There was a time a few generations ago when a large percentage of American workers retired with a pension – basically a guarantee of income for life, typically based on longevity with the company. The workers who retired with pension benefits weren’t just blue-collar laborers either: many white-collar employees enjoyed the sense of security that came from knowing they would never outlive the steady income from their employer’s pension account.

But for the past four decades or more, the burden of planning for income in retirement has shifted, thanks in large part to the transformation brought about by the adoption of the 401(k) model which was launched in 1978. Today, while some workers still receive pension benefits, the majority do not. Is there a way for retirees and those about to retire to plan for their retirement in such a way that they can re-create for themselves the steady, predictable income offered by pensions? The answer is yes, in the form of a financial tool called an annuity.

We came across this article reprinted from the Entrepreneur website. In it, writer John Rampton does what we consider a pretty good job explaining what annuities are, what their advantages are, and what factors might cause you to avoid investing in annuities. The article is long and we’ve had to condense it, but if you want to know more, take a look at the original piece. You should also consult a fee-based financial adviser and see whether an annuity fits your plan.

Annuities Help Provide Income Retirees Can Count On

“Is your retirement income sufficient?” Rampton asks. “Can you count on it being enough for life so that you will not run out of money when you reach old age? If you haven’t answered these questions, it’s about time you do.”

In his Entrepreneur piece, Rampton quotes the Schroders U.S. Retirement Survey for 2022 which asked retirees how much they thought a person might need to retire comfortably. The average response was $1.1 million – yet fewer than one-fourth of respondents said they expect to reach that threshold. “In addition,” said the article, “56 percent of respondents expect to save less than $500,000, including 36 percent who will save less than $250,000.”

Rampton’s point is that, along with “a solid nest egg,” retirees “also need a guaranteed income that you won’t outlive. That’s a tall glass to fill. However, a retirement annuity might just do the trick.”

Retirement Annuities: What Are They and How Do They Work?

The article offers a basic explanation of annuity mechanics. “With a retirement annuity,” Rampton writes, “you put money aside to receive an income in retirement. A schedule is outlined for the payment of this income. The payment is usually made monthly, quarterly, or annually.” In essence, he says, “buying a retirement annuity involves paying a premium,” either in a lump sum or over time.

As Rampton explains, there are three annuity categories: fixed, variable, and indexed. Without going into detail, a fixed annuity is just what is implies: your contribution determines a fixed rate of return. A variable annuity involves investment of your contribution into what Rampton calls “sub-accounts,” whose performance caused the value of your annuity to vary. An indexed annuity is often linked to an index such as the S&P 500, and offer returns based on percentages of that index.

Immediate vs. Deferred Retirement Annuities

Once you get past the three types of annuities, there’s another major either/or scenario: immediate annuities versus deferred annuities. “It is important to note that some annuities are immediate, meaning that payments can begin as soon as the annuity is purchased,” Rampton explains. “With an immediate annuity, you pay the insurer a lump sum,” and payments begin shortly thereafter. Immediate annuities are popular with retirees seeking regular income.

By contrast, as the name suggests, deferred annuities don’t start paying until a certain date is reached. For example, you may purchase a $100,000 annuity at age 65 but defer payments until age 75. By paying the premium and then waiting until you need the income, you’ll receive a higher payment over a shorter period of time. Some plans let you benefit from market gains during the deferment period.

Annuitization: Getting Payments from Your Annuity

“The process of converting your annuity balance into income is known as annuitization,” says the article. “Your funds could remain invested indefinitely if your contract doesn’t require annuitization. In some cases, you may be able to take one-time withdrawals or designate a beneficiary to receive the money upon your death.”

More commonly, however, annuities will eventually (or immediately) be converted into payments. The income you’ll get is based on several factors, including:

• Your annuity’s accumulated funds (or one-time lump-sum premium);
• The investments that have been made with those funds (for indexed annuities);
• The duration of your income payments – either a pre-set time period, e.g., 20 years, or for the rest of your life – and your spouse’s life for a joint-life annuity.

Many annuities also include an option to adjust payments based on inflation.

The Importance of Retirement Annuities

Ranford clearly seems to lean in favor of annuities. “In the face of retirement, an entire generation feels unprepared and unequipped due to the lack of pensions,” he writes. “No wonder a study by the Insured Retirement Institute shows that only 25 percent of baby boomers think they will have enough money when they retire.” With longer life spans, American retirees face risks unknown to our parents and grandparents.

In his article, Ranford quotes Michael Finke of the American College of Financial Services, who points out that over-reliance on income from 401(k)-style retirement accounts puts retirees in jeopardy of exhausting their resources. “If they had an annuity to accompany their savings and investments, [retirees] could always count on a source of guaranteed monthly income, which would reduce the risk of running out of money. And annuities are a solution that can provide that protected income for life,” added Finke.

