Americans hold billions of dollars in annuities, yet they are widely misunderstood. Used properly, an annuity can serve valuable purposes in personal financial planning. On the other hand, some types of annuities are widely criticized, even scorned, by some financial advisers.

Lifelong income

What might be considered the purest type of annuity is a contract with an issuer, often an insurance company, for a stream of cash flow. For example, a person might buy an annuity that pays the purchaser a guaranteed amount every month for the rest of the purchaser’s life. These contracts have usually been called immediate annuities, although they now may be labeled income annuities or payout annuities because those labels may be more appealing to consumers.

Immediate annuities have a great advantage: the promise of lifelong cash flow. More people are living into their 90s and beyond, so a lifetime annuity can help keep them from running short of money in very old age. But lifetime annuities also come with risk. If an annuitant dies at a younger age than expected, the payments will end before the annuity’s premium has been returned.

Adding uncertainty

Insurers have come up with various methods of addressing these risks. One method is the period certain annuity which guarantees that payments will continue for at least a certain amount of time, even if the annuitant dies.

An annuity with this type of guarantee will produce smaller checks than a straight life annuity because the insurer has more risk. Other features may also be added to an income annuity, such as access to principal, but all of these variations will reduce the amount of the checks paid to consumers.

Annuity taxation can also be complex. If an immediate annuity is held in a taxable account, part of each payment is taxable, and part is tax-free. If you need help calculating what portion of your annuity payment is taxable, contact our office and we would be happy to help you.

Later rather than sooner

Some annuities start distributing cash right away, as described above, but others are deferred. The deferral could be a wait for some years until an income annuity starts.

Alternatively, there may be some provision for the invested amount to grow untaxed until the payouts start. These annuities may peg growth to a promised interest rate or to results in the financial markets. Often, there is some type of guarantee from the insurer of a minimum return or protection against loss. The manner of future payouts can be left up to the consumer.

While annuities can be an important tool in retirement planning, critics charge that some annuities, especially deferred annuities, can be complex, illiquid, and burdened with high fees. Be sure to read the fine print of any annuity before making a commitment.

This article carries no official authority, and its contents should not be acted upon without professional advice. For more information about this topic, please contact our office.