Funding Your Future with Annuities: Where Do I Start?

Retirement is a time to relax and do what you please after years of hard work. It’s a newfound freedom with increased leisure and family time. However, many aren’t sure how much they’ll be able to enjoy themselves due to financial concerns. 

You must learn how to transition from depending on a regular paycheck to creating your own income from your personal savings. Pinpointing how you’ll source income may lead to a variety of concerns, questions, and challenges financial professionals can help with. Below are some common concerns you may have and what you should know about annuities as an option for retirement income.

 

Reviewing retirement concerns

Health

How likely is it you may have a health issue? This is something completely unpredictable, and medical costs increase as we age. There is a 70% chance a person 65 and older will need some kind of long-term care in their lives.¹

In 2024, the price for someone to stay in a Midwest assisted living facility is between $3,500 to $8,000 per month.² Looking at these figures, it’s easy to see how an illness or any other medical expense could substantially reduce your retirement income.

Outliving your savings

The flip side of the coin is living long enough that you risk outliving your savings. It may sound counterintuitive that not getting sick could also cause a problem for you financially, but more years in retirement mean more time to stretch funds. The average American spends 20 years in retirement, which is why it is important to prepare for a retirement that could last two decades or more.³

Market volatility

As we all know, the market can be volatile. People are hesitant to invest in the stock market because of the uncertainty tied to these investments. Stocks are prone to sudden declines in value. 

These declines seem to happen at random, but many factors cause the stock market to go up or down. Sometimes stocks recover their value quickly, while other times the decline could last for a while. Because no one can predict market declines with certainty, a diversified portfolio may be the best solution for a long-term investor concerned about both return and risk. 

What can you do to get ahead of these concerns surrounding retirement? To combat the rising cost of healthcare, consider long-term care insurance, a robust health insurance plan, or annuities that can be accessed in case of an emergency. 

To protect your income against the possibility of outliving it, make sure your Social Security payout is maximized. Guard against market volatility by diversifying your assets. And lastly, if you don’t have a traditional pension, consider an annuity that would pay a specified income for life. This option is discussed in more detail below. 

How do annuities work? 

An annuity is an investment that pays out a fixed amount of money each year. It is essentially a contract between you and an insurance company. Annuities are most commonly used to help fund retirement.

Several potential benefits of annuities include the ability to grow your account value on a tax-deferred basis (meaning earnings on the investment will not be taxed until they are paid out), the potential for a future income stream that can’t be outlived, or even a lump sum benefit that can be paid to a surviving spouse. They can also be transferred with no tax penalty under the 1035 exchange provision. 

Annuities are versatile and can be used in many ways to help provide financial assistance. Common reasons people buy annuities include: 

• Accumulate funds for retirement through tax-deferred accumulation.
• Supplement other retirement income resources such as Social Security, savings, and pension plans.
• Help provide for a lifetime stream of income.
• Cover basic and discretionary living expenses in retirement.
• Provide an inheritance (Note: annuities go directly to the beneficiary thus avoiding probate).

Economic conditions and annuity options 

Different types of annuities may perform better under varying economic conditions. Here’s how economic shifts can influence your decision: 

• Fixed annuities provide a guaranteed payout regardless of market conditions, making them ideal in low-interest-rate environments or times of market volatility. If you're seeking stability, especially during economic downturns, a fixed annuity offers protection from market risks. 
• Variable annuities are tied to market performance. If the economy is growing and stock markets are performing well, variable annuities can offer higher returns. However, they carry more risk and may not be suitable for those nearing retirement during periods of volatility. 

Indexed annuities combine elements of fixed and variable annuities. These may be appropriate in times of moderate economic growth, offering the opportunity for higher returns than fixed annuities, but with more protection than variable annuities. Indexed annuities often track benchmarks like the S&P 500, making them attractive when the market is expected to perform steadily. 

Inflation-linked annuities adjust payouts based on inflation rates. In times of high inflation, these annuities can help preserve purchasing power by increasing payouts in line with rising costs, making them a good choice during inflationary periods. 

Here’s how an annuity can be used at different life stages: 

• Until age 55, annuities are used mainly as a tax deferred vehicle.
• Once age 55 is reached, annuities can be set up to provide a lifetime income stream, so people can ensure they won’t run out of money during their retirement years. Annuities can also help bridge the gap with other substantial expenses.

Purchasing options

While all annuities grow tax-deferred, if and when taxes are due differ based on the initial purchasing method. A qualified annuity is one purchased with pre-tax dollars, such as IRA or 401(k) funds. The money is only taxed when you begin receiving funds, typically in retirement. 

If you buy an annuity with after-tax dollars not part of a tax-favored retirement plan, this is known as a non-qualified annuity. Your purchase is made with funds on which you’ve already paid income tax or other taxes. 

Therefore, there is no tax due on the principal, but you must pay income tax on the earnings and interest. The IRS uses the exclusion ratio to determine the portion of the annuity withdrawal that is taxable, looking at the length of the annuity, the principal, and your earnings. 

Payout options

Both fixed and variable annuities can be purchased as either “immediate” or “deferred.” The latter just means funds are paid out at a later date, often many years in the future. An immediate annuity will start to pay out right away. 

Deferred annuities can offer you an opportunity to grow your account value in what is called the “accumulation phase.” During this phase, the account value increases because you are earning interest on your investment. 

Later, you can start withdrawing money when you enter the distribution phase. An immediate annuity doesn’t really have an “accumulation phase” since it begins paying out right away. 

Buying annuities

Like all financial decisions, it’s important to devote time and careful consideration as to whether or not you should purchase an annuity. If or when you are ready to buy an annuity, here are some items to consider:

• Understand the risk you are willing to take on.
• Understand the time frame associated with the annuity payout.
• Talk to your financial professional so you can understand the annuity product and features.
• Shop around – compare features, fees, and charges.

It is also important to understand potential changes when purchasing an annuity. Why? Because they can reduce the overall return from the annuity. Unfortunately, fees and charges will vary from each company and annuity contract. Here are the most common types of fees and charges you will see with annuities:

• Mortality and expense fees: Normally referred to as “M&E fees,” this charge compensates the insurance company for administering the annuity contract and providing the death benefit. 
• Surrender charges: While they may be looked upon as a negative feature of annuities, these charges discourage early withdrawals since annuities are tax-deferred vehicles intended for retirement savings. 
• Administrative fees: These are fees for record-keeping and other administrative expenses the insurance company will charge for managing the annuity. 
• Underlying fund expense: This usually applies only to variable annuities. In a variable annuity, the subaccounts will incur fees from the fund management companies. 
• Special feature and benefit charges: There may be special features available on an annuity, such as enhanced death benefit or Return of Premium provisions. In this case, any extra features offered on the annuity will likely incur a fee as well. 

As you’ve learned, annuities can be part of the overall plan to meet retirement challenges—to combat the rising cost of health care, to protect against outliving and running out of money, and more. Ready to begin planning, but not sure where to start? Schedule a consultation with Investment Services, available through CUSO Financial Services, L.P. (CFS).⁴