Are Annuities Good for Retirement Income?

Summary: Discover how annuities can provide a steady income stream for retirement, with different options to suit your financial goals. Learn about the different types of annuities, their benefits, and how they compare to other retirement income strategies to help you make an informed decision.

You’re finally retired, ready to enjoy the freedom you’ve worked decades to achieve. But instead of feeling secure, you’re staring at your savings, wondering if it will last through the next 20 or 30 years. Sound familiar? That’s the reality many retirees face—balancing the need for reliable income with the fear of outliving their money.

Annuities are a financial product often praised as a solution to this problem. But are annuities really the key to a worry-free retirement, or just another investment trap? Let’s break it down and see if they’re the right fit for you.

What are annuities?

Annuities are contracts with insurance companies designed to provide a steady stream of income, often used as a tool for retirement. You pay an insurer a lump sum or periodic payments, and in return, they agree to make regular payments to you—either immediately or at a future date.

There are typically three participants in an annuity contract:

1. The annuitant: This is the individual who will receive the income payments. Usually, it’s the person who buys the annuity and is the primary beneficiary.
2. The insurer: This is the insurance company that provides the annuity and guarantees the income payments.
3. The owner: This can be the same person as the annuitant, but in some cases, it may be a different individual, such as a spouse or family member, who owns the annuity contract but is not the one receiving the income payments.

Retirement annuities are particularly popular because they offer financial stability and reduce the risk of outliving your savings. There are various types of annuities, such as fixed, variable, and indexed. Each type has unique features designed to meet different retirement goals.

While annuities can provide some security, they’re not always the best fit for everyone. Factors such as annuity rates, fees, and flexibility are critical to consider.

Types of annuities

Annuities come in various forms to meet different financial goals during retirement. To help you figure out if an annuity is right for you, let’s break down the most common types, along with the potential benefits and risks associated with each.

Fixed annuities

Fixed annuities give you a reliable way to receive a steady income during retirement. They’re simple, predictable, and unaffected by market ups and downs.

Pros:

• Predictable income: Fixed annuities provide regular, guaranteed payments, offering reliability and financial stability.
• No market risk: Payments are not affected by market performance, providing certainty for retirees.
• Tax-deferred growth: You won’t pay taxes on the growth in your annuity’s value each year, as taxes are due only when you make withdrawals.

Cons:

• Limited growth potential: Fixed annuities typically offer lower returns than more market-exposed investments, such as stocks.
• Inflation risk: If payments are not adjusted for inflation, they may lose purchasing power over time.
• Cashing-out restrictions: During the accumulation phase, you can cash out your fixed annuity for things like emergencies, though fees may apply. Once you start withdrawing, the insurance company pays you monthly, but you can’t cash out the policy, as they hold your principal, and you are only entitled to the income stream.

Variable annuities

With variable annuities, you invest in subaccounts that function like mutual funds. This means your payouts can fluctuate based on how the investments perform.

Pros:

• Potential for higher returns: Variable annuities can offer growth if the market performs well, potentially yielding higher returns than fixed annuities.
• Investment flexibility: You can choose how to allocate your premiums among different subaccounts, which may include equity, bonds, or other types of funds.
• Tax-deferred growth: Similar to fixed annuities, your earnings aren’t taxed until you begin to receive distributions, which means the value could build up faster due to compounding earnings.

Cons:

• Market risk: The value of your annuity is subject to the performance of the investments you choose, so your payments can decrease if the market underperforms.
• Higher fees: Variable annuities often come with additional costs, such as management fees and optional rider fees (e.g., for guaranteed income).
• Complexity: The variety of investment options and terms can make variable annuities more difficult to understand.

Indexed annuities

Indexed annuities are linked to a stock market index (like the S&P 500) and offer a minimum guaranteed return, with the potential to earn more if the index performs well.

Pros:

• Guaranteed minimum return: You’ll receive a minimum return, even if the stock market performs poorly.
• Potential for market gains: If the market performs well, you could earn more than with a fixed annuity, offering a balance between safety and growth.

