What is an Annuity? The Ultimate Guide

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If you’re in retirement or nearing retirement you might consider an annuity as a source of retirement income. Before we dig into all things annuities—a word of warning, Wealthsimple is not insurance licensed and we don’t offer annuities. That said, here’s some information you might want to know about annuities if you’re considering purchasing one.

What is an Annuity?

The simple answer: An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments over time. It’s one option to fund your retirement if you’d like to depend on a steady stream of income.

Types of Annuities

There are many types of annuities to choose from some of these include: fixed annuities, variable annuities or indexed annuities. Here’s what each of these actually mean.

Fixed annuities guarantee that your insurer will pay you, the purchaser, a guaranteed, fixed interest rate on your contributions to the annuity for an agreed-upon period of time.

Variable annuities change in value depending on the performance of investments (often mutual funds). Unlike fixed annuities, variable annuities don’t provide a specific or guaranteed return.

Indexed annuities depend on the performance of an index, like the S&P 500, which gives you the chance for investment growth. Index annuities offer a guaranteed minimum return which is why some people might see them as being advantageous over traditional investing.

As you can see, there are so many types of annuities out there. Your best bet is to consider which one is best for you — and take into account investment risk, your needs and pesky rules like withdrawal penalties.

Pros and Cons of Annuities

Do you think an annuity is a great fit for you? As with anything, it’s best to go through the pros and cons before you dive right in.

Pros of annuities

  • Already maxed out your RRSP? Annuities can provide more tax-sheltered ways to save for retirement.

  • You can stuff away a larger amount of cash and defer paying taxes. There’s no annual contribution limit for an annuity.

  • Annuities are tax-deferred — you don’t pay taxes on the money while it’s in the annuity. You only pay taxes on the money when you withdraw it.

Cons of annuities

  • Illiquidity. Period. Your money is locked up and you can’t access it.

  • You’ll pay commissions on annuities because they’re an insurance product.

  • You can add a rider, which can have income, legacy or long-term care provisions, such as taking care of beneficiaries when you die — but that’ll cost extra.

  • They’re only as good as the insurance company providing them. There’s no guarantee that an annuity will be there for you. What if the insurance company folds? There goes your annuity.

  • You can still lose money, and since current interest rates are low, you expose yourself to inflation risk

  • Your heirs inherit your cost basis and may pay tax at their ordinary income rate.

How Does an Annuity Work?

Putting an annuity together is a lot like going through a buffet. You can mix-and-match your “plate” based on your tastes and your own personal situation. If you’re in the market for an annuity, here are a few things to keep in mind.

Consider Premiums

Single premiums or multiple premiums? Which works best for your needs? Would you rather pay for an annuity in one big payment or make a series of payments over a number of years? You can make monthly, quarterly, annual or even a lump sum payment.

Decide Which Type You Want

Whenever professionals discuss annuities, two types typically come up: immediate and deferred.

Immediate annuities pay you income right away (or almost right away). Remember that lump sum option? Here’s where it comes into effect. You make a single lump sum payment to the insurance company and you begin making income one annuity period after you purchase it. How soon after depends on the company. You can generally make money from 30 days to one year after your first payment. Immediate annuities are a really popular option among retirees — can you see why? You get paid fairly quickly.

Deferred annuities offer tax-advantaged saving and lifetime income. What’s the benefit of a deferred annuity? Your annuity garners interest during that time and you may increase your future income. With a deferred annuity, you begin receiving payments years or decades in the future. Your premiums grow tax-deferred inside the annuity. In other words, it’s like planting a seedling to grow a maple tree years from now.

A lot of people use deferred annuities to supplement individual retirement accounts and employer-sponsored retirement plans. (There’s a good reason why — keep reading!)

Other Types of Retirement Investing

Not sure annuities are your best bet? Understandable. Let’s check out a few other options.

Retirement Accounts

Retirement accounts can’t be excluded from the list, right? Retirement accounts are a great option if you already have access to one through your job and are still working. You can learn more about various account types here.

If you’ve never taken the time to set up your retirement account, you’re probably leaving money on the table. Many companies offer a percentage on the dollar that you invest yourself.

Check with your company’s human resources office to find out if you have a retirement plan. Then, don’t waste any time. Sign up for it so your company chips in money, too.

Robo-advisor

robo-advisor is a service that uses highly specialized software to do the job of wealth managers or investment advisors – people who decide what you should invest in and then tinker with those investments over time.

Robo-advisors typically have you answer a few questions to determine your appetite for risk which will probably be low if you’re heading into retirement. Then, through the use of proprietary algorithms, they spread your money into appropriate investments, making adjustments as your situation and the market change.

When you open an account with a robo-advisor they typically collect between 1% less in fees than a professional investment advisor. They can charge lower fees as they generally don’t have brick and mortar branches like most other financial institutions and they automate a lot of manual work. A 1% fee on your entire retirement savings can amount to quite the sum of money so it’s very wise to shop around and find a low fee alternative like a robo-advisor, if that best suits your needs.

Laddered Bonds

Have you ever heard of a bond ladder? It’s a way to take advantage of bonds at different maturity rates. Here’s an example of how it works:

  1. Let’s say you plan to invest $30,000.

  2. You buy three bonds each with a face value of $10,000.

  3. Or — you buy 10 bonds with a face value of $3,000.

  4. The bonds all mature at different times. The first bond matures in a year, the next the year after, the next — you guessed it. You can spread them out over 10 years, too.

It’s a potential low-risk way to gain a return on your retirement savings.

Index Funds

Nervous about plunging your funds into an index fund that tracks the market? (It means your money can also bear down with the market, as well.) However, index funds are inexpensive and also generally recover with the market since they track it. Popular ETFs like Vanguard Index 500 (VFINX) or an exchange-traded fund (ETF) such as the SPDR S&P 500 ETF (SPY) are options.

Decide Whether Annuities Are Right for You

If you’re scratching your head wondering what option is best for you then you’ll want to consider the following:

Regardless of your decision, you shouldn’t take it lightly. Choosing an annuity is a major decision so make sure it’s the right one for you and talk to a professional that offers annuities before whipping out your wallet.

Last Updated October 13, 2020

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