You have access to a multitude of financial products that can help you save for your retirement. So why consider a variable annuity? Because annuities in retirement planning can offer different features than other investments and help balance your retirement income strategy.
Think of it as part of building a “floor” for your retirement income—an amount of money you can rely on each month that won’t fluctuate with economic volatility. If you can piece together Social Security, an annuity, and possibly other sources of guaranteed income to cover your needs, the market swings of your investments have less impact on your retirement income.
However, keep in mind that you may need to pay more—perhaps a few percentage points more in annual fees—for the sort of guaranteed income you want. Always consider the tradeoff between affordability and reliability. Only you (and your financial professional, if you have one) know the cost you’re willing to pay to guarantee a certain retirement income as part of your holistic financial plan.
What is a Variable Annuity?
A variable annuity is a long-term contract between you and the annuity provider that’s part investment, part insurance—it allows you to build your retirement funds by investing them through the market, and then receive a guaranteed monthly income in the future.
The contract is an agreement that the insurer will provide those income payments—and the nature of the contract will determine when and how those payments are given.
There are two phases of a variable annuity contract: the accumulation phase and the annuitization phase.
1. Accumulation phase
During the accumulation phase, you may make either a single payment or additional premium payments, which are then invested into your annuity investment account, also known as sub-accounts. (Sub-accounts operate similarly to mutual funds, but you cannot purchase sub-accounts outside of the annuity contract.)
You can choose the sub-accounts that you would like to allocate with your VA, giving you control over how aggressively you want to invest.
2. Payout phase
Once you’re ready to receive payments for your investment, you enter the annuitization or payout phase. This simply means you are converting the annuity investment into periodic payments. The annuitization payment method offers a few different additional considerations, like the joint-life option, which allows you to continue payment to your spouse when you die.
If you decide to add a Guaranteed Lifetime Withdrawal Benefit (GLWB rider) to your annuity contract, you will gain access to a lifetime withdrawal benefit that offers a guaranteed income stream with the potential for growth—without having to annuitize your contract.
“A GLWB rider allows you to invest in the marketplace and participate in the market while guaranteeing an income stream that will last for your lifetime,” says Atlas. “You can invest in equities between now and when you’re going to retire.”
How variable annuities work: An example with an income rider
As with any investment, risk is inevitable. When considering risk and variable annuities, it’s important to distinguish the risk associated with the account value of your investment from the risk of income loss.
- Your account value is the amount of money within your annuity sub-accounts. This value is the balance of your premiums, fees and gains and losses based on the assets the account is invested in.
- Your income is provided by the insurer and comes from either annuitizing the contract or from implementing the additional living benefits rider. Though, you may not receive growth from the market.
Account value fluctuation does not impact your guaranteed lifetime income with variable annuities when they are in the payout phase or if you are using a GLWB. Let’s look at how a lifetime withdrawal benefit could work with a variable annuity product:
Let’s say your variable annuity contract includes a GLWB designed to guarantee that for every year you don’t take income out of your annuity investment, your benefit base,3 which is what’s used to calculate your income, will increase by 6% in years that no withdrawals are taken, with potential to increase with the market. This will occur for up to 10 years or age 80, whichever comes first.
For example, if you invest $100,000 and you don’t take any income or investment gains, your benefit base after one year would be $106,000. After two years, your benefit base would be $112,000.
Let’s say that in the third year, the market tanks and the actual cash value of your investment drops to $50,000. Despite the market fluctuation, your income is still going to be based off the $112,000 because it’s calculated off the benefit base, not the account value. So, your income won’t go down, but it could potentially go up again if the market improves.
In that same example, where after two years your income would be based off $112,000, let’s say in year three there’s a huge up year in the market and the account value jumps up to $125,000, rather than the anticipated $118,000.
Read Also: The Pros and Cons of Investing in Variable Annuities
The annuity issuer will give you the greater of the 6% or what the market has returned. Now your income will be based off $125,000, even if the market crashes your contract to zero in the following year, your income is still going to be based off $125,000.
Let’s start with the two basic categories of annuities:
- Variable annuities invest in market-based subaccounts that go up and down with the market, which tends to mean greater growth potential and risk, and your balance will vary day-to-day. They may cost more than a mutual-fund IRA, because there are costs for the annuity structure and underlying investments. The more flexibility (death benefit protections, etc.) you add to the basic shell of the annuity, the more it may cost.
- Fixed annuities tend to be more conservative and provide a guaranteed interest rate for a specific period (typically three, five, or 10 years). When that time is up, the annuity renews at the market’s current interest rate.
Now, here are the five reasons variable annuities may fit into your retirement plan:
1. You can purchase a variable annuity with tax-deferred assets.
How do you fund an annuity? You can purchase an annuity with money from your savings or investment account. If you use qualified money from your 401(k) or IRA to purchase an annuity, your money will continue growing tax deferred. Some variable annuities allow you to make additional premiums, offering you a tax-deferred investment opportunity with no IRS contribution limits. (If the annuity is an IRA, the IRS contribution limits still apply.)
2. Variable annuities give you control over your investments.
Variable annuities offer market-based investments through subaccounts. By investing in annuities for retirement you can choose which subaccounts to put your money in. And if your goals change you can move your money in and out of subaccounts generally without tax consequences or additional fees.
