What Is an Annuity?

Annuities may have a reputation for being difficult to understand, but they can also go a long way towards helping you save for retirement. Read on to learn more about different annuities policies and whether one might be right for you. 

How Do Annuities Work?

In the simplest sense, an annuity is a financial product you buy from an insurance company. You make a lump sum payment or deposits into the product over time and earn interest on your money. Then, when you retire (or whenever you’re ready to receive income), you begin getting a regular stream of payments from your account. Here’s what that typically looks like:

• The accumulation phase is the first stage of an annuity. This is the period during which the investor — or annuitant — funds the product with either a lump sum or periodic payments.
• Annuities usually have a surrender period, which may last several years. During that time, annuitants cannot make withdrawals without paying a surrender charge or fee.
• During the annuitization period, the annuitant begins receiving payments for a fixed period, amount or for the rest of their life. 

What Are the Pros and Cons of Annuities?

If that sounds a lot like an IRA and/or a CD, you’re right. There are similarities among all retirement savings vehicles. After all, each is designed to help you work toward the same goal, and annuity funds are no different. Like any investment product, annuities come with unique pros and cons:

Pros

• Lifetime income. Annuities can offer guaranteed income for life. Guarantees are based on the claims-paying ability of the life insurance company.
• No annual limits on deposits. Other retirement income options have limits on how much you can deposit each year. Annuities do not.
• Higher guaranteed rates. Because they’re invested differently, annuities often offer a higher guaranteed rate than other products. As of May 1, 2023, annuity rates range from 4.5% for a 2-year contract to 5.45% for a 10-year commitment.
• Tax-deferred interest. You won’t pay taxes on the interest you earn until you’re ready to begin receiving income from your annuity.

Cons

• Potentially higher tax rates. You pay taxes when you receive your annuity income, and no one can predict what the taxable rate will be at the time.
• Complexity. Annuities can be difficult to understand. You’ll want to work with an advisor you trust.
• Fees. When compared to other retirement investment options, annuities can have higher fees. 
• Illiquidity. Deposits into annuity contracts are typically locked up for a period of time, where the annuitant would incur a penalty if all or part of that money were withdrawn.

What Are the Different Types of Annuities?

Each type of annuity has its own unique benefits. Figuring out which one is right for you will depend on factors like your age, risk tolerance and how much you have to invest. You’ll want to discuss each option with an agent before deciding.

Fixed Annuity 

A fixed annuity is perhaps the simplest member of the annuity family. You make deposits to your annuity contract and earn a pre-determined annual interest rate from the company you purchased with. In most cases, you’re also given a guaranteed minimum interest rate, which means you know that you’ll never earn less than that amount on your investment each year. There is a low level of risk with this type of product.

Variable Annuity

Variable annuities allow the owner to receive larger future payments if investments of the annuity fund do well and smaller annuity payments if its investments do poorly, which provides for less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns. Variable annuities carry market risk and the potential to lose principal.

Indexed Annuity

One of the more popular annuities today is the indexed annuity. This product is a blend of its fixed and variable relatives, and that makes it a little more complicated. The interest rate paid to annuitant is based on the performance of a specified market index. With an indexed annuity, you have the opportunity to earn higher returns than you would with a fixed annuity with more protection against losses than with a variable annuity.

How Do You Know If an Annuity Is Right for You?

You’ll want to discuss whether an indexed, fixed or variable annuity fund is right for you with your agent or advisor. Some examples of when an annuity might make sense include:

• If you’re an investor looking for a steady stream of income throughout retirement.
• If you’re an investor looking for a relatively safe way to grow retirement funds, but wanting higher returns than the bank offers on a product like a CD.
• If you’re an investor ready to put money aside for a number of years.
• If you’re an investor concerned about the risk of outliving your savings.

Get Help Funding Your Retirement

Because of their complexity, the decision to purchase an annuity is one you should discuss with a professional. Now that you know what an annuity is, get in touch with your local Farm Bureau agent or advisor to understand your options and create a retirement strategy that works for you