While annuities are not strictly retirement investments, they are often favored during this life stage because of the potential steady stream of income they can provide. An annuity is essentially an insurance contract. An individual either makes a series of payments or pays one lump sum to a financial institution, with the guarantee that the institution will invest the individual’s money and pay him regular income. This income may begin right away, or it may start on a predetermined date in the future. The income may be paid out as a lump sum, it may last a brief period of time or it may continue until the individual's death.
Annuities are commonly purchased as part of a retirement savings portfolio. Retirees often favor annuities because of the regular income, and they depend upon this income, in part, for life after retirement. Annuities also carry death benefits that allow the investment to provide for loved ones after the passing of the purchaser. If an individual buys an annuity and passes away before payments have begun, the person named as beneficiary receives the payments intended for the deceased. Annuities also experience tax-deferred growth. An individual pays no taxes on the income he will receive or on any gains made from his investment until the money is withdrawn or until the payments begin.
There are two basic types of annuities: immediate and deferred. Within these two basic categories, an annuity may also be fixed, variable or a combination of the two. Deferred annuities may also be converted to immediate annuities if an individual wants or needs to begin receiving payments sooner.
Immediate annuities, commonly referred to as single premium immediate annuities, are generally the right option for an individual seeking payments that begin right away or right after the purchase of the annuity. These annuities are purchased from an insurance company with a premium or single lump sum payment.
In return for this lump sum payment, an insurance company issues the buyer an agreement or a promise to make steady payments to the buyer, or a specified payee, for the length of time that the buyer has chosen. In most cases, the buyer chooses to have payments issued for the remainder of his life. In general, these payouts begin approximately one month after the immediate annuity has been purchased. The payments are received based on the frequency determined by the buyer. The most common option for payment frequency is in monthly increments, but annuities can pay out quarterly or yearly. It often depends upon the financial institution's policies and guidelines, but generally an annuity buyer can choose any frequency of payment.
There are several ways to fund an immediate annuity. The cash gained from a maturing certificate of deposit (CD) can be used, along with the profit generated from the sale of a home, a business, stocks or bonds. Even a lump sum distribution from a 401(k) or an IRA can be used as a full or partial source of funding for an immediate annuity.
Financial advisors consistently push immediate annuities. Retirees favor immediate annuities because of the benefits they offer – especially the security provided by such investments. These annuities provide a steady income that is at least guaranteed for a specific amount of time and has the potential to last after the retiree's death. Employees close to retirement age favor immediate annuities, as they allow for an easy transition between work and retirement while receiving a steady and dependable income. For an individual who fears outliving the current savings in his retirement portfolio, this security provides a sense of safety as he faces his life after retirement.
These annuities are also generally favored for the simplicity of the investment. In simple terms, a buyer can purchase an immediate annuity, then forget about it. The only conscious effort required after buying the annuity is to collect the stream of payments. Immediate annuities that are not variable prevent an individual from needing to watch the markets or worry about dividends and interest rates.
Immediate annuities are also generally favored because of the amount the buyer receives back. The interest rates that an insurance company uses to calculate immediate annuities are typically higher than CD or Treasury rates. Every payment includes portions of the principal, so there is a larger return than interest alone.
These annuities also receive preferential tax treatment. An immediate annuity is an ideal way to defer payment of taxes until later into retirement, when tax rates are generally lower. The funds in an immediate annuity are guaranteed by the insurance company's assets. The annuity value is only subject to the fluctuations of bullish and bearish markets if it is variable instead of fixed.
Deferred annuities are ideal for buyers who have money to put into annuities without requiring immediate payouts. Sometimes referred to as a longevity annuity, a deferred annuity can be purchased with a premium, or it may be purchased with multiple deposits made over a period of time.
Deferred annuities are essentially the same as immediate annuities, in terms of funding sources and payout options, and in terms of the advantages such investments offer. The greatest benefit to a deferred annuity over an immediate annuity is the delay of payout to allow the funds in the annuity to accumulate.
Both immediate and deferred annuities may be fixed or variable, or a combination of the two. Fixed annuities always offer the buyer a guaranteed amount in payout that will never change. Variable annuities also offer the buyer a guaranteed payout; the value is generally lower, but it is based on the premium paid. The remainder of the payout received by the buyer depends upon how well the underlying assets within the annuity portfolio perform.
Annuity buyers may also opt for a combination of these two annuities, guaranteeing generally higher regular payouts with the potential to earn higher returns based on the performances of their portfolios in the market.