If you've ever had the experience of running out of money way before the month was over, you know it isn't especially pleasant. So imagine what it's like to outlive your retirement income. Annuities can help you avoid that by providing an income for as long as you live. If you're just beginning to explore them as an investment option, the difference between deferred annuities and other annuities may not be clear.
The easiest way to think about an annuity is to picture a life insurance policy turned inside out, like a sock. With life insurance, the insurer turns your small monthly payments into a lump-sum death benefit. With an annuity, the insurer turns your lump sum into retirement income paid out by the month, quarter or year. Payouts can be for a set time period or the rest of your life. If you choose lifetime payments, the insurer calculates the payment amount from your life expectancy. The longer you're likely to live, the smaller those payments will be.
Immediate vs. Deferred
If you plunk down a big wad of cash with your insurer and start taking income from the annuity right away, that's called an "immediate" annuity. For young investors that isn't usually an option, unless you've won the lottery or come into an inheritance. More often, you'll build up that retirement fund by making small payments over a long period, then converting it to income decades later when you retire. That approach is called a "deferred" annuity, because you're putting off the part where you take out income.
When it's time to start taking money out of your annuity, you've got to make some choices. For example, if you want to retire at age 55 and you have a pension coming at 65, you could use the annuity as income for those 10 years. Alternatively, you can take an income until a certain age or for the rest of your life. You can even set up a joint annuity that will cover you and your spouse for as long as either of you lives. Knowing you can't outlive your income is a pretty reassuring thing as retirement gets closer.
Annuities can be a useful part of your retirement planning, but there are some things you need to know. For starters, annuities seldom give you the returns you can get on some other investments. They also tend to have higher costs because they have to pay commissions and calculate your life expectancy, as well as manage your money. Companies make that back through "surrender charges" if you need to take your money out of the annuity, so that's something to do only in times of dire emergency. If you take out money before you turn 59 1/2, the Internal Revenue Service will also hit you with a tax penalty.
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.