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When it comes to post-retirement investing, probably no other subject causes as much confusion as annuities. Here are some basics.

Essentially, an annuity is the mirror image of a life insurance policy.  While life insurance protects your family against the risk of you dying sooner than expected, annuities protect you against the risk of you dying later than expected (and thereby outliving your savings).  Like Social Security or a company pension, a purchased annuity can provide an income stream for as long as your live, or for a specific number of  years.

With life insurance some people pay premiums, but never receive a payout before they let the policy lapse. In the case of a life annuity, payouts are made at regular intervals to provide income to policyholders, and typically stop only when the policyholder dies. When this happens soon after the annuity is purchased, the "annuitant" receives less than the premium he or she originally paid. However, when the person dies many years after the annuity is purchased, he or she often receives payments well in excess of the premium paid.

 Vesta Views

  • Annuities are best thought of as insurance to provide an income stream that will not run out before you die.

  • This purpose is best served for most retirees through the lump sum purchase of an immediate annuity that will pay out an income stream over a lifetime.

  • An immediate annuity makes the most sense if you think you will outlive your actuarial life expectancy. (See time horizon), and

  • Your income from other "annuitized" sources such as Social Security and a company pension plan is relatively low.

  • So-called tax-deferred, variable annuities are rarely, if ever, a useful tool for a retiree. 

    Annuities come in many different forms. Two of the most important differences between them have to do with the length of time over which the payments are made, and whether they are fixed or variable. With respect to the length of time, among the most important annuity types are "lifetime" annuities, which make payments only until the annuitant dies; "joint and last survivor" annuities, which make payments until the second of two people dies; "guaranteed term" annuities, which make payments for a guaranteed period, even if the original annuitant has died (with the remaining payments going to a designated beneficiary).

    With respect to fixed and variable payments, some of the most important distinctions are between fixed payment annuities (where the amount remains fixed over time), variable annuities (where the size of the payment is tied to the performance of underlying investment accounts), and inflation indexed annuities (where the payment is increased with the consumer price index, to keep real purchasing power constant over time).

    While annuities reduce the risk that you will outlive your savings (and suffer a drop in your standard of living), they do so at a cost. First, they reduce the amount of money you have available for precautionary savings and bequests. Second, they are not liquid -- once you have purchased one, it can be expensive or impossible to change your mind later. For this reason, studies have shown that using a portion of one's savings to purchase an annuity tends to be most attractive when (a) a person or couple expect to live for many more years; (b) they have relatively low income from other annuities (e.g., from Social Security and private employer defined benefit pension plans).


     Additional Perspectives

    Primer on All Annuities
    See what SmartMoney.com has to say about:
    What's Wrong With Variable Annuities
    Who Should Buy Variable Annuities?
    Why does AARP.org report:
    About Annuities: They're Not For Every Investor
    Read what the SEC says you should know about Variable Annuities
    Read what the SEC says about Equity-Indexed Annuities


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