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What is an Annuity?

An annuity is an insurance investment that provides a stable and reliable income stream during retirement. It is essentially a contract between an individual and an insurance company stating the insurance company will return the original investment plus interest at a later date in fixed installments.

Two Annuity Phases

Accumulation Phase

The person purchasing the annuity, known as the annuitant, either purchases an annuity with a lump sum or makes monthly payments. This phase is called the accumulation phase.
During the accumulation phase, your annuity begins to earn tax-deferred interest via the investments the insurance company has purchased using your premium(s). The kinds of investments they buy depend on the annuity, ranging from more aggressive to more conservative.

Payout Phase

The payout phase is when the insurance company starts returning your premium. The payout phase can be a set term or, more often, for the remainder of your life. The longer your life expectancy, the lower the payout will be, similar to a Required Minimum Distribution.

Annuities in Retirement Planning

The intention of annuities is to be a safeguard in case all other investments fail. Your traditional investment portfolio is prone to market fluctuations. In some cases, even great, diversified portfolios cannot withstand bear markets, especially if one occurs at the beginning of retirement, known as the sequence of returns risk.

Isn’t there Social Security?

Of course, there is always Social Security (if it doesn’t run out), but most individuals would prefer a lifestyle more lavish than that which Social Security can provide on its own.
Annuities fill that gap between potential portfolio failure and a reduced lifestyle that Social Security would provide. It is, in essence, insurance against the financial markets. And if your portfolio performs as planned, congratulations! An annuity will only enhance your retirement experience.
With an annuity, you can have a more stable retirement without fear of running out of money. At least, in theory. We’ll get into that later on.
There are several different types of annuities to consider, including fixed, variable, and indexed.

Fixed Annuities

Fixed annuities provide a guaranteed rate of return because the premiums you give to the insurance company are, in turn, invested into fixed-income securities, such as federal, municipal, and corporate bonds. These bonds or other debt securities are chosen for their stability and risk aversiveness.
Of course, with investing, reward is usually proportional to risk. Therefore, the payoff will be substantially less with a Fixed Annuity. As of February 2023, you can expect a 4% to 6% yield through a Fixed Annuity.
The upshot is that you’ll receive your income regardless of how the markets are doing.

Variable Annuities

Variable Annuities invest in more aggressive mutual funds that consist of a mixture of stocks, bonds, and money market instruments. Accordingly, the performance of a Variable Annuity is quite variable, as it has a higher exposure to the whims of the market compared to a Fixed Annuity.
On the other hand, there is a higher chance of making a greater profit. According to SmartAsset, the average Variably Annuity provides an 8% – 10% interest rate – it should be noted, though, that these are more likely to come with higher management fees than fixed annuities, which will eat into your profits, just like a regular mutual fund or ETF.
The reasoning, however, is simple. The investor is pushing the responsibility of volatility and loss onto the insurance company. That doesn’t come for free!

Index Annuities

An index annuity invests in an industry benchmark consisting of a wide range of stocks that meet benchmark criteria. The S&P500 is the most popular benchmark. Stock market indexes offer more stability than individual stocks or actively managed mutual funds, but the profits are limited. Funds are spread thin through various companies so that, even if one fails, you don’t lose everything. If one company’s stock soars, you don’t have enough money invested in that company to exactly strike it right.
An index fund wrapped inside an annuity provides further stability and protection, with less chance of loss but less upside as a result. Again, the payoff is that the payment is guaranteed, though at a lesser payout than investing in the S&P 500 would alone.

The Pros of Annuities

Annuities provide a nominally guaranteed source of income when you may need it most. Since they are part of an insurance contract, they are safer than directly purchasing securities while also being tax-deductible with tax-free growth.

The Cons of Annuities

There are also some drawbacks to consider. Annuities can be complex, difficult to understand, and typically more expensive than regular investments. They also tie up a substantial sum of cash due to hefty fees for withdrawing funds early, making them highly illiquid.
Additionally, they are not FDIC-insured. If the insurance company files for bankruptcy, the state will step in and attempt to salvage annuities by transferring them to another insurance company or, if that fails, move them into the State Guaranty Fund. Limits do apply, however, and they may not cover variable annuities.
Do annuities have a place in your retirement plan? Possibly. But it is crucial to go through the process with a skilled and experienced financial advisor who understands annuities’ complex tax implications.
At Walters Strategic Advisors, we possess the requisite knowledge and experience to guide you through the whole process and help you determine if an annuity is right for you.

About the Authors

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.

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  • Jose Joia

    Jose M. Joia is a Wealth Advisor at Walters Strategic Advisors, LLC. As a member of the team, Jose’s responsibilities involve comprehensive wealth management, planning and customer service. He has over 6 years of industry experience specializing in planning and solving unique issues his clients encounter. Jose has experience serving individual clients, business owners and non-profit organizations.

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