Annuities Explained: How to Protect the Retirement You Want

6 minute read time.

We just want to set it and forget it and say, ‘I’m going to get a paycheck.’ That’s what I want in my own retirement.”

Retirement should be about financial confidence, not uncertainty. But we’re living longer, don’t have the retirement security that pensions provided past generations, and we know that Social Security won’t be enough.  And today, we’re now facing high inflation, extreme market volatility and an uncertain economy.

With this as a backdrop, how can you be sure your retirement savings will last?

For many, protected income in the form of an annuity offers a powerful solution, providing guaranteed lifetime income that protects you from outliving your money. In other words, income certainty in an uncertain world. But, despite their benefits, recent research shows 4 out of 5 American adults still don’t know what annuities are, or how they can help secure their financial futures.

If you’re one of them, you might be more familiar with protected income and annuities than you realize. Annuities are one item on a list of just three income sources you can count on to last for life: Social Security, pensions, and yes, annuities. Virtually everything else is at the mercy of the markets. “Protected income is income that is essentially like a paycheck,” explains Michael Finke, an Alliance Research Fellow and Professor of Wealth Management at The American College of Financial Services. “It’s income that’s going to come in on a regular basis, and it’s going to continue as long as I’m alive.”

ANNUITIES DEFINED

Similar to the way you insure your home, your health and your vehicle, an annuity helps insure your retirement. How? By insuring an income. Essentially, an annuity is an insurance product that can help you meet various financial goals, with one of its most important features being that it can turn part of your savings into steady, protected income for the rest of your life.

Annuities are purchased from life insurance companies, either through a lump sum or multiple payments. When you do so, your money can grow tax-deferred until you withdraw it. Your annuity can be converted into protected income for a set period of time, or you can choose an option for payments to continue as long as you live.

The four most common types of annuities include:

• Fixed Annuities: This annuity provides a “fixed” or guaranteed interest rate on your money for a specific time period (typically from 1–10 years).
• Fixed Index Annuities (FIA): Instead of a fixed interest rate, an FIA’s growth is tied to a market index, like the S&P 500®. This type of annuity protects your initial investment from market losses while offering a chance for higher returns than a traditional fixed annuity.
• Variable Annuities:  Variable annuities allow you to invest in a combination of mutual funds, stocks, and bonds. While these offer growth potential, both your original purchase amount and returns will vary with market changes, meaning losses are also possible.
• Registered-Index Linked Annuities: RILAs track the performance of a market index, like the S&P 500. When the market goes up, your account value can grow with it—up to a maximum percentage you select. These growth limits are usually higher than what’s available with traditional fixed or fixed index annuities. You choose how much market decline you’re protected against, keeping in mind that some investment risk remains.

HOW TO TELL IF AN ANNUITY IS RIGHT FOR YOU

In addition to the promise of a “lifetime paycheck,” there are a number of other attributes that make annuities appealing. “Annuities can do different things, either before you retire or after you retire,” says Tamiko Toland, an Alliance Education Fellow and CEO of IncomePath. “That’s something to bear in mind, that sometimes people actually just use them as a safe place to grow their money.”

One of the most common reasons people consider annuities is to protect against economic volatility. As Toland notes, annuities are good for “Anybody who is concerned about the risk of markets, who wants a place where their money is going to be growing – and potentially earning – or providing them income when they’re ready to retire.”

Annuities are also a good hedge against longevity, in particular for women who typically live longer than men and, as research has shown, are less confident than them about various aspects of creating their retirement income. “This [the risk of running out of money] is a risk you can give to an insurance company,” says Toland. “It’s a very efficient way of making sure you have income for the rest of your life and really reduce any worry that you otherwise might have.”

Many people who opt for annuities also like the idea of automating their retirement income. “We just want to set it and forget it and say, ‘I’m going to get a paycheck,’” adds Finke. “That’s what I want in my own retirement.”

SO, YOU’D LIKE AN ANNUITY…NOW WHAT?

If an annuity sounds right for you, you might be wondering – what’s the next step? First, look at your nest egg. Then, estimate how much you’ll spend per month in retirement. This involves looking at your fixed expenses, as well as the type of lifestyle you’d like to have. As you think about your retirement lifestyle, consider how much variability you’re willing to accept, suggests Finke. “When they think about risk, they think about the chances their investments are going to go down. But when they think about lifestyle, risk means the possibility that you might have to cut back on spending.”

