Most people are only dimly aware of annuities and how they can help them achieve their financial goals and help ensure they’ll have enough income and savings for retirement.
About 79% of American adults struggle to correctly define an annuity, according to a 2024 Policygenius annuities survey. A 2023 study by the American College of Financial Services found that respondents aged 50 to 75 scored only 12% on annuity-related questions, ranking their knowledge of annuities below that of Medicare, life insurance, and long-term care.
It’s not surprising. The topic is complex, and there are many different types of annuities. Most people hear more about stocks, bonds, insurance and bank certificates of deposit (CDs). Annuities are in a bit of an obscure corner.
Lack of knowledge may contribute to resistance to buying annuities. The Center for Retirement Research at Boston College found that while about half of survey respondents expressed willingness to purchase an annuity at prevailing market rates, only 12% had done so. On the other hand, a survey by the American Council of Life Insurers found that 54% of retirement savers are considering products that provide guaranteed lifetime income, similar to a pension—in other words, lifetime income annuities. The survey gave no clues on what percentage will actually go forward.
Social Security’s uncertain future means you’ll need to be more self-reliant
When you’re young, you probably don’t need to know much about annuities because they’re more germane for people in their 50s and older. But once you’re in that age range, it becomes necessary to know the basics about annuities. They’re not for everyone, but if you don’t know anything about them, you’ll never know if an annuity might be a good choice for you.
It’s important to know at least the basics about annuities because they can be a keystone for successful retirement. Going forward, it’s probable you’ll have to rely more on yourself and less on the government for your retirement income.
Social Security, essentially a pay-as-you-go system, faces a tough future as the population ages. As of 2023, roughly 2.7 covered workers were paying into Social Security for each individual collecting benefits. This ratio is projected to decline further in the coming decades due to demographic shifts. If you’re 55 today, your benefits when you turn 75 may be substantially lower than they are today. Another possibility is that the full retirement age may be delayed from 66 - 67 today to 70 or older.
Furthermore, few people, other than government workers, have old-fashioned pensions that guarantee lifetime income. Most employers offer 401(k) or similar plans. Such plans, while great, can expose you to investment risk and volatility and may not guarantee income.
The Employee Benefit Research Institute’s 2019 study estimated that 40% of U.S. households risk running short of money in retirement.
Annuities offer more tools for successful retirement
One or more annuities can be part of your self-reliant retirement plan so that you won’t run out of money, and equally important, not worry about managing it.
Annuities began as pensions in ancient Rome. And many people think of income annuities only, but it isn’t the only type, as we’ll see.
An income annuity is a contract that promises to provide an individual income for a fixed period of years or their lifetime. You deposit your money with an insurance company and in return you get contractual guarantees. Having lifetime income that will keep going at the same level no matter how long you (and, optionally, your spouse) live promotes peace of mind and reduces worry. It’s “longevity insurance.” You’re creating your own private pension.
Another advantage is that you won’t pay any taxes until you start receiving payments. And even then, much of the income will be non-taxable return of premium.
The downside is that you no longer have control over that money. You’re relying on the life insurers to keep its promise. For many people, this is a deal very worth taking, but not everyone is comfortable with it. Furthermore, because an income annuity is somewhat inflexible and illiquid, it may not be a good choice if you have little in liquid savings or investments.
Income annuities are vastly underused, I believe, and many independent experts agree. Last year, sales totaled $18.5 billion, according to LIMRA. This is a small amount when compared to other financial vehicles.
So, on one side of the annuity world, we have annuities that guarantee either future (deferred) income or immediate income. The other half of the annuity universe is made up of various types that are designed to help you grow savings for the future. They can provide interest income too, which you can receive or plow back into the annuity.
A fixed-rate annuity provides a set interest rate for a fixed number of years, plus your principal is guaranteed, much like a bank certificate of deposit (CD). This type of annuity is called a multi-year guaranteed annuity (MYGA). If it’s held in a nonqualified account (not in an IRA or Roth IRA), the interest is tax-deferred as long as you reinvest it in the annuity. The interest rate usually beats a CD with the same term.
Because fixed-rate annuities are somewhat standardized—the details differ, so make sure you understand the penalties for withdrawals during the penalty period—they’re easy to understand and compare and still rank as one of the most popular types of annuities. Sales in 2024 totaled $153.4 billion, according to LIMRA.
A fixed indexed annuity offers the potential for higher interest earnings, pegged to the performance of a market index, such as the S&P 500, while guaranteeing your principal (which is why it’s called “fixed”). It pays a fluctuating interest rate, which can go as low as zero when the stock market declines. Also, there are caps on upside gains.
Over the long term, a fixed indexed annuity stands a good chance of outperforming bonds, CDs and MYGAs. But you have to be able to accept and withstand fluctuating returns. Furthermore, they’re complex, so it takes some time and expert guidance to choose the one that best suits you.
A variable annuity is much like a set of mutual funds within an annuity wrapper that provides tax deferral and optional income and death-benefit guarantees. It is called variable because it doesn’t normally have the principal guarantee that comes with a fixed annuity. While other types of annuities offer a safe haven for your money, the variable annuity offers the chance for higher gains over time. But the downsides are volatility, the potential for loss and high fees.
Taxes
While nonqualified annuities offer tax deferral that can be extended indefinitely, don’t buy a deferred annuity if you may need to withdraw the money before age 59½. In addition to ordinary income tax on withdrawals of earnings, you’ll also pay a 10% IRS penalty tax. There is one safety valve: the penalty won’t apply if you become permanently disabled.
Annuities can be held in qualified accounts (Roth and traditional IRAs) too, and one interesting choice is the QLAC.
Annuities, especially income annuities, are long-term commitments. Choose a financially strong insurer that can fulfill its promises. The industry is strictly regulated by the states and has a good track record.
Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.