Most investors share the same goal of long-term wealth accumulation. Some of us have no problem watching our investments bounce up and down from day to day, while risk-averse investors or those nearing retirement generally can't withstand short-term volatility within their portfolios. If you are this type of investor - or one who has a moderate risk tolerance - annuities can be a valuable investment tool. (Learn more, in Designating A Trust As Retirement Beneficiary.)

TUTORIAL: Retirement Planning

Today's Annuities
An annuity is a contract between you - the annuitant - and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides a kind of retirement-income insurance: you contribute funds to the annuity in exchange for the guaranteed income stream of your choosing later in life. Typically, annuities are purchased by investors who wish to guarantee themselves a minimum income stream during their retirement years.

Most annuities offer tax sheltering, meaning your contributions reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw an income from them. This feature can be very attractive to young investors, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments.

Because they are a long-term, retirement planning instrument, most annuities have provisions that penalize investors if they withdraw funds before accumulating for a minimum number of years. Also, tax rules generally encourage investors to prolong withdrawing annuity funds until a minimum age. However, most annuities have provisions that allow about 10-15% of the account to be withdrawn for emergency purposes without penalty. (Find out more, in Delay In Retirement Savings Costs More In The Long Run.)

How They Work
Generally speaking, there are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities.

With an
immediate annuity, you contribute a lump sum to the annuity account and immediately begin receiving regular payments, which can be a specified, fixed amount or variable depending upon your choice of annuity package and usually last for the rest of your life. Typically, you would choose this type of annuity if you have experienced a one-time payment of a large amount of capital, such as lottery winnings or inheritance. Immediate annuities convert a cash pool into a lifelong income stream, providing you with a guaranteed monthly allowance for your old age.

Deferred annuities are structured to meet a different type of investor need - to contribute and accumulate capital over your working life to build a sizable income stream for your retirement. The regular contributions you make to the annuity account grow tax sheltered until you choose to draw an income from the account. This period of regular contributions and tax-sheltered growth is called the accumulation phase.

Sometimes, when establishing a deferred annuity, an investor may transfer a large sum of assets from another investment account, such as a pension plan. In this way the investor begins the accumulation phase with a large lump-sum contribution, followed by smaller periodic contributions. (Learn more about retirement, in Guaranteed Retirement Income - In Any Market.)

Perks of Tax Deferral
It is important to note the benefits of tax sheltering during the accumulation phase of a deferred annuity. If you contribute funds to the annuity through an IRA or similar type of account, you are usually able to annually defer taxable income equal to the amount of your contributions, giving you tax savings for the year of your contributions. Also, any capital gains you realize in the annuity account over the life of the accumulation phase are not taxable. Over a long period of time, your tax savings can compound and result in substantially boosted returns.

It's also worth noting that since you're likely to earn less in retirement than in your working years, you will probably fit into a lower tax bracket once your retire. This means you will pay less taxes on the assets than you would have had you claimed the income when you earned it. In the end, this provides you with even higher after-tax return on your investment.

Retirement Income
The goal of any annuity is to provide a stable, long-term income supplement for the annuitant. Once you decide to start the distribution phase of your annuity, you inform your insurance company of your desire to do so. The insurer employs actuaries who then determine your periodic payment amount by means of a mathematical model.

The primary factors taken into account in the calculation are the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your payments will be), the expected future inflation-adjusted returns from the account's assets and your life expectancy (based on industry-standard life-expectancy tables). Finally, the spousal provisions included in the annuity contract are also factored into the equation.

Most annuitants choose to receive monthly payments for the rest of their life and their spouse's life (meaning the insurer stops issuing payments only after both parties are deceased). If you chose this distribution arrangement and you live a long retirement life, the total value you receive from your annuity contract will be significantly more than what you paid into it. However, should you pass away relatively early, you may receive less than what you paid the insurance company. Regardless of how long you live, the primary benefit you receive from your contract is peace of mind: guaranteed income for the rest of your life.

Furthermore, your insurance company - while it is impossible for you to predict your lifespan - need only be concerned with the average retirement life span of all their clients, which is relatively easy to predict. Thus, the insurer operates on certainty, pricing annuities so that it will marginally retain more funds than its aggregate payout to clients. At the same time, each client receives the certainty of a guaranteed retirement income.

Annuities can have other provisions, such as a guaranteed number of payment years. If you (and your spouse, if applicable) die before the guaranteed payment period is over, the insurer pays the remaining funds to the annuitant's estate. Generally, the more guarantees inserted into an annuity contract, the smaller the monthly payments will be. (Read 7 Counterintuitive Retirement Strategies That Work for more insight.)

