expectancy to figure out how many payments they’re likely to make over time. 

3. The insurer invests the capital pool. Often, these are conservative investments designed to ensure the company has enough money to make its contractual payments to policy holders. However, the exact investing strategies vary and will be outlined in the terms of your annuity. For instance, some insurance companies use complex and risky investment tools, such as derivatives, to hedge risk or attempt to amplify returns. It’s important you understand the investment philosophy that underlies any annuity you purchase. 

Note: Regulators require insurance companies to keep cash reserves to ensure they’re able to meet future payment obligations. It is possible that an insurance company will default on annuity payments or go insolvent, which is why understanding the details of the product is so important.

4. You receive payments. At this point, the insurer must pay you according to the terms of your contract. In other words, you’ll get a payment regardless of how markets perform, how long you live, and other extenuating factors. This is the main “pro” ascribed to annuities: Performance risk and longevity risk shift off you and onto the insurance company. 

Now that you understand the basic structure, let’s get into a few of the more common variants you’re likely to see if you decide to shop for an annuity. 

Types of annuities

There are a few key features that determine the type of annuity. First: When payments start. Second: Payment amounts and how they’re structured.

• Immediate vs. deferred annuities. With an immediate annuity, payments start (as the name implies) close to immediately after you purchase the annuity. With deferred annuities, you might purchase the annuity in your 50s with payments set to begin in your 70s or 80s. If you choose a deferred annuity, it’s important to understand surrender terms. Once you’ve purchased the annuity, you may not be able to change your mind or withdraw funds without incurring significant penalties. However, if you’re confident you can wait, deferred annuities may offer beneficial terms.
• Fixed vs. variable income annuities. In the initial example, Jake purchased a fixed annuity—the interest payments were fixed (similar to any other fixed income payment, like a bond). With variable annuities, payments vary according to whatever investment accounts the insurance company is using to underwrite the product. Variable annuities tend to carry similar risks to a standard investment account, and it’s important to understand the terms and fee structures to evaluate if they are offering benefits that a typical investment account would not. Recently, fixed-index annuities have looked to thread the needle between fixed and variable annuities. These products tend to offer returns that are linked to an index (like the S&P 500) but with upside and downside protection. In other words, you wouldn’t lose money like you might by investing in the market, but your upside potential is capped, and your monthly payments will still vary based on market performance.

There are additional details that you can adjust in an annuity, beyond these core differentiators. For instance, you might look for a fixed annuity that includes inflation adjustments—which may come at a higher cost. Or you may want a guarantee that you receive a certain amount of your principal pack (which could benefit your heirs if you die young). Again, these riders tend to carry additional fine print and costs.

Finally, the term of an annuity can vary. While lifetime annuities tend to be the most discussed, there are shorter-term products, as well. These fixed-period or certain term annuities can be more cost-effective options, since the insurer is taking on less risk. 

At Revo, we often suggest these shorter-term contracts (5-10 years) so clients can experience the benefits of the income stream without a lifetime commitment. At the end of the period, we can evaluate market conditions and their personal circumstances to see if another annuity might make sense.

Choosing the right annuity

At Revo, there are two main things we address before recommending an annuity to a client. 

First, we want to know the problem the client is hoping to solve. Oftentimes, the desire for a consistent income stream comes down to peace of mind. While there are other ways to create similar fixed income streams using an investment portfolio, they often come with an element of psychological risk. 

(Who among us hasn’t been tempted to sell when markets plummet, even if we know it’s likely temporary? And in these instances, the risk management that comes via an annuity can make a huge difference that’s hard to quantify.)

Second, we tend to suggest a shorter-term contract to start. Whether annuities make sense can depend on market conditions and personal circumstances, both of which change over time.

With any annuity, it’s critical that you trust the insurance company to uphold its end of the contract, and that often comes down to understanding how it’s underwriting the products and investing the capital pools that will ultimately generate your payments. This is perhaps even more important when you’re talking about fixed-index or variable annuities.

At Revo, we can help you evaluate whether an annuity makes sense as part of your broader retirement and/or financial plan. We can also help you identify products that suit your specific circumstances (or help you evaluate a sales pitch you may have received from elsewhere).

If you have questions about annuities, this article, or your finances in general, don’t hesitate to reach out.