Planning for retirement is about more than just saving money—it’s about making sure your savings can provide you with reliable income for the rest of your life. That’s where annuities come in. If you’ve heard the term but aren’t sure what it means, or if you’re overwhelmed by the different types, you’re not alone. This guide will explain the main types of annuities available in the United States, how they work, and how to choose the right one for your retirement needs.
What Is an Annuity?
An annuity is a contract between you and an insurance company. You pay the insurer either a lump sum or a series of payments, and in return, the insurer promises to provide you with regular income payments—either for a set period or for the rest of your life. Annuities are designed to help manage the risk of outliving your savings, offering peace of mind as you transition into retirement.
Why Consider an Annuity?
- Guaranteed Income: Many annuities can provide income for life, no matter how long you live7.
- Tax Deferral: Money in an annuity grows tax-deferred until you withdraw it, helping your savings grow faster.
- Protection from Market Volatility: Some types of annuities offer protection from market downturns, making them attractive for conservative investors.
The Main Types of Annuities
Let’s break down the most common annuities you’ll encounter in the U.S. market.
1. Fixed Annuities
How they work: Fixed annuities pay a guaranteed interest rate for a set period, and your payments remain the same throughout the payout phase. They’re straightforward and predictable, making them a popular choice for retirees who want stability.
Pros:
- Predictable, steady income
- No exposure to market risk
- Simple to understand
Cons:
- Lower potential returns compared to variable or indexed annuities
- May not keep up with inflation over long periods
Who they’re for: People who want safety and predictability in retirement income.
2. Variable Annuities
How they work: With a variable annuity, your money is invested in subaccounts (similar to mutual funds), and your income payments fluctuate based on the performance of those investments. This means your payments can go up or down, depending on market returns.
Pros:
- Potential for higher returns
- Investment flexibility
- Optional riders for death benefits or income guarantees
Cons:
- Exposed to market risk—payments can decrease
- Higher fees and more complexity
Who they’re for: Investors comfortable with risk who want the potential for greater growth.
3. Indexed Annuities (Fixed Indexed Annuities)
How they work: Indexed annuities offer a guaranteed minimum interest rate, but your returns are linked to the performance of a market index, like the S&P 500. If the index performs well, you can earn more—but there’s usually a cap on how much you can earn in any given year.
Pros:
- Potential for higher returns than fixed annuities
- Downside protection—your principal is protected from market losses
- Steady income stream
Cons:
- Complexity—can be difficult to understand all the features
- Returns are capped and may not keep up with strong market gains
Who they’re for: Those who want some market upside but don’t want to risk losing their principal.
4. Immediate Annuities
How they work: You pay a lump sum to the insurance company, and they start making payments to you almost immediately—usually within 12 months. Payments can last for a set period or for your lifetime.
Pros:
- Income starts quickly
- Simple and easy to set up
- Can provide lifetime income
Cons:
- No access to your lump sum after purchase
- Little flexibility if your needs change
Who they’re for: Retirees who need income right away and want to convert a portion of their savings into a predictable stream.
5. Deferred Annuities
How they work: With a deferred annuity, you invest your money now, and income payments begin at a future date you choose. This allows your money to grow tax-deferred during the accumulation phase.
Pros:
- Tax-deferred growth
- Flexibility in choosing when to start income
- Can accumulate more over time
Cons:
- Early withdrawals may be subject to penalties and taxes
- Income is delayed
Who they’re for: Those still working or not yet ready to start drawing retirement income.
Special Types and Features
- Multiyear Guaranteed Annuities (MYGAs): A type of fixed annuity that guarantees a set interest rate for a specific period, often three to ten years.
- Joint and Survivor Annuities: Provide income for two people, typically spouses. Payments continue until both have passed away.
- Period Certain Annuities: Pay income for a fixed period (e.g., 10 or 20 years), regardless of whether you live that long.
- Qualified and Non-Qualified Annuities: Qualified annuities are purchased with pre-tax dollars (often through retirement plans), while non-qualified annuities are funded with after-tax dollars.
Key Considerations When Choosing an Annuity
- Fees and Expenses: Variable and indexed annuities often have higher fees, which can eat into your returns.
- Liquidity: Annuities are designed for long-term income, so accessing your money early can result in penalties and surrender charges.
- Financial Strength of the Insurer: Choose a reputable insurance company with strong financial ratings to ensure your income is secure.
- Taxation: Withdrawals are taxed as ordinary income. Early withdrawals (before age 59½) may incur a 10% penalty.
- Optional Riders: These add benefits like guaranteed minimum income or enhanced death benefits, but usually come at an extra cost.
How to Decide Which Annuity Is Right for You
- Assess Your Retirement Goals: Do you want guaranteed income, growth potential, or a mix?
- Evaluate Your Risk Tolerance: Are you comfortable with market fluctuations, or do you prefer steady returns?
- Consider When You Need Income: Immediate annuities are for those needing income now; deferred annuities work for future needs.
- Compare Products and Providers: Look at fees, features, and the financial strength of insurers.
- Consult a Financial Advisor: Annuities can be complex. A professional can help you match the right product to your needs.
Final Thoughts
Annuities can be a powerful tool in your retirement planning toolkit, offering guaranteed income, tax advantages, and peace of mind. The key is to understand the different types—fixed, variable, indexed, immediate, and deferred—and match them to your personal goals and risk tolerance. Take your time, ask questions, and work with a trusted advisor to make the best choice for your future.
References:
- RetireGuide: The Different Types of Annuities and How They Work
- Annuity.org: Types of Annuities Made Easy
- SmartAsset: Types of Annuities to Consider for Retirement
- FINRA: Annuities
- Investopedia: Guide to Annuities
At Towering Dreams we help American families to choose the right type of Indexed Universal Life ( IUL ) & Annuity plan.