What Is a
Deferred Annuity?
An annuity is a
contract with an insurance company that offers a guarantee in the form of a
steady stream of income. You can purchase a deferred annuity with a lump sum
payment or make payments over a set number of years. Deferred annuities have an
investment phase and an income phase.
“Where the deferred
part of an annuity comes in is that you don't start taking the money until some
future date because otherwise it would be an immediate annuity,” Gilliland
says.
Deferred annuities have
many benefits and drawbacks, and you should talk to a financial advisor and have
an expert review your contract before signing onto what can be a complicated
investment.
Types of
Deferred Annuities
Deferred annuities can
be structured in several distinct ways that affect how interest accumulates on
your investment.
Fixed
Annuities
A fixed annuity pays a
specified interest rate on your funds while they are invested. “You put money in
and it pays an interest rate,” Gilliland says. The predictable interest rate can
be useful to retirees but is not guaranteed to keep up with inflation.
Gilliland says rising
interest rates make fixed annuities more attractive today. “Now you're starting
to see rates that that are higher than that of U.S. Treasuries,” he says. “Right
now, you can look at a 4.75% rate guaranteed over the next five or six
years.”
Variable
Annuities
A variable annuity
doesn't guarantee a specific return. Instead, you can select investments such as
mutual funds or exchange-traded funds, and your rate of return is subject to the
performance of the investments. “A portion of their premiums are invested into
mutual funds that are offered by that insurance carrier,” says Peter Landry,
director of insurance and annuities at Wells Fargo. “The client can invest in
those mutual funds and have the opportunity to have those proceeds grow over
time versus a fixed option.”
Your investments might
grow with the market and potentially keep up with inflation but could also
suffer losses.
Indexed
Annuities
The returns in an
indexed annuity are tied to a market index such as the S&P 500. There is
usually a guaranteed minimum rate and a maximum rate of return. For example, you
might have a minimum rate of 2% and a maximum of 6%, Gilliland
says.
Indexed annuities might
allow you to get a higher rate of return than fixed annuities, but they also
have less potential for significant gains or losses than variable
annuities.
Eric Bond, wealth
advisor with Bond Wealth Management in Long Beach, California, says a newer type
of annuity increasing in popularity is a registered index-linked annuity. “Think
of it as almost a hybrid between an index and a variable,” he
says.
You invest in an index
such as the S&P 500, and this product offers buffer protection. “All that
basically means is if you choose a 25% buffer, at the end of your term, say six
years, let's say if the money is down 10%, 15% or 20%, they make you whole,"
Bond says.
When Does a
Deferred Annuity Begin Payments?
When your deferred
annuity begins to make payments depends on how the insurance contract is
structured. You might opt for a lifetime deferred annuity that provides future
payments for the rest of your life, regardless of how long you live. However,
the payments stop if the annuity holder dies, even if that's not long after
payments start.
A joint and survivor
annuity continues to make payments to a spouse or survivor if the annuity holder
dies. However, the payments are lower due to the risk of paying over two
lifetimes instead of one.
A period certain
annuity pays benefits for a set period of time rather than a lifetime. The
payments are provided over a fixed amount of time, such as 10 or 20 years. If
you die during the payment period, payments can continue to a beneficiary.
However, if you live longer than the payment period, payments will
stop.
Advantages of a
Deferred Annuity
Annuities provide a
guaranteed lifetime income much like traditional company pensions. People who
want a guaranteed income for life can achieve that with a deferred
annuity.
Contributions to
deferred annuities are tax-deferred, much like an IRA or 401(k), and the funds
are not taxed until they are withdrawn from the account. “The tax gain is
deferred until some period of time,” says Dan Hawley, president of Hawley
Advisors Wealth Planning in Walnut Creek, California.
Unlike 401(k)s and
IRAs, there's no limit on how much you can contribute to a deferred annuity.
Those who have already maxed out other types of retirement accounts can qualify
for additional tax breaks using a deferred annuity. “That's really the primary
benefit of that deferred annuity is it provides another tax-deferral vehicle,
just like their 401(k) or their traditional or Roth IRAs,” Landry says. “If
they've maxed out on those options in terms of income level on their IRA or
capped out on their 401(k), it’s another vehicle to create tax-deferred income
growth.”
Disadvantages
of a Deferred Annuity
One of the biggest
drawbacks of deferred annuities is that your financial flexibility is
restricted. You are buying a contract, and it will cost you part of that money
to cancel the contract and regain full control of your funds. The fees and
penalties for making changes can be high.
Deferred annuities
generally have long and complex contracts, and it can be difficult to understand
all the fees you might pay. Insurance salespeople often receive commissions for
selling annuities, which could encourage them to sell annuities to people
regardless of whether they are a good fit for their financial
plans.
Who Should Buy
a Deferred Annuity?
Those who want a
guaranteed income stream in retirement might choose a deferred annuity for a
portion of their assets.
“If you have a
$10,000-a-month need for income and $3,000 is going to come from Social
Security, depending on the annuity you can get another $2,000 from that
annuity,” Gilliland says. “So, you have 50% of your needs in effect guaranteed
for retirement.”
Gilliland says if
market volatility continues, more people will look to annuities to be a portion
– but not all - of their retirement income.
“And the reason I say
that is as they're entering retirement, it seems that people who have the
happiest retirements have the highest amount of guaranteed income. That way they
don't have to worry about what's happening with the with the markets,” he
adds.
Source
https://money.usnews.com/money/retirement/401ks/articles/what-is-a-deferred-annuity
