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It’s never too early to start saving for your retirement, and there are many ways to do it. Annuities are one of the options. But they are usually considered in the context of those approaching or entering retirement. Can they be an option for younger folks?
The considered answer, like most things in finance, is … it depends.
But here's the short answer: If you are somewhat risk averse yet want to lock in investment growth and a guaranteed source of income in retirement, an annuity may be worth considering. Especially as various types of annuities are evolving.
“Historically, annuities were more appropriate for folks nearing or already into retirement,” said Jon Preston, CFP®, a financial professional with Commonwealth Financial Group in Needham, Massachusetts. “Now, that rule of thumb is being tested. The once stodgy annuity market is undergoing a renaissance. Today’s annuities look quite different than those our grandparents knew.”
To understand the opportunities, it’s important to understand the basics of what annuities are and how they work.
Annuity basics
At their core, annuities are contracts with an insurance company that, in exchange for a lump-sum purchase payment or a series of payments, will provide a stream of income at some point in the future. That said, there are many different types of annuities with various benefits and features aimed at accomplishing a range of purposes on different timelines. And the amount of the future payments will depend on the growth of the initial annuity purchase payments over time.
Among the range of offerings there is one broad category — deferred annuities — that is geared toward building long-term, tax-deferred growth.1
This group includes:
- Fixed annuities
- Variable annuities
- Fixed index annuities
These types of growth-oriented annuities may be of interest to investors, depending on their financial objectives and risk tolerance. These annuities offer varying trade-offs between growth potential and risk exposure.
- For investors younger than 40 years old, a variable annuity may not make sense given the fees that will add up over time and decrease the long-term growth potential. A fixed index annuity may also not be appropriate as growth potential is usually limited to cap and participation rates, whereas “younger” investors tend to have a longer investment time horizon and a greater appetite for risk than those close to or nearing retirement.
- Certain types of fixed annuities, multiyear guaranteed annuities, may not make sense for those younger than 55 years old who have long-term investment time horizons, a desire for maximum growth potential, and the willingness to accept some level of market risk.
Nevertheless, there are instances where annuities may be an option for middle-aged investors — those who aren’t starting out but also not on the front doorstep of retirement.
“I’ve seen compelling cases for annuities in a mid-career professional’s plan,” commented Preston, noting that some middle-aged investors find the growth opportunities balanced with some downside protection attractive for a long-term retirement investment plan.
Annuities can also help diversify a portfolio beyond the stock and bond investments sensitive to market swings and sentiment, while offering the ability to earn guaranteed interest with the opportunity to generate guaranteed lifetime income. (Related: Taking money off the table with annuities and life insurance)
Fixed annuities
For those seeking safety, fixed annuities can offer guaranteed interest rates with no exposure to loss. Typically, the interest rate on a fixed annuity contract is set at the beginning of the contract, usually at the prevailing interest rate. That rate can then be adjusted after a specified period of years. Usually, the new interest rate cannot fall below the minimum rate specified in your contract.
That means guaranteed growth in your investment, provided no withdrawals or surrenders are made. The interest rates fixed annuities offer may not be as high as the returns of some other types of investments, but they offer safety.
Additionally, these annuities offer tax-deferred growth, meaning you only pay taxes on the earnings once you withdraw funds or start receiving income payments. In most cases, that will happen in retirement, when many people’s income taxes are typically lower. Deferring income tax on annuity gains until retirement, then, means a lighter tax bill overall.
Also, the tax deferral allows money that would otherwise go to taxes each year to stay invested and contribute to the overall compounded growth.
In short, fixed annuities are appropriate for those who want to:
- Build tax-deferred savings at a fixed interest rate.
- Protect against market risk.
- Gain a guaranteed retirement income stream.
- Diversify their portfolio with a conservative investment.
You can learn more about fixed annuities here.
Variable annuities
Variable annuities, in contrast to fixed annuities, can provide the full return potential of the market, but are subject to risk as well. These may be appropriate choices for younger investors seeking maximum growth in exchange for a greater element of risk, since they have time to recover from possible losses.
