What Is the Role of Annuities in Retirement Planning? If you've spent time developing an investment strategy, you might be familiar with the concept of annuities. While you never want every investment in your portfolio to be the same,...

If you've spent time developing an investment strategy, you might be familiar with the concept of annuities. While you never want every investment in your portfolio to be the same, annuities are an essential part of creating durable wealth. Annuities have become sought after as a retirement planning resource as pension plans become scarcer in the private sector. Before you commit to an investment type, you need to have some knowledge about it in order to choose what will best meet your needs and goals.

What exactly are annuities, and how can you benefit from annuities in your diversified portfolio?

How Do Annuities Work?

Annuities are investments that offer investors a form of guaranteed steady income. People often invest in annuities as part of their long-term retirement strategies.

Ty Young of Ty J. Young Wealth Management explains the overall concept: "Here is how the best index annuities work: you contribute money that is completely protected against market losses. However, when the market goes up, your gains lock-in annually. You are earning compound interest without annual fees."

That might sound too good to be true — you benefit from market gains while remaining completely protected from market losses. Indeed, annuities provide steady, risk-free returns.

Diving deeper from Young's explanation, here's how annuities work:

• As soon as you invest money in a given annuity, you're protected from market losses
• You go up with the stock market, and your gains are locked in on an annual basis
• When the stock market goes down, you lose nothing
• You earn returns via compound interest
• You pay no annual fees

Many investment portfolios include a mix of high- and low-risk investments. The former offers the possibility of greater returns but also carries the risk of greater losses. The latter offers moderate returns with far less risk. For many, annuities are the ideal low-risk investment product as they protect your money from losing value, making it possible to maintain the lifestyle you have worked for. Annuities also offer the option to add additional features and riders, such as death benefits for loved ones and long-term care, which is especially important as people live longer.

Types of Annuities

The world of