3. Variable annuities help grow your money tax-deferred.
The money you contribute to a variable annuity grows tax-deferred. Gains made within the account are reinvested—and tax-deferred—which compounds growth. Taxes on your investment gains aren’t applied until money is withdrawn. (Also, if using nonqualified funds for your annuity, any distributions include a return on your investment—so, you don’t pay tax on the full distribution.)
But consult a tax expert: As with other tax-deferred retirement accounts, there can be penalties for early or unscheduled withdrawals. Depending on your financial situation, you may not realize a tax saving when annuity funds are converted from capital gains to ordinary income at the time of withdrawal.
4. Ensure guaranteed income for life with variable annuities.
A variable annuity allows you to convert a portion of your investments into a stream of guaranteed income that’s protected from market volatility. Money not converted to guaranteed income remains invested for further potential growth. By creating a guaranteed, steady income stream, you can set up annuity payments for life or for a set period, depending on your needs. Guaranteed lifetime income means you can’t outlive your money.
5. Create a financial legacy with variable annuities.
A variable annuity also could provide greater financial security to your loved ones when you’re gone. Variable annuities provide death benefit features that don’t require underwriting. Plus, proceeds pass outside of probate (if the estate isn’t the beneficiary). But, again, keep in mind that greater security usually costs more. You can pay to add a “rider” onto the annuity to guarantee a certain level of income during your lifetime, or to guarantee a certain payment to your beneficiaries when you die.
If you’re interested in growing your retirement funds with the added protection of guaranteed income, then variable annuities can be a great option.
As you consider your investment options, note that variable annuities include a cost in addition to the risk of fluctuation of the market. However, that cost is the insurance component, with the added benefit of solely upside potential through the market. Mutual funds, on the other hand, can go up and down without that guaranteed income stream provided through an annuity contract.
So, if you’re more concerned with guaranteeing income for life, then variable annuities could be the safer choice because you will receive income regardless of market performance. The “variable” part is the opportunity for growth.
It’s also important to consider that your investments grow with time, so the longer your investments can benefit from the market, the stronger they’ll be. If you have 20+ years to invest toward retirement, then a variable annuity could make more sense for you than if you plan to retire in the next 5 to 10 years.
Which Annuity Plan is Best for Retirement?
An annuity is a contract with an insurance company. You buy one by making either a single, large lump-sum payment or a series of smaller payments, typically stretching for several years. In return, the insurer sends you regular payments beginning either immediately or at some future date. Payments can be set to last for a certain number of years or, when used for retirement, for the life of the annuity buyer.
Annuities benefit from favorable tax treatment. When you use your savings to purchase an annuity, your savings grow tax-deferred. Upon withdrawal, you pay ordinary income tax on the portion representing earnings. Similar to 401(k) plans and other tax-advantaged retirement savings accounts, there is typically a 10% penalty for withdrawals before age 59 1⁄2.
In retirement planning, annuities are particularly useful for hedging against market risk and life expectancy risk. That’s because they can guarantee income for life regardless of how long you live or how markets perform. Some annuities can also continue payouts to a surviving spouse. However, you give up control over the lump sum in exchange for this security.
Annuities come in many varieties with a broad menu of different options. However, the three main structures of annuities used for retirement funding are fairly straightforward. They include:
Fixed annuities. These offer a minimum guaranteed interest rate for a set timeframe, which can range from one to 10 years. The insurer declares a new guaranteed rate at the beginning of a new year or other period. Fixed annuity payments remain the same over time.
Variable annuities. These invest your purchase payment in securities like stocks and bonds. Without a guaranteed rate of return, payouts fluctuate based on performance of these underlying investments. Variable annuities carry exposure to market risk but offer potentially higher returns than fixed products.
Indexed annuities. These hybrids provide a minimum guaranteed rate combined with the possibility of higher returns linked to a market index, such as the S&P 500. Even if the index declines, your account will never earn less than the minimum rate. However, caps also limit the amount of positive index performance you can access.
Any of these types of annuities can vary in the timing of payments. Immediate annuities begin payouts within 12 months after purchase, while deferred annuities have an accumulation stage where funds grow tax-deferred before eventual distribution.
Your answers to some key questions help identify the which type of retirement annuity might work for you. Questions to ask include:
- What is your risk tolerance? Variable and indexed annuities carry some market risk. More conservative investors may prefer fixed products.
- What are your income needs? Consider if you require payouts that never vary or can accept flexibility. This guides the choice between fixed versus variable options.
- How long will you need income? Lifetime payout products make sense for those with greater longevity expectations.
- What are your liquidity needs? Assess if you will need access to the lump sum in the future. Deferred annuities have longer lockup periods than immediate ones.
- How much can you afford to invest upfront? Larger lump sums allow bigger ultimate payouts. However, some annuities accept smaller periodic contributions.
- What fees work best for your budget? Less affluent retirees may need to optimize for lower-cost products.
The ideal product aligns with your risk appetite, age, life expectancy, income requirements, liquidity needs, investable assets and tolerance for fees. Annuities also vary in terms of fees, withdrawal options and death benefits. It can be challenging to sort through all the options, but thoroughly investigating alternatives prevents making an expensive mistake.
Bottom Line
The right annuity product can greatly enhance retirement security by guaranteeing lifetime income. Annuities lack a one-size-fits-all approach, however, and there are many varieties. Figuring them all out can take time and effort. To pick the right one for you, research options thoroughly and integrate annuities into your overall plans. Be wary of pitfalls such as high fees and make sure the insurance company is financially sound.