According to the United States Government Accountability Office (GAO), Americans need to place a greater dependence on annuities in their retirement plan. The GAO advises that at least half of your retirement savings be converted to an annuity.

The investor class is already following this principle. In fact, nearly half of all investors currently own an annuity.

As you inch closer towards retirement, now is the perfect time to research annuities. Read on to learn 10 things that you need to know about buying annuities.

1. What Is an Annuity?

Before diving into annuity formulas and other complicated topics, you should understand precisely what an annuity is. Many people mistakenly believe that an annuity is an investment.

In its simplest form, an annuity is a signed contract that guarantees income payments over a lifetime. These payments are triggered when you make a lump sum contribution to the plan administrator.

Insurance companies are the primary source of an annuity contract. Although slightly different, pension payments are analogous to annuities.

2. Why Do Retirees Prefer Buying Annuities?

Americans prefer buying annuities because it substantially reduces the risk in their retirement portfolio. Annuities became popular in the United States after the Great Depression.

Investors were gravely concerned about the volatility of the stock market and desired more security. Annuities provide that security as the income payment terms are contractually required.

In the past, Americans used to rely on guaranteed payments through pension plans. However, only 13 percent of Americans currently have a defined pension plan.

In the 1990s, this number was nearly 40 percent. As a result, Americans are shifting to annuities as a source of guaranteed retirement income.

3. Should All of Your Retirement Savings Go Towards an Annuity?

No serious retirement planner would recommend placing all your eggs in one basket. The best retirement strategy is to diversify your portfolio.

Buying annuities are just one of many potential income streams you should generate to support your retirement. You should continue to contribute to 401(k) plans and other retirement savings accounts.

While annuities do provide guaranteed income, this is somewhat dependent on the health of the company you are purchasing from. If the insurance company goes out of business, your guaranteed income could be vulnerable. For this reason alone, retirement experts always advise for the establishment of a diverse portfolio.

4. What Types of Annuity Plans Are Available?

There are a number of different annuity plans to choose from. Before making a decision, you should be familiar with the characteristics of each one.

The three most common types are fixed, variable, and indexed annuity plans. In a fixed annuity plan, the interest rate is guaranteed over a set period of time. The fixed rate of return is based on a yield from the insurance company.

Typically, the term ranges from 1 to 10 years. When the initial guarantee period expires, the yield on a fixed annuity plan adjusts based on current market rates. Many people prefer fixed plans because the contract sets a minimum guaranteed rate, and fixed annuities typically offer higher guaranteed rates than CDs.

Variable annuity plans pose greater risk and reward to the buyer. The rate of return fluctuates based on market conditions. In good economic times, the buyer may see higher annuity payments than a fixed plan.

The disadvantage is that a downturn in the market can shrink annuity payments and create hardship for your family. Remember, variable annuity funds are invested in mutual funds or exchange-traded funds. The performance of the cash value is dependent on the performance of the underlying funds.

Another key element to variable annuities to keep mind of is that they are notorious for higher fees. Common fees include but are not limited to mortality and expense charges, income or death benefit rider fees, principal protection rider fees, 12b1 fees, and administration fees.

It’s not uncommon to see a variable annuity rack up to a combined 5% in annual fees. Those fees get charged whether you are making money or not. Most of the fees listed above are not required to be reported on statements, so many policyholders don’t realize just how much they are paying.

Ways to avoid this pitfall is to ensure you know what share class you are purchasing, and what do different share classes for the same product charge in fees and provide in benefits.

There is a prospectus that comes with all variable annuities. Be sure to ask for one if it’s not offered to you. Take it home and read through it. Be sure to look at all areas that carry potential fees and ask the broker which fees apply to the variable annuity you’re about to purchase.

The final annuity type is called a fixed index annuity. Like a variable annuity, fixed indexed annuities have the potential of earning more interest than traditional fixed annuities. The biggest differentiating factor between variable and fixed indexed annuities is the fact that a fixed indexed annuity cannot lose value due to stock market fluctuations. Principle and earnings are always protected even in a down market.

