How Annuities Help Retirees
Let us discuss two different kinds of fixed annuities, an immediate annuity and a deferred annuity.
In a fixed immediate annuity, an insurance company guarantees to pay monthly income, for life, in exchange for your premium. Economists have shown that the yearly income from this kind of annuity can be much higher than the yearly income that retirees could prudently pay to themselves. We explain why this is so, and provide examples, in the Planning Retirement Income Section.
Our Retirement Research section summarizes and reproduces some of the economists' findings. Here is how Professor Laurence J. Kotlikoff and Scott Burns summarized their view of fixed immediate annuities in retirement in their 2008 book "Spend 'til the End":
- We can easily outlive our money.
- Annuities can dramatically raise our sustainable living standards.
- There are now inflation-indexed annuities that can mitigate longevity risk.
- All retirees should carefully consider buying inflation-indexed annuities.
Now let us consider a fixed deferred annuity. In this contract, the insurance company credits guaranteed interest to the premium you pay. The interest rate you receive in the deferred annuity may be higher than that available to you from other sources.
All fixed deferred annuities contain an option that allows you to convert all or part of the account value into an immediate annuity. Thus, a deferred annuity is a safe place to grow your assets that may be used, someday, to purchase an immediate annuity.
There are income tax advantages to a deferred annuity. In addition, there is no tax penalty, when and if you convert your deferred annuity into an immediate annuity. For example, income tax on interest earned in the deferred annuity is deferred until that interest is actually withdrawn. In addition, conversion of your account value in a deferred annuity into an immediate annuity is not a taxable event. Of course, income tax will be due on the payments from the immediate annuity when those payments are received. Some portion of the payment is not taxable because it is considered a return of principal. The insurance company will inform you how much of the payment may be taxable because it is considered interest.
Here is a summary of the advantages of the deferred annuity to retirees and those near retirement:
- Interest is guaranteed by the insurance company and may be at a higher rate than is available from other savings sources.
- A deferred annuity may be converted, in whole or in part, into an immediate annuity.
- Interest credited to deferred annuities is tax deferred until payments are actually received.
Annuities also come with some disadvantages. For example, the typical fixed immediate annuity is noncancellable and provides no liquidity. You should, therefore, make certain that your other assets have the liquidity you may need.
Most, if not all, fixed deferred annuity contracts impose charges for "early" withdrawals. These penalties and "early" withdrawal periods vary from contract to contract. Please understand these limitations before you buy.