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Annuities are often misunderstood financial tools that can significantly contribute to retirement planning, despite most people having only a vague awareness of them. Recent research highlights this gap in understanding, with a 2024 Policygenius survey indicating that around 79% of American adults struggle to define what an annuity is. Furthermore, a study conducted by the American College of Financial Services in 2023 revealed that individuals aged 50 to 75 scored a mere 12% on annuity-related knowledge, which is lower than their understanding of other financial products like Medicare, life insurance, and long-term care.
The relatively low familiarity with annuities could be a reason for the hesitance in purchasing them. Research from the Center for Retirement Research at Boston College found that while about half of respondents showed interest in buying an annuity at current market rates, only 12% had actually made such a purchase. Conversely, a survey by the American Council of Life Insurers indicated that 54% of retirement savers are considering options that provide guaranteed lifetime income, akin to a pension, which implies a growing interest in lifetime income annuities; however, the actual follow-through remains uncertain.
Understanding the Importance of Annuities
Annuities play a crucial role as individuals approach retirement age, particularly for those in their 50s and older. Gaining insight about these financial products is essential; without such knowledge, individuals may overlook potentially beneficial options that could secure their financial future.
With the Federal Social Security system facing significant challenges as a substantial demographic shift occurs, it is increasingly important for future retirees to rely on their savings and investments rather than solely on government-provided benefits. In 1950, there were approximately 16 workers for every retiree receiving Social Security benefits. By 2023, the ratio had dwindled to about 2.7 workers supporting each retiree, according to data from the Social Security Administration. Projections suggest that by 2035, this number could further decrease to 2.4 workers per beneficiary, meaning that if you are currently 55 years old, your benefits at age 75 may not meet your needs.
Potential delays in retirement age could be another factor, with current full retirement ages ranging from 66 to 67 years, likely shifting to 70 or older in the future. Additionally, few employers still offer traditional pensions that guarantee a lifetime income; instead, many opt for 401(k) plans, which, while advantageous, bring exposure to investment risks and market volatility without guaranteed income streams.
In light of the increasing pressures on Social Security and the declining availability of pensions, many experts warn that future retirees face potential financial shortfalls. Evidence from the Employee Benefit Research Institute indicates that around 40% of U.S. households might risk running out of money in retirement. Hence, incorporating one or more annuities into retirement planning can help secure a more reliable income stream and less concern about fund management.
The concept of annuities dates back to ancient Rome, where they provided annual payments for life. Nowadays, while many are familiar with income annuities, it’s important to acknowledge the diverse types available.
An income annuity serves as a contractual arrangement that guarantees an income for a specified number of years or for the individual’s lifetime. By depositing a sum with an insurance provider, individuals can receive guaranteed payments, providing peace of mind as this “longevity insurance” mimics the benefits of a private pension.
This type of annuity allows for deferral of taxes until the payments begin, with much of the received income potentially classified as a non-taxable return of premium. However, it does entail ceding control of the principal amount to the insurer, a trade-off that not everyone may find comfortable. Additionally, lack of liquidity and inflexibility may be concerns for individuals with limited liquid savings or investments.
Despite their advantages, income annuities are underutilized—sales reached $18.5 billion last year, a modest sum relative to other financial products.
Within the annuity market, income annuities provide either immediate or deferred income, while the second category consists of various types aimed at growing savings.
A fixed-rate annuity guarantees a specific interest rate for a designated period and protects the principal, similar to bank certificates of deposit (CDs). This type is referred to as a multi-year guaranteed annuity (MYGA). Interest earned in non-qualified accounts is tax-deferred if reinvested back into the annuity, and these products often provide better interest rates than CDs of similar duration. Their straightforward nature contributes to their popularity, with sales hitting $153.4 billion in 2024.
A fixed indexed annuity links your earnings to the performance of a market index, such as the S&P 500, allowing you to benefit from market gains while safeguarding your principal. However, the interest rates can be variable, with potential zero gains during market downturns, and caps may restrict maximum returns. Although they can outperform traditional fixed-income products over time, their inherent complexity necessitates careful consideration.
A variable annuity functions like a portfolio of mutual funds within an annuity contract, offering tax-deferred growth and optional income guarantees. Notably, variable annuities typically lack the principal guarantees associated with fixed products, exposing investors to both volatility and high fees while aiming for higher long-term returns.
Understanding Annuity Taxes
It is crucial to approach non-qualified annuities, those funded with after-tax dollars, with caution; withdrawing funds before age 59½ incurs ordinary income tax on earnings plus a 10% IRS penalty, although an exception applies in the case of permanent disability. Annuities can also be placed in qualified accounts such as IRAs, with the QLAC offered as a noteworthy alternative.
A vital consideration when contemplating annuities, especially income annuities, is the long-term commitment involved. Selecting a financially sound insurer is paramount, ensuring they can meet their obligations. The insurance industry is heavily regulated at the state level, contributing to a reliable track record.
Ken Nuss is recognized as a leading expert in annuities and serves as the founder and CEO of AnnuityAdvantage, a prominent online platform for fixed-rate, fixed-indexed, and lifetime income annuities. A complimentary rate comparison service featuring interest rates from various insurers is available at www.annuityadvantage.com or by calling (800) 239-0356.
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This article presents the views of the contributing adviser and not the editorial staff. Check adviser records with the SEC or FINRA.
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