Are Annuities a Good Investment?

When you’re saving for retirement, the task can seem fairly basic: accumulate a large nest egg that you’ll live off of in retirement. But when you get to retirement, turning that savings into income becomes a little more difficult. Simply leaving everything invested in the stock market and withdrawing your money can leave your nest egg at risk.

Insurance products like annuities, when combined with investments, can help you generate reliable retirement income while also helping to protect you from some common risks like market volatility. Given their connection to retirement income, it can be natural to wonder if annuities are a good investment.

Well, to be frank, that’s probably the wrong question to ask. For one, an annuity isn’t an investment like a stock or bond; rather, it’s a contract between you and an insurance company. That makes it a unique asset plays a special role in your financial plan. When combined with other sources of retirement income like Social Security, accounts like 401(k)s or IRAs as well as other tools, an annuity can play a critical role in a plan to generate retirement income.

So perhaps the better question to ask is, “How does an annuity strengthen your financial plan?”

How an annuity strengthens a financial plan

A good plan in retirement generates income from several different sources to help you manage the impact of taxes and shield your savings from a variety of risks. That means an annuity isn’t necessarily better or worse than investments. Instead, every financial product fulfills a different need. Investments can generate tax-advantaged growth to stay ahead of inflation and provide the optionality of taxable (401(k) or IRA) and non-taxable income (Roth IRA or 401(k)) in retirement.

Annuities come with their own pros and cons. Annuities may not have the upside of an aggressive investment strategy, but they don’t need to. That’s because an income annuity’s job is to hedge longevity and market volatility risk in your portfolio. And, they can also be used for tax-advantaged growth. Lifetime guarantees ensure you’ll have some money coming in the door no matter how long you live or what happens in markets. Income annuities, along with Social Security and other guaranteed income sources, provide a floor or safety net for your savings that investments alone can’t provide.

Income annuities bring consistency and reliability to your financial plan, and that goes a long way reducing worries about money and what the future holds.

What is the biggest advantage of an annuity?

Annuities will likely bring you the biggest benefit as you approach retirement, but depending on your situation, an annuity could benefit you as you save for retirement even at a younger age.

Annuities when saving for retirement

If you’re a long way from retirement, an accumulation annuity can help you save while enjoying the potential for tax-deferred growth. While you could eventually get your money back from an accumulation annuity once it hits certain milestones, many people choose to convert accumulation annuities into a stream of income to provide regular, guaranteed payments in retirement. While you won’t pay taxes during accumulation, you may pay income taxes on a portion of the withdrawals you make or payments you receive.

There are a few types of accumulation annuities to choose from:

• Fixed annuities grow at a fixed rate and are a good option for someone seeking more certainty.

• Variable annuities do not grow at a fixed rate, as they can have some exposure to the markets through subaccounts that you choose. The growth rate of your annuity can fluctuate, but annuity providers often add riders that can guarantee a minimum level of income or return.

You can also have a qualified annuity or a nonqualified annuity. Nonqualified annuities are funded with after-tax funds. Therefore, when you begin receiving payments, you won’t need to pay taxes on any money you’re getting back that used to purchase the annuity—only on the growth. This can be a good option to avoid being subject to increases in tax rates when you retire. You can also purchase a qualified annuity, which is annuity funded with pre-tax dollars, usually through a 401(k) or IRA. With qualified annuities, you would need to pay income tax on the payments distributed to you as well as on the growth.

Annuities when you’re closer to retirement

As you get closer to retirement, you’ll likely want to skip right to an annuity that provides regular payments.

Income annuities are often purchased as people approach or have started retirement. You make a lump sum payment to a financial institution, such as an insurance company, and the company, in turn, will pay you a guaranteed, regular income for the rest of your life. The level of income depends on a number of factors, including how much you paid in and how long you’re expected to live.

Income annuities also come in different varieties:

• An immediate income annuity is exactly what it sounds like—you make a lump sum payment, and payments back to you start immediately.

• There are also deferred income annuities, which don’t begin paying out for a pre-determined period of time. Payments from a deferred income annuity are typically higher than what you would get with the same premium toward an immediate income annuity. Some deferred income annuities also have the potential to grow through dividends.

When should you buy an annuity?

There’s not one magic time when it makes the most sense to buy an annuity, but depending on your financial situation, there could be some circumstances in which buying an annuity would be to your benefit.

If you’re seeking long-term, low-risk income guaranteed to last your lifetime

Though subjecting your money to the market can grow it substantially over time, growth is not guaranteed and rarely happens in a straight line. There’s risk with any investment, but buying an annuity carries less risk. Your funds may not grow as much as they otherwise would, but if you’re someone that likes a guarantee, an annuity could be a great fit. Rather than having to part with investments you’ve held for a long time and having to track the market to find the "right” time to sell, an annuity can give you the security of a steady income you can plan on as you budget for retirement.

If you have already maxed out other retirement accounts

Perhaps you’re already contributing to a 401(k) or IRA, and you’re looking for other ways to supplement your retirement savings. If you’ve met the annual contribution limits for a 401(k) and IRA and you’d like to contribute even more toward your retirement savings, an annuity could be the way to do it.

If you’re looking to diversify your retirement savings

As you near retirement, you’ll likely talk with your financial advisor more specifically about what streams of income you’ll be relying on in retirement. Depending on your age and how much you have saved when you retire, you might find that your retirement savings may not cover you for the rest of your life. In this case, an annuity could provide some lifetime income security.

Diversifying your retirement savings involves some strategy, so you’ll want to make sure to consult a financial advisor if you’re considering adding an annuity to your retirement portfolio. Annuities are part of a broader financial plan, so you’ll want to understand how to leverage an annuity to work with other assets in retirement. A Northwestern Mutual financial advisor can help you decide if an annuity is right for you and make other recommendations to help you get the most out of your retirement savings while also planning for common risks.

*The performance of variable funds is not guaranteed, subject to market risk including loss of principal. No investment strategy can guarantee a profit or protect against loss. Variable annuities are considered long-term investments, potentially suitable for retirement and other long-range goals.

**Neither the existence nor the amount of a dividend is guaranteed on any contract in any given contract year. Some policies may not receive any dividends in a particular year or years, even while other policies receive dividends. Dividends paid can be taken in cash or used to purchase increased income payments.

Income annuities (either immediate or deferred) have no cash value and once issued they can’t be terminated (surrendered). The original premium paid is not refundable and cannot be withdrawn. With any annuity, distributions may be subject to ordinary income tax and a 10 percent IRS penalty if taken prior to age 59 ½. Guarantees in an annuity are backed solely by the claims-paying ability of the issuer.