Annuity 101: Simplified & Demystified

Annuities have been described as ‘complicated,’ ‘costly,’ and ‘too good to be true.’ While not entirely baseless, these smears to annuities’ good name often come from a place of misunderstanding and misrepresentation.

When you get caught up in all the finance industry jargon and technicalities, it’s very easy to lose the plot and turn your nose up at annuities. However, when understood for what they are and what purpose they serve, it’s clear they’re not actually all that dense or risky, and perhaps the most sensible thing for your retirement plan.

‘Annuity 101’ is NAE’s go-to resource for curious readers wanting to learn what an annuity is, what it isn’t, and what all of it could mean for you and your loved ones.

What is an Annuity?

An ‘annuity’ is a contract between you and an insurance company, in which you pay them one lump sum or a series of payments, and in return you receive a stream of income, either now or in the future. 

Put another way, imagine if the funds in your savings account could be turned into a steady stream of paychecks you can cash for the rest of your life. That’s basically what an annuity is: you buy in, it pays out. Plain and simple.

How It Works

To expand on the above, every annuity follows a two-part process:

• Accumulation, the Growth Phase: you contribute money and the funds grow tax-deferred, meaning you aren't paying taxes on the interest or gains until you start taking the money out.

• Distribution (or Annuitization), the Payout Phase: the insurance company begins sending you checks.

It’s important to note how you receive your annuity income can be tailored to your preferences; it could be guaranteed lifetime income, a predictable and secure fixed amount, or tied to market performance with the option to protect yourself from volatility.

Why Annuities Seem Complicated

So if understanding annuities is so easy, how come you’ll hear otherwise? There are actually a couple of reasons:

Reason #1: There’s More than One Kind of Annuity

There are in fact a number of different annuities, namely:

• Fixed (the safest option)

• Variable (based on market performance)

• Indexed (has a floor and a ceiling)

• Immediate (pays within the month of purchase)

• Deferred (delayed for increased accumulation)

While they’re all the same thing in essence, each comes with their own set of pros and cons, and better suited for one purpose over another. While these differences are good to know, it’s easy to be inundated with information overload when presented with multiple options.

Reason #2: Misinformation

A major source of confusion about annuities is treating them like an investment, like putting money into the stock market and expecting big returns. This of course leads to disappointment and disillusionment with annuities, all because of misrepresentation of their actual use and value.

There are also misconceptions that come out of certain arguments against annuities, which in fact are criticisms of outdated versions that no longer apply to modern products.

Is ‘Guaranteed Income’ Too Good to Be True?

It’s easy to be skeptical over the promise of income for the rest of your life, and having to pay upfront sounds makes it sound like an outright scam.

However, annuities are completely legitimate, and not just because an advisor says so. There is more than one reason to put your trust in annuities:

• They involve strategic planning, not speculation and selling a dream

• They use actuarial math (or risk pooling) instead of market returns

• Their purpose is to provide stable income, not to invest in for income growth

• They are regulated financial products and backed by insurance companies

Annuities by design deliver on predictable payouts, making the possibility of guaranteed income absolutely real and achievable.

When Annuities are Right for Your Retirement Plan

Annuities may sound great, but they’re not for everyone (with one important caveat). Here’s a quick guide for whether you should or should not consider an annuity:

Say ‘Yes’ When:

• Your #1 priority is insuring you have consistent income throughout your retirement

• You find tax-deferred accumulation of wealth appealing

• You want retirement income that is safe from market forces like volatility and interest rate changes

Say ‘No’ When:

• You don’t want to be too involved in strategizing for your retirement

• You hate paying fees (especially true for variable annuities)

• You don’t like having limited liquidity (applicable to some, but not all cases)

• You don’t want to put up with inflation risk (depends on structure of the annuity)

Now for that caveat: note how for most reasons to say ‘no’ there was some exception? Exploring your options with annuities isn’t really a matter of deciding whether they’re ‘good’ or ‘bad’ for your retirement plan. The question is whether or not annuities are used correctly in a broader plan involving other strategies.

Annuities are versatile products, and can be combined with other sources of income and investments as part of a strategic portfolio. Whether you want a portfolio that leans more conservative or more aggressive, an annuity will always serve as a solid foundation to whatever retirement plan you have in mind.

The Bottom Line: a Smart & Actually Easy Choice

Annuities have gotten a reputation that largely reflects the worst examples of the category rather than the category itself. Never let an advisor mislead you; with the right application of an annuity to your retirement plan, it can be one of the most sensible avenues for securing guaranteed  income for the rest of your life.

With market instability and the slow disappearance of traditional pensions, the case for incorporating guaranteed income into a retirement strategy has never been stronger. For more information, please reach out to us at National Annuity Educators.