Annuities 101: What You Need to Know

In planning for retirement, the biggest priority for most people—both military servicemembers and civilians—is creating a predictable stream of income to fund the lifestyle they envision. The challenge is how to convert the assets you have spent years accumulating into the income you will need to live on for the rest of your life.

Let’s take a closer look at one financial tool that could play a useful role in addressing your retirement planning challenge.

What is an Annuity and How Does it Work?

An annuity is a contract between you and an insurance company in which you make a lump-sum payment (or series of payments) and, in return, receive regular payments for life, joint life (until the death of the second spouse, should you select and pay for this option) or for a specified number of years, which is typically referred to as period certain. The payments can begin immediately or at some point in the future, and can be made on a monthly, quarterly, semiannual, or annual basis. Annuities are designed to create a guaranteed stream of income from your accumulated assets while shielding you from the volatility often associated with investing in financial markets.

What Are the Different Types of Annuities?

Insurance companies offer a broad array of annuities, but all of them fit into a few general categories: immediate or deferred and fixed or variable.

• Immediate annuities are typically purchased with a lump sum payment and start distributing guaranteed income right away.
• Deferred annuities can be purchased with a lump sum or a series of payments over time. They provide a stream of income that begins at a future date.
• Fixed annuities are a type of insurance contract that promise to pay the buyer a specific, guaranteed interest rate on their contributions to the account.
• Variable annuities pay a rate that varies according to the performance of an investment portfolio chosen by the account owner.

As with most financial products, selecting the right annuity is a function of your situation and objectives. If you are retired or plan to retire soon and your objective is to generate an additional stream of guaranteed income now, a fixed immediate annuity may be the right option. But if you’re 40 years old and don’t plan to retire for 20 years, a deferred variable annuity that has more risk, but gives you the opportunity for tax-deferred growth might make more sense. A knowledgeable financial advisor will take the time to understand your specific needs and help you determine if an annuity is appropriate for you and, if so, what type of annuity is the best fit.

Are Annuities a Good Investment for Military Retirees?

If you retired from the military and are seeking an additional stream of guaranteed income now or in the future, an annuity might be worthy of consideration. But it’s important to understand that your military retirement income is, effectively, a lifetime annuity in that your payments are guaranteed to continue for as long as you live and beyond if you opted for SBP and die before your spouse. Another benefit you may be eligible for is VA Disability pay, which can further supplement your income. You may also be eligible for Social Security, which is the equivalent of yet another lifetime annuity.

Because you might be in the enviable position of already having at least two significant streams of guaranteed income, developing a diversified investment strategy may be a more appropriate course of action than adding a third guaranteed stream of income in the form of an annuity. Because, as detailed in the next section, there are some restrictions and limitations associated with annuities.

The Disadvantages of Annuities

Fees

Let’s start with the fees. Because of their simple structure, fixed annuities are relatively inexpensive, but you should be aware that they typically do have what are called “surrender fees” that apply if you choose to terminate your contract before a certain amount of time – ranging anywhere from two to 10 years – has passed. These fees can be substantial but are avoidable. Variable annuities, on the other hand, typically have several layers of fees, including surrender fees, insurance charges and investment management fees. It’s not uncommon for the total of these fees to amount to two or three percent of your total investment every year. And that could be substantially more than the normal fees on a mutual fund.

Liquidity

Another disadvantage of annuities is that they are somewhat illiquid. First, assets in a variable annuity have the same tax advantages as a traditional IRA, but like an IRA, withdrawals prior to age 59 ½ are subject to a 10 percent tax penalty. Second, deposits into annuity contracts are typically locked up for an extended period of time, known as the surrender period. The annuitant, which is the person receiving payments, incurs a penalty if all or part of that money is withdrawn.

Leaving an Inheritance

If it’s a priority for you to leave an inheritance to your children or grandchildren, an annuity might not be the best choice. Depending on the type of annuity you choose, your heirs may get nothing after you die, even if far less was paid out than you had contributed. And in the case of a variable annuity, your heirs would not receive the same step-up in basis at death that they would with stocks or mutual funds because they are considered insurance contracts, not investments. That means they would need to pay taxes on any gains as ordinary income. This can be especially problematic if the annuity has been growing for a long time and the cost basis is low.    

Should I Buy an Annuity?

If you’re a service member or veteran, a First Command Financial Advisor can help you determine whether an annuity is right for you. Our comprehensive knowledge of military benefits makes us uniquely qualified to address this topic, and we’d love to work with you to build a complimentary financial plan that includes a properly balanced retirement income plan.

Learn more about the different types of annuities that may be appropriate for your situation. Then, schedule a meeting with your First Command Financial Advisor to determine how to navigate your retirement journey with confidence.

Guarantee depends on the claims-paying ability of the issuing insurance company and does not apply to the investment return or principal value of the separate account. Before buying an annuity, you should find out about the particular annuity you are considering. Request a prospectus from your Financial Advisor and read it carefully. The prospectus contains important information about the annuity contract, including fees and charges, investment options, death benefits and annuity payment options.

Diversification, asset allocation and portfolio rebalancing do not guarantee a profit or protect against a loss in a declining market. They are methods used to help manage risk. Investment returns and principal value will fluctuate and your investment, when redeemed, may be worth more or less than its original cost. Sales charges and taxes may apply.

First Command does not provide legal or tax advice, and this article does not contain any legal or tax advice. Any recommendations provided to you in this article are strictly for financial planning purposes only. Should you require legal or tax advice, you should consult with your attorney or tax advisor.