Ideally, Finke says, individuals will use Social Security to cover a chunk of their basic expenses – everything from health care costs to property taxes. While recent headlines have caused uneasiness about the program’s future, he’s confident Americans can continue to rely on it. “I think you can count on some sort of a solution that is going to give people about what they expect to get. It may mean that we have to increase taxes. It may mean that we have to make some small tweaks in the amount of benefits that people receive, and it may mean the government’s just going to borrow even more money,” Finke says. “But generally speaking, you can expect to get those social security benefits. It’s not going to go away.”

CHECK OFF THE BASICS

For expenses Social Security won’t cover (Social Security is estimated to cover an average of 40% of your pre-retirement income), Finke says an annuity can help fill the gap. “The advantage of the annuity is since I don’t know how long I’m going to live, I can take that risk and transfer it to an institution like an insurance company, and that actually allows me to spend more every year, or it allows me to take a smaller percentage of my portfolio and use it to fund that basic spending goal,” he adds.

TALKING ANNUITIES WITH YOUR FINANCIAL PROFESSIONAL

The next step, for many people, will be talking through annuity options with a financial professional. In doing so, it’s important to work with an advisor who “speaks annuity.” As Toland suggests, start by asking whether the professional recommends annuities and if so, what kind.

DECIPHERING ANNUITY “WORD SALAD”

While most annuities fall into the categories mentioned above, if you’ve ever tried to research these financial products, you know they are far from straightforward. According to Alliance research, 64% of consumers say annuities are the most difficult financial product to understand. That’s due in large part to the jargon many advisors unfortunately use, often to adhere to regulatory requirements.

[See the Annuities Language Glossary to unpeel and simplify the complex annuity terms and definitions.]

For example, as Finke describes, a person could buy a single premium immediate annuity for $300,000 that would guarantee a $20,000 per-year payment. They’re fairly priced and straightforward, yet “nobody buys them.” “Often, people don’t like the idea of having to give up a bunch of money today for a promise of income in the future,” he says. “Psychologically, that’s a little bit difficult to get over.”

To help people overcome that mental barrier, companies have designed various annuities that allow consumers to retain more liquidity yet still receive a guaranteed amount of income every month or year.

ANNUITIES = A “LICENSE TO SPEND”

One of the biggest fears retirees have is spending down the savings they’ve worked so hard to amass. Finke, along with David Blanchett, a Research Fellow in the Alliance for Lifetime Income Institute, recently studied the retirement spending puzzle in a new research paper, “Retirees Spend Lifetime Income, Not Savings.”

One of its most fascinating findings? Retirees with assets that annuitize income spend twice as much as retirees with an equal amount of non-annuitized savings. In other words, protected income can “allow retirees to spend their savings without the discomfort generated by seeing one’s nest egg gradually get smaller,” their research noted.

“There has to be some sort of behavioral phenomenon going on, and what we think is that people just don’t feel comfortable spending money out of savings,” adds Finke. “I think I’m the same way. If I have a certain amount of money in my savings account, and it gets below that amount, I feel a certain amount of emotion. I feel like I’ve lost something. And I think most retirees behave that way.”

THE BOTTOM LINE

If you’re thinking about making annuities part of your retirement income plan, Finke and Toland say there are three key things to consider:

• Your lifestyle: Think about how much you will need to spend in retirement and what your monthly budget will look like. “Start thinking ahead about a way to get to that number,” suggests Finke. “Instead of thinking about savings, the lump sum aspect of investing, let’s start thinking about lifestyle, the income part of investing.”
• Where your money is currently sitting: If you have money in savings accounts or CDs, think about what your purpose for that money is and whether you’re getting the “biggest bang for your buck.” “If the purpose of the money is lifetime income, then some kind of a deferred income annuity makes a lot of sense because you don’t have to pay tax on the growth of that money,” adds Finke.
• Your biggest worries: Think about your biggest worries for the future and how an annuity could take some of the risks off the table.“If you know when you get older that you’re not going to be able to manage a lot of the things that you’re able to manage before you retire, this could make it much easier on yourself and other people that might be helping you,” says Toland. “It’s really part of a holistic planning process.”

Related Content:

Ready to demystify some of the language used when describing annuities? Check out ALI’s Annuities Language Glossary.

Even when they can easily afford it, many retirees are reluctant to spend their savings to enhance their lifestyle. Find out why in a new ALI research paper, “Retirees Spend Lifetime Income, Not Savings.”

Dive deeper into protected income with “Understanding Protected Income: Your Guide to Annuity Solutions for a Secure Retirement,” the definitive consumer guide to annuities.