Fixed and Variable Annuities
Different investors place different values on a guaranteed retirement income. For some, it is critical to secure a risk-free income for their retirement. Other investors are less concerned about receiving a fixed income from their annuity investment than they are about continuing to enjoy the capital gains of their funds. Which needs and priorities you have will determine whether you choose a fixed or variable annuity.

A fixed annuity offers you a very low-risk retirement - you receive a fixed amount of money every month for the rest of their life. However, the price for removing risk is missing out on growth opportunity. Should the financial markets enjoy bull market conditions during your retirement, you forgo additional gains on your annuity funds.

Variable annuities
allow you to participate in potential further appreciation of your assets while still drawing an income from your annuity. With this type of annuity, the insurance company typically guarantees a minimum income stream, through what is called a guaranteed income benefit option, and offers an excess payment amount that fluctuates with the performance of the annuity's investments. You enjoy larger payments when your managed portfolio renders high returns and smaller payments when it does not. Variable annuities may offer a comfortable balance between guaranteed retirement income and continued growth exposure.

Conclusion

Annuities offer tax-sheltered growth, which can result in significant long-term returns for you if you contribute to the annuity for a long period and wait to withdraw funds until retirement. You get peace of mind from an annuity's guaranteed income stream, and the tax benefits of deferred annuities can amount to substantial savings. Finally, variable annuities allow less risk-averse retirees prolonged exposure to the financial markets. Be sure to consider annuities as part of your overall investment strategy, as they may add value to your retirement in more ways than you think. (Learn to plan ahead, inRetirement Savings Tips For 18- To 24-Year-Olds.)

Related Articles
  1. Mutual Funds & ETFs

    Which Fund Share Class is Best for Retirement?

    Mutual funds are a popular investment for retirement. Here's how to choose the best share class when investing in them.
  2. Retirement

    6 Robo-Advisors That Require Little to Start

    There are many well-regarded robo-advisor options that come with minimum investment amounts. Here are snapshots of a handful of them.
  3. Retirement

    Smart Ways to Tap Your Retirement Portfolio

    A rundown of strategies, from what to liquidate first to how much to withdraw, along with their tax consquences.
  4. Saving and Spending

    Social Security: Navigating it with Your Clients

    Many people don’t realize how confusing Social Security can be until they're face to face with taking it. Here's how to talk to clients about it.
  5. Your Clients

    How to Construct an Annual Review for Clients

    One of the best things that advisors can provide to clients is an annual review of their financial situation. Here are some guidelines.
  6. Mutual Funds & ETFs

    Pimco’s Top Funds for Retirement Income

    Once you're living off the money you've saved for retirement, is it invested in the right assets? Here are some from PIMCO that may be good options.
  7. Budgeting

    5 Alternatives to Traditional Health Insurance

    Discover five of the most popular alternatives to traditional health insurance plans, alternatives that are increasingly popular as health insurance costs rise.
  8. Mutual Funds & ETFs

    Top 4 Davis Funds for Retirement Diversification in 2016

    Discover the four best mutual funds managed by Davis Advisors that pursue different investment strategies that can help diversify retirement portfolios.
  9. Retirement

    Is it Safe for Retirees to Invest in Technology?

    Tech stocks are volatile creatures, but there are ways even risk-adverse retirees can reap rewards from them. Here are some strategies.
  10. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
RELATED FAQS
  1. Where else can I save for retirement after I max out my Roth IRA?

    With uncertainty about the sustainability of Social Security benefits for future retirees, a lot of responsibility for saving ... Read Full Answer >>
  2. What would privatized Social Security mean for Americans?

    The current Social Security system in the United States operates in a pay-as-you-go framework; the Social Security taxes ... Read Full Answer >>
  3. What are the most common deferred tax assets used by individuals?

    Deferred tax assets – those that are only taxed when funds are withdrawn or the asset is sold – are quite common in estate ... Read Full Answer >>
  4. Where can I transfer money from a Locked-in Retirement Account (LIRA) to?

    Money from a Locked-in Retirement Account, or LIRA, may be transferred to another LIRA, an insurance company in order to ... Read Full Answer >>
  5. Am I losing the right to collect spousal Social Security benefits before I collect ...

    The short answer is yes, if you haven't reached age 62 by December 31, 2015. The Bipartisan Budget Act of 2015 disrupted ... Read Full Answer >>
  6. What is the maximum I can receive from my Social Security retirement benefit?

    The maximum monthly Social Security benefit payment for a person retiring in 2016 at full retirement age is $2,639. However, ... Read Full Answer >>
Trading Center