A variable annuity owner can pick among a diverse range of investment choices offering multiple asset classes and investment styles, depending on the choices provided by the insurance company offering the annuity. Choices usually can range from stock funds to bond funds to specialty ETFs. Such options allow an investor to allocate funds to investments that reflect their particular retirement goals, time horizon, and risk tolerance.
And, like fixed annuities, variable annuities offer tax-deferred growth and the potential for growth through positive market performance. However, they also have fees that can add up and affect returns to some extent over the long term.
In short, variable annuities may be appropriate for those who want to:
- Build tax-deferred savings at market rates.
- Have control over their investments.
- Take on market risk in exchange for possibly greater gains.
- Create a source of guaranteed retirement income.
You can learn more about variable annuities here.
Fixed index annuities
Fixed index annuities provide the opportunity for higher growth potential than a traditional fixed annuity and create a stream of guaranteed lifetime income. At the same time, they offer a degree of protection from market loss.
More specifically, a fixed index annuity links its return potential to market indexes, such as the Standard & Poor’s 500 Index®. The performance of the index over a specific time frame helps determine the interest credited to the annuity. If the benchmark index has negative performance, then the annuity doesn’t get credited any interest, but the principal is protected, limiting downside risk. However, the upside is typically limited by a cap rate that is predetermined. That is the trade-off for the downside protection.
In this area are also registered index-linked annuities, also called structured index annuities. These are annuity contracts where, like fixed index annuities, the rate of interest credited is linked to the return of an index. There is typically a higher cap rate on positive returns of an index, but there is less protection from market loss.
In short, fixed index annuities may be appropriate for those looking for:
- Moderate, tax-deferred growth over the long term.
- Principal protection from market loss.
- A relatively low risk way to generate guaranteed income in retirement.
You can learn more about fixed index annuities here.
The payoff and other features
Of course, the object of an investment is to eventually reap rewards. And there are a variety of ways to generate income from an annuity. One way is through withdrawals. Another is through annuitization, which distributes funds from the contract providing guaranteed income for life or a set period of time.
There are other benefits to be had with annuities as well, appealing to both younger and older investors. Sometimes these are a standard part of the annuity contract or can be obtained through the purchase of a rider to the annuity.
Death benefit. If you die during the accumulation phase of your annuity contract, your beneficiary will receive a death benefit. Any annuity death benefit payable during the annuity phase is based upon the annuity payout option selected.
Optional living benefits. These generally guarantee, in exchange for an added fee, some sort of defined payout while the insured or annuitant is still alive. Some living benefits guarantee the contract holder's principal and others guarantee a certain rate of hypothetical growth as long as certain conditions are met. The rider, for example, may require you to annuitize the contract instead of taking a systematic withdrawal.
A guaranteed lifetime withdrawal benefit (GLWB) annuity rider is an optional living benefit that you can add to a variable annuity, fixed annuity, or fixed index annuity contract to secure guaranteed annual lifetime income in retirement. (Related: Understanding GLWB riders)
Some of the annuity choices, such as fixed index and variable annuities, can be complex and need to work in tandem with other retirement savings plans. Many people opt to consult a financial professional to help navigate the choices.
“Annuities aren’t one-size-fits-all,” noted Preston. “As always, it pays to seek the advice of a qualified financial professional. They’ll help determine what role an annuity could play in a comprehensive financial plan.”
Also bear in mind that annuities are long-term investments and, as such, have fees and surrender charges should an investor want to get money back earlier than contractually provided for. Therefore, someone considering an annuity should only use money that they are unlikely to need until their retirement years.
Conclusion
Younger people could consider buying an annuity if it aligns with their risk tolerance profile and financial goals. It’s never too early to begin saving for retirement and annuities can offer another avenue for doing so.
Discover more from MassMutual …
Does an annuity fit your retirement goals?
Annuities: Criticisms and rebuttals
5 reasons why you may need an annuity
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