Additionally, a variety of studies ( and news reports such as this Kiplinger article ) have shown that “retirees who receive guaranteed income in addition to Social Security are happier,” Rampton suggests. “Furthermore, a guaranteed lifetime income in retirement can provide a safety net during market downturns caused by unpredictable events like COVID-19.”

The Advantages of Retirement Annuities

In his article, Rampton goes into detail about how annuities pay out and what the income can be used for – important information for which we lack the space. Instead, we wanted to know his views on annuity pros and cons. Let’s start with the upside.

“There are two main reasons why people buy annuities,” he writes: “tax deferral and guaranteed income.”

• Tax-deferred earnings: “If you invest in an annuity, your funds will either earn a fixed rate of interest or grow with underlying investments,” Rampton explains. “As with a 401(k), annuities do not need to be taxed until payments start coming in.”
• Guaranteed income: “As soon as you annuitize, the insurer is contractually obligated to pay you an income,” says the article. “In most cases, you’ll receive a monthly payment — often for life.” Most states provide security if an insurer goes bankrupt.

Rampton also lists these additional advantages of an annuity:

• Guaranteed rates of return: Both fixed and indexed annuities typically set a floor below which your return can never fall. However, in times of positive stock markets, as Rampton puts it, “it is possible for this floor to result in a loss instead of a gain.”
• No contribution limits: There are limits to annual contributions to 401(k) and IRA accounts. However, retirement annuities do not have contribution limits.
• Survivor options: Each insurer has different rules, but annuities do offer some flexibility regarding survivor benefits. For example, many couples choose a joint-life annuity which continues to pay out as long as either spouse lives. Others offer to return a portion of the initial premium to beneficiaries if the annuitant dies before the entire lump sum has been distributed.

The Disadvantages of Retirement Annuities

Annuities, like all financial tools, have their drawbacks. “Despite the advantages listed above,” Rampton writes, “retirement annuities aren’t flawless. As such, you should also be aware of [their] disadvantages.” He lists these:

• Hefty fees: “In comparison with mutual funds and CDs, annuities are expensive,” says the article. If you buy from an agent, for example, you may be paying his or her sales commission upfront. While buying directly from the insurance company can help you avoid some upfront fees, you may still face what Rampton calls “significant annual expenses, often exceeding 2 percent.” Riders such as inflation protection add to the cost. (We should note that there are firms which do not charge fees, so do your homework before you buy.)
• Early withdrawal penalties: Rampton warns that withdrawals from a retirement annuity made before age 59 ½ will result in income tax and a 10 percent penalty.
• Illiquid asset: The loss of liquidity is the biggest concern of many experts. “It is not possible to change the terms of the payments once you have annuitized,” Rampton states. Trying to surrender your annuity or withdraw any cash will trigger hefty penalties. Again, make sure you understand these terms before investing.
• Higher tax rates: While annuities can help defer taxes as noted above, once payments begin, they are taxed as ordinary income. This requires careful planning with your financial adviser.
• Complexity:  Depending on the terms and the type, annuities can be complex financial tools. “Sometimes,” writes Rampton, “it can be difficult to understand what you’re paying for.” Not to sound repetitive, but make sure to get good advice!
• Possibility of insurer default: While unlikely, this is a risk worth citing. “It is the insurance company that issues the contract that guarantees annuities,” warns Rampton. “Although there haven’t been many annuity defaults, it is possible.” Besides investigating the insurer’s financial stability, you can also check with your state’s insurance commissioner’s office to see how your state handles insurance company defaults. This article shows how much protection against default each state offers.

Thoughts on Annuities from Rajiv Nagaich

As you might imagine, Rajiv has extensive experience in observing how annuities can add to, or detract from, financial health in retirement. As a result of that experience, he adds another potential drawback to annuities that many people overlook: the fact that annuity income could disqualify you from receiving long-term care benefits through the VA or Medicaid.

“Medicaid and VA are both means-tested programs,” Rajiv explains. “Let’s say you need nursing home coverage someday and like most people, you can’t afford the cost. If you as a single person apply for benefits from these government agencies, one of the first things they’ll look at is what sources of income you have. In Washington State where AgingOptions is located, you’ll be disqualified from Medicaid coverage if your income is more than 133 percent of the poverty line – about $17,000 or so. People don’t often know about this until it’s too late.”

Rajiv asserts that he’s not saying annuities are a bad idea – just that, as with any investment, you need to understand the implications before you leap. “This is where the concept of a financial dashboard is super important,” he says. “I urge you to sit down with an objective planner and get a dashboard in place. Then you’ll be able to see much clearer what the implications of today’s decisions might be on your finances, 10 or 20 or 30 years from now.”

Contact us at AgingOptions and we’ll gladly refer you to a trusted planner who will help you. And as always, for answers to all your retirement planning questions, we invite you to attend the next LifePlanning Seminar with Rajiv Nagaich. You’ll find a complete schedule here. Age on!

(originally reported at www.entrepreneur.com)