Cons:

• Capped returns: Even if the market does well, there is typically a cap on how much you can earn, limiting the growth potential.
• Complex terms: The way returns are calculated and capped can be difficult to understand, requiring careful attention to the contract terms.

Immediate annuities

Immediate annuities begin payouts soon after a lump sum payment is made—typically within one month to a year. These are suitable for people who need income immediately.

Pros:

• Quick access to income: Immediate annuities begin paying out relatively soon after the initial payment, which can be ideal for those in need of immediate retirement income.
• Predictable payments: Once established, payments remain fixed, providing financial stability.

Cons:

• Limited flexibility: Once you begin receiving payments, it is challenging to modify the terms or access the initial lump sum.
• Lower growth potential: Compared to other investment options, immediate annuities tend to offer less growth potential.

Deferred annuities

Deferred annuities can allow you to build savings over time before payouts begin. These can provide flexibility depending on how the annuity is structured.

Pros:

• Growth potential: If you choose a variable or indexed deferred annuity, your account may grow based on market performance, offering potential for higher returns.
• Tax-deferred growth: Your investment can grow without being taxed until you start receiving payouts, which may help accumulate more savings over time.

Cons:

• Market risk: For variable or indexed deferred annuities, there’s a risk that your investment could lose value if market conditions deteriorate.
• Early withdrawal penalties: Deferred annuities often come with penalties for early withdrawals, which reduces liquidity and flexibility.
• Complexity: Understanding how your funds can grow, particularly in variable and indexed annuities, requires a careful review of the terms.

Are annuities a good investment for retirement?

At the end of the day, annuities can be a valuable component of your retirement strategy, especially when you’re aiming for stability and predictable income. However, they don’t have to be your sole focus. It’s important to understand that you don’t have to choose between an annuity and other retirement products like 401(k)s, IRAs, or Social Security. Rather, an annuity can serve as an integral piece of the income puzzle.

In many cases, a balanced strategy involves creating “buckets” of money in different types of products to provide a baseline income, while also leaving room for growth potential through other investments. A financial advisor can help you design a portfolio that aligns with your unique retirement goals, combining different products to meet your needs for both security and growth.

How annuities complement other retirement income sources

Annuities can play an important role in retirement planning, particularly in providing reliable income to supplement other retirement income sources like 401(k)s, IRAs, pensions, and Social Security. Here’s a look at how they can fit into a comprehensive retirement strategy:

Annuities and 401(k)s/IRAs

• Guaranteed income: While 401(k)s and IRAs can grow based on contributions and investment performance, they don’t usually guarantee a steady income. With most annuity contracts, you can turn your savings into predictable payments, providing some peace of mind in retirement.
• Tax-deferred growth: Contributions to 401(k)s and traditional IRAs are tax-deferred, similar to annuities. However, annuities offer this benefit even after you’ve maxed out your contributions to other tax-advantaged accounts.
• Withdrawal considerations: Annuities may have restrictions on when and how funds can be accessed similar to 401(k) early-withdrawal penalties.
• Investment options: 401(k)s and IRAs often provide more diverse investment options, while annuities, depending on the type – fixed, variable, or indexed – often provide fewer choices.

Annuities and pensions

• Declining access to pensions: Traditional defined benefit pensions are becoming less common in the private sector. For those without pensions, annuities can mimic the steady, lifelong income that pensions provide. ⁽¹⁾
• Funding differences: While employers typically fund pensions, annuities are funded by the individual, offering flexibility in how much to invest and when to start payouts.
• Customizable payouts: With an annuity, you can choose payout options tailored to your needs, such as lifetime income, joint spousal income, or period-certain payments. Pensions often come with pre-set terms.

