Wondering about what an annuity is? Our experts explain the ins-and-outs of the investment option that's also been called a DIY pension.
What is an annuity, anyway?
The National Council on Aging describes annuities as “investment options that can provide a guaranteed income for an individual or their spouse throughout their retirement. Annuities are purchased for a set period and payout a specific amount in retirement based on the investment strategy and amount invested.
SUBSCRIBE: Learn more about getting the most out of your retirement, and join the judgment-free zone. Subscribe to HerMoney today. It’s Free!
“Overall, an annuity should be viewed as another investment option, either to complement your own portfolio or to be an addition to your Social Security, pension, and savings. In other words, an annuity can be yet another way to diversify your income streams in retirement.
So, Who Buys Annuities?
I once heard of annuities described as a “DIY pension” and I’ve always loved that train of thought. Pensions used to be a major part of the average American’s retirement portfolio. Yes, we have Social Security as a pension, but it’s not likely to cover all your fixed costs, and in 2023, very few of us have a pension from our employers. But when you buy an annuity, you’re guaranteeing that your money will last as long as you do, and there’s a lot of peace of mind in that.
Annuities are purchased either via a lump sum payment or via monthly payments, and once you purchase an annuity, you (typically) can’t get your money out again as a lump sum without paying withdrawal penalties. In other words, annuities are great for people who want to know their DIY pension is there for them every month — but they may not be great for people who prefer to keep their assets liquid.
Pre-retirees who are specifically seeking a guaranteed source of income may want to consider annuities, explains Jordan Gilberti, CFP and Senior Lead Planner at Facet, a consumer subscription service providing expert financial advice. Other candidates for annuities include extremely conservative investors or those with after-tax dollars who are more tax-conscious — who want to defer their taxes to a later date, Gilberti explains. But before you move forward with an annuity, you should always have a financial advisor review your situation, risk tolerance, and goals, he advises.
What Does An Annuity Pay Out?
It depends on the size of the annuity, the age you are when you purchase it and the age you are when you start collecting or “turn on” your annuity and interest rates. According to Annuity Expert Advice, an online insurance agency, a $50,000 annuity would pay approximately $260/month if purchased at age 70 with collections starting immediately. But if you purchased that same annuity at age 60 and began taking payments, it would only pay you approximately $219/month.
If we continue doing that math, and you put that same $50,000 (again, at age 60) into a low-interest savings account and pay yourself $219 a month, the money would last you until you’re around 80. (So, if you’re only 60 and you have the money to buy an annuity, plus you’ve got longevity in your genes, an annuity may indeed be the wiser move.)
How Does An Annuity Invest to Guarantee Its Payout?
In a word, actuaries. In two others, pooled risk. Math and life expectancy statistics tell the annuity writer how many clients are going to live past the “profitability mark,” and the annuities are priced accordingly. “An annuity typically invests the funds it receives from clients into a diversified portfolio of assets, such as stocks, bonds, or other investment vehicles,” Gilberti says.
Are There Any Safeguards If The Annuity Fails?
An annuity is guaranteed through the contract you sign with the insurance company when you purchase one, Gilberti says. “The guarantee is backed primarily by the financial strength of the specific company you use, with safeguards in each state in place from the state guaranty associations.”
In other words, an annuity from a reputable company that you trust is perfectly safe. But an annuity is like any other financial product — you need to shop around to make sure you’re getting the best deal, from a company with a great reputation.
Is There a “Best” Age To Purchase An Annuity?
Annuities are most common among pre-retirees/retirees, around 55 years old and up, Gilberti says, although they’re available to everyone. “The important question to ask yourself is: ‘Is this the absolute best use of my dollars? Are there alternatives I haven’t explored?’ It’s also important to consider the objectives of the agent selling the annuity. In most cases, they are paid a commission from the insurance company to sell their products. Thus, it may not be in their best interest to offer you alternative investment options.”
In other words, brokers who sell annuities are selling insurance. They earn commissions when you buy an annuity… Which is why it’s so important for you to do your own research and make sure you’re getting exactly what you want.
Can An Individual Invest Like an Annuity?
Individual investors can absolutely mimic the diversified investment strategy of an annuity, but individuals don’t have the economies of scale required to guarantee an annuity.
“It’s nearly impossible to replicate all aspects of an annuity,” Gilberti says, “but there are strategies individuals can employ to create a stream of income that functions similar to an annuity. Some examples include bond laddering, dividend paying stocks, and rental properties. Of course, none of these hold ‘guarantees’ like an annuity would, but they can be lucrative options for those seeking income, while still maintaining some growth potential.”
(Bond laddering means to invest in multiple bonds with different maturities. As each bond matures, you can reinvest the principal in new bonds with new terms.)
Read more: Do You Know How Much You’ll Need For Retirement?
SUBSCRIBE: Learn more about getting the most out of your retirement, and join the judgment-free zone. Subscribe to HerMoney today!
Editor’s note: We maintain a strict editorial policy and a judgment-free zone for our community, and we also strive to remain transparent in everything we do. Posts may contain references and links to products from our partners. Learn more about how we make money.
