What is an annuity? A simple guide for families
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As a parent, you want your kids to have every resource available to them. Learning about financial tools is one of the best ways to prepare them for the future — and introduce yourself to new tools as well.
Take annuities, for example. If your first reaction is "What is an annuity," don't worry — it's one of those financial products that doesn't get very much attention. This annuity guide explains the basics, including how to decide whether this option is right for your family.
What is an annuity?
An annuity is a contract that you usually buy from an insurance company, though some financial institutions also sell them. You deposit an agreed-upon amount, and the company commits to sending periodic payments for a specified period in the future. That period can range from a few years to a lifetime.
Types of annuities
Annuities typically come in one of three forms:
Fixed annuity: The insurance company promises a set number of regular payments and a guaranteed minimum interest rate.
Variable annuity: You can choose where to invest your deposits, usually in mutual funds. Your payout will depend on how much those investments grow.
Indexed annuity: Your annuity's growth parallels a market index, which tracks the performance of a category of stocks. Your payments will be higher if those stocks rise in value and lower if they drop.
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A margin on an indexed annuity serves as your fee. If the indexed annuity grows by 10% and there's a margin of 2%, you'd receive 8% as your gain.
How annuities work: A simple breakdown
Annuities work in two phases: accumulation and annuitization.
To start the accumulation period, you deposit a lump sum or a series of payments, depending on the terms of your contract with the insurance company. Your deposit grows based on your guaranteed interest rate or investment selections, depending on the type of annuity you chose.
You don't pay taxes on those gains until you start receiving payments.
After the accumulation period ends, you enter the annuitization period, when your deposits and investment earnings turn into periodic payments. These payments typically occur monthly, but some contracts allow you to collect a lump sum instead.
Who uses annuities and why
Many families choose annuities as a way of saving for retirement. An annuity guarantees a monthly income, which can supplement savings once you've left your job. If you choose an annuity with a death benefit, your kids can receive those payments after you pass away.
How annuities compare to other savings tools
Now that you've learned what an annuity fund is, you can consider how they stack up against other options.
Annuities vs. savings accounts
Savings accounts are more flexible, making them better for short-term savings. Unlike annuities, they let you access your money at any time. Interest rates may be lower than you'd get with an annuity, primarily because annuities invest your deposits.
Annuities vs. certificates of deposit (CDs)
CDs are deposit accounts that hold your money for a specified period of time. After that period ends, you receive your original deposit plus interest. Interest rates are usually higher than those in traditional savings accounts but lower than what you'd likely get with an annuity.
Annuities vs. 401(k)s and IRAs
Individual retirement arrangements (IRAs) and 401(k)s are common types of retirement plans. You make deposits into an account, which invests your deposits to grow over time.
An IRA or 401(k) can be better than an annuity for retirement planning, since you don't need a large deposit to get started. An annuity may be better if you already have a nest egg, because it turns your savings into a reliable income.
Annuities vs. pension plans
Both annuities and pension plans provide guaranteed retirement. Pensions are available through employers, but anyone can buy an annuity on the open market.
Annuities vs. bonds
Bonds work like mini-loans to governments and corporations. You collect interest payments until the bond matures, at which point, you collect repayment on your principal. Both provide regular income for the life of the product, but bonds don't offer a lifetime income option.
Pros of annuities for families
Annuities are valuable tools for family money management. They can provide:
Guaranteed income: When you buy an annuity, you choose the length of the payout period. You can select lifetime payments or a fixed duration, such as 15 or 20 years. You receive regular income through that period.
Long-term savings protection: Once you enter the annuitization period, an annuity locks you into your agreed-upon payments — no additional withdrawals, so no spending through your savings.
Flexible payout options: Annuity contracts let you choose between collecting immediately or in the future. The length of the payout period is also up to you, within the limits specified in your contract.
Potential drawbacks of annuities
Before investing in annuities, it's important to consider the potential disadvantages. One of the biggest is that you'll have limited access to funds, even during the accumulation period. Some annuities don't allow withdrawals at all. Others do, but you may face surrender charges. These fees discourage taking money out before it has a chance to grow.
Withdrawal rules are just an example of how complex annuities can be. You can and should ask as many questions as necessary, but the details can be challenging to grasp. Some families prefer to consider simpler options.
How to learn more as a family
If you're considering an annuity as part of your family financial planning, you'll want to explore options in detail. Consider scheduling an appointment with a financial advisor to provide personalized advice.
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