Annuities Explained: Your Simple Guide to Retirement Income

Imagine you’re building a retirement nest egg, like a squirrel storing nuts for the winter. You diligently save money over your working years, hoping it will last when you stop working. But what if you could turn those savings into a reliable, regular paycheck that lasts for your entire retirement, no matter how long you live? That’s essentially what an annuity is designed to do.

At its core, an annuity is a contract between you and an insurance company. You pay the insurance company a sum of money, either in a single lump sum or through a series of payments over time. In return, the insurance company promises to provide you with a stream of payments in the future. Think of it as the reverse of a life insurance policy. With life insurance, you pay premiums, and your beneficiaries receive a payout when you pass away. With an annuity, you pay premiums (or a lump sum), and you receive payouts, typically starting in retirement and continuing for a set period or even for your entire lifetime.

There are two main phases to understand with annuities: the accumulation phase and the payout phase (also known as the annuitization phase).

During the accumulation phase, you are putting money into the annuity. This money grows over time, often on a tax-deferred basis. This means you don’t pay taxes on the earnings until you start taking withdrawals in retirement. Think of it like a retirement savings account, but specifically designed within an insurance contract. The growth can be based on a fixed interest rate, or it can be tied to the performance of various investment options, depending on the type of annuity you choose.

The payout phase is when you start receiving regular income payments from the insurance company. This is the “income stream” part of the annuity. You can choose when you want these payments to begin. You can also decide how long you want the payments to last. For example, you might choose to receive payments for a specific number of years, or you might opt for payments for the rest of your life, no matter how long that may be. This lifetime income option is a key feature of annuities and provides a sense of security, knowing you won’t outlive your income.

There are different types of annuities to consider, mainly categorized by how they grow and when payments begin. Two common types based on growth are:

• Fixed Annuities: These are the simplest type. They offer a guaranteed interest rate on your money during the accumulation phase. This means your money grows at a predictable rate, and when you start receiving payments, those payments are also fixed and guaranteed. Think of it like a Certificate of Deposit (CD) from a bank, but with the added benefit of tax deferral and the option for lifetime income.

• Variable Annuities: With variable annuities, you have more investment options. Your money is invested in subaccounts, which are similar to mutual funds. The value of your annuity and the amount of your future payments will fluctuate based on the performance of these investments. This offers the potential for higher growth, but also comes with more risk, as your principal could decrease.

Based on when payments begin, annuities can be:

• Immediate Annuities: These are designed for people who need income to start right away. You typically make a single lump-sum payment, and payments begin within a short period, usually within a year.

• Deferred Annuities: These are designed for people who are saving for retirement in the future. Your money grows during the accumulation phase, and payments begin at a later date you choose.

Why might someone choose an annuity? The primary reason is to create a reliable stream of income in retirement that they can’t outlive. Annuities can provide peace of mind, knowing that you’ll have a regular income to cover your living expenses, regardless of market fluctuations or how long you live. They are often considered as a tool for retirement income planning, particularly for those looking for guaranteed income and a way to convert savings into a lifelong paycheck.