Annuities and Social Security

• Supplementing income: Social Security provides a foundational income, but it may not cover all expenses. Annuities can help fill this gap by offering a reliable income stream to cover additional costs.
• Customizable timing and amounts: Social Security payments are fixed based on your earnings history and the age you start claiming benefits. Annuities allow you to control when payments begin and how much you receive, depending on the contract terms.
• Inflation protection: Some annuities offer inflation-adjusted payments to maintain purchasing power over time, similar to the cost-of-living adjustments built into Social Security.⁽²⁾

Who should consider annuities for retirement?

Annuities for retirement may not be the right fit for everyone, but they can offer good benefits for certain people. Let’s take a look at who might find them most helpful.

Those who want guaranteed income

If the idea of knowing exactly how much money you’ll have each month sounds appealing, annuities could be a perfect fit. With fixed annuity contracts, for instance, you can get a steady stream of income that can help you feel confident about covering your expenses without worrying about market fluctuations.

Those who prefer low-risk options

For people who want to preserve their savings and avoid market volatility, certain types of annuities, such as fixed annuities, may provide more stability compared to other investments. However, it’s important to note that variable and indexed annuities carry risks tied to market performance, and even fixed annuities may result in losses due to fees or early withdrawal penalties. Carefully reviewing the terms of an annuity contract can help you make an informed decision that aligns with your financial goals.

Those nearing or in retirement

As retirement approaches, securing reliable income becomes even more important. Annuities for retirement offer a solid option for people looking to help ensure they’ll have a consistent, guaranteed income, especially if you’re concerned about the volatility of investment-based retirement plans.

For those looking to supplement existing income

For anyone already receiving Social Security or a pension, but feeling it’s not enough to cover all expenses, annuities can provide that extra boost.

Final thoughts: Is an annuity right for your retirement plan?

Annuities can be a reliable source of retirement income, but it’s important to understand your options before committing. The best choice for you depends on your unique financial goals and needs. A Mutual of Omaha financial professional can help you navigate these decisions.

Contact us today to discuss how annuities for retirement may work for you.

FAQs

Q1: What are annuity rates?

Annuity rates determine how much income you’ll receive from your annuity contract. These rates vary based on factors like the type of annuity, the length of the payout period, your age, and market conditions at the time of purchase. It’s important to shop around to find the best annuity rates for your retirement goals.

Q2: What is a pension annuity?

A pension annuity is a financial product tied specifically to a pension plan. When you retire, your pension provider may offer the option to convert your pension savings lump sum into a pension annuity. This conversion provides you with a guaranteed income for life or for a set time, depending on the terms of the annuity.

This type of annuity is only available to those with a pension. Unlike other annuities that can be purchased independently, a pension annuity uses funds saved in a pension plan to generate retirement income.

Q3: Are annuities taxable?

Yes, the income you receive from annuities for retirement is generally taxable. The amount of tax depends on how the annuity was purchased and the type of payout option chosen. If you purchased with after-tax dollars, the principal amount won’t be taxed, but the earnings will be. If purchased with pre-tax dollars, both the principal and earnings will be taxed as ordinary income.

Q4: Can I withdraw money from my annuity?

Withdrawals from annuity contracts can be limited, especially during the early years of the contract. Depending on the terms, there may be surrender charges if you withdraw money too soon. Annuities are designed to provide steady income rather than flexibility, so they may not be ideal if you need quick access to cash.

Disclosures:

Annuity guarantees are backed by the claims-paying ability of the issuer.

Registered Representatives offer securities through Mutual of Omaha Investor Services, Inc., Member FINRA/SIPC. Investment Advisor Representatives offer advisory services through Mutual of Omaha Investor Services, Inc.

Mutual of Omaha and its representatives do not provide tax and/or legal advice, and the information provided herein is general in nature and should not be considered tax and/or legal advice.

Not all Mutual of Omaha agents are registered representatives or financial advisors.

Footnotes:

1. Nasdaq, Annuities Could Be Pension Replacement, March 2024
2. Investopedia, Inflation-Protected Annuity (IPA): What it Means, How it Works, June 2024

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