A fixed indexed annuity earns interest based on the performance of an index linked to the annuity. If the index has a positive rate of return in a contract year, then your annuity earns a portion of that interest. Notice I said portion. They don’t give you all of the interest.

They may give you a percentage of the gain, or cap you at a percentage, and there are even spreads and participation rates that come into play. That all being said, if the index is negative for a given contract year, you don’t lose any principal or previous gains.

You would simply earn 0% for that year. The tradeoff can be an attractive alternative to a variable annuity for someone close to retirement or already retired, and is looking to be more conservative, preserve principal, and still have a good potential for growth.

5. How Do Taxes Work on Annuity Plans?

Tax preparation is one of the primary benefits of holding an annuity plan. The financial benefit comes in the form of tax-deferred accumulation of income.

This means, in a non-qualified (non-IRA) annuity, that your earnings accumulate at a faster pace without taxes being withdrawn. The earnings are not taxed until they are withdrawn and even then, are considered ordinary income instead of capital gains.

An annuity can be an IRA. In this case, where qualified retirement funds are held in an annuity IRA, there is no tax advantage to the annuity, because the retirement funds are already tax-deferred.

6. How Often Do You Receive Payments?

This is an important question for many retirees.

The answer is that it depends on the terms and conditions of the contract. Many annuities give flexible pay-out options such as monthly, quarterly, annually, or even on-demand cash withdrawals. Choosing the right payment plan involves reverse engineering what you’ll need and when. Then it narrows products and features down to most suit your needs.

7. When Do Payments Start?

Many retirees are hesitant to make a large, lump sum payment. They get some peace of mind by learning when the payments start.

Like the periodicity of payments, the start date is also dependent on the terms and conditions of the plan. Some annuity payments start immediately, while other plans do not issue payment until one year later.

The longer you wait to take income from an annuity you’ve funded, the higher the payouts can be. Pay-outs are determined by your age at the time the income starts, who much the annuity or benefit is worth at the time income starts, and the length of time you’ve waited to take payments after you’ve funded the annuity.

8. Does Every Retiree Need an Annuity Plan?

Simply put, the answer is no. It depends on each person’s retirement portfolio.

It depends on if your 401(k) withdrawals and Social Security payments are significant enough to maintain a quality of life. So long as you have enough money to meet your financial obligations, an annuity plan may not be right for you.

Annuities can be used as an accumulation tool. Many people will use fixed or fixed indexed annuities for the safe money portion of their portfolio. Maybe using low interest-bearing bond funds to fund the annuity, or even cash sitting in CD’s where there’s really no near-term need for the funds.

9. What Are Riders?

You can increase the value of your annuity plan by purchasing contract riders. The two options available are living riders and death benefit riders.

Living riders are designed to benefit the policyholder. Income riders guarantee a certain amount of income regardless of the actual investment performance in a variable annuity or the index performance in the case of a fixed indexed annuity. This is called a living rider. Income riders can ensure that even if an account runs out of funds, the income continues for the life of the annuitant.

Death benefit riders work in a similar fashion. However, they work to the advantage of your designated benefactors in the event of death. The death benefit value of the annuity will grow at a guaranteed rate or provide interest rate bonuses to the performance of the annuity for the purpose of enhancing the death benefit.

This benefit can create a piece of mind that the annuity will grow for legacy objectives. This can sometimes be helpful in the case where someone can’t get life insurance but wants to enhance the legacy aspect of the annuity for passing on.

10. Read the Contract for Fees

Before buying annuities, read the fine print for any annual fees. Variable annuity plans commonly have annual fees.

They are significant fees and can be up to 5 percent. Many plans do not have annual fees, but you should carefully read the contract so you can plan accordingly.

Wrapping It Up

Annuities are an excellent way to plan for retirement. They provide a guaranteed income source in an era where pensions are becoming less common.

There are different plans that allow each retiree to take on varying degrees of risk. If you want to learn more about buying annuities or if have an annuity and want to know if it’s still right for you, please contact us for assistance.