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Annuities critical in retirement planning

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Retirement income estimates vary considerably, but one thing is clear across the board:  it’s essential for every individual to have a solid retirement strategy that includes enough savings and/or a steady stream of cash to guard against outliving assets. One rule of thumb is that an individual will need 70 percent of pre-retirement yearly salary to live comfortably, but those who are looking to travel or improve their lifestyle will likely need more, according to CNN Money.

Annuities can provide that reliable and periodic payout. Annuities function very differently than other investment types. Essentially, an annuity is a contract between an individual investor and an insurance company. It’s a product that’s not only designed to meet retirement goals, but other long-range goals. An annuity requires an individual to make either a lump-sum payment, or a series of payments to buy in. The insurer then makes payments to the individual on a time schedule—monthly, quarterly, annually, bi-annually, etc.—or as a single payment at a future date. Payment amounts vary, but are typically influenced by the size of the initial investment and the length of the payout period.

There remains some mystery about annuities among the public, and even within the ranks of agents. At its most basic, an annuity is an income-producing insurance product that can act as a source of regular income for investors. Annuities can be used as one component in an individual retirement plan, in combination with Social Security, pensions and other retirement savings and sources of income. 

There are two basic categories of annuities available to investors.

Deferred annuities: These require an investment of money either as a large up-front sum or as monthly payments for a period of time until the investor plans to withdraw, which is typically in retirement. All money invested in deferred annuities accumulates tax-free until the investor retires. These annuities are a good fit for investors who either have significant money to invest at one time or a minimum of 20 years to grow their money before receiving monthly payouts.

Immediate annuities: Also known as income annuities, immediate annuities begin to pay out immediately, or shortly after investment. These annuities are especially appealing to those nearing retirement. Also known as lifetime annuities, Investopedia calls this category of annuities “The Instant Pension Plan,” since it can transform a sizable nest egg into predictable, regular payments for the remaining lifetime of the investor.

Within these two categories, there are there are three general types of annuities:

Fixed annuities: In a fixed annuity, an insurer agrees to pay an investor a specified rate of interest while the account is growing, and payments are a specified amount per dollar in the account. Periodic payments may last for a pre-determined period, like 30 years, or payments can stretch over an indefinite period, like over an investor’s lifetime. Fixed annuities aren’t considered securities and are not regulated by the SEC but are regulated by state insurance commissioners.

Indexed annuities: Returns for indexed annuities are based on changes in an index, like the S&P 500 Composite Stock Price Index. Indexed annuity contracts also typically specify that the contract value won’t be less than a specified minimum, regardless of index performance. During the accumulation period, when the investor makes a lump-sum payment or a series of payments, the insurer credits the investor with a return based on changes in a securities index, like the S&P 500 Composite Stock Price Index. An indexed annuity may or may not be considered a security, and most indexed annuities aren’t registered with the SEC.

Variable annuities: Variable annuities give investors the choice of purchasing payments from a range of different investment options, which are typically mutual funds that invest in some combination of stocks, bonds, money market instruments. The rate of return on the purchase payments and the number of payments an investor will receive vary depending on how the selected investment options perform. Variable annuities are regulated by the SEC.

Variable annuities allow individuals to receive periodic payments for life, or the life of an individual’s spouse or designate, protecting against the possibility of outliving assets. Variable annuities also come with a death benefit that guarantees a beneficiary will receive a specified amount at the time of an investor’s death. And variable annuities are tax-deferred, so investors pay no taxes on income and investment gains from the annuity until withdrawals begin, and then earnings are taxed at ordinary income tax rates instead of lower capital gains rates.

Fixed index annuities represent another annuity type. Fixed index annuities, or FIAs, provide investors with the benefits of a fixed annuity while being linked to an equity index, like in an indexed annuity. Fixed index annuities (FIAs) can be either immediate or deferred, and have a number of benefits. For instance, since they’re linked to the return of an index, they offer the possibility of earning extra interest.

Investors need to research annuities in general prior to including them in an overall retirement strategy. In addition, investors should thoroughly research each annuity before making the final investment decision. Agents armed with general information on annuities, and with information on particular annuity types, can go a long way toward helping their clients understand the various types of annuities and matching investors to the optimal product to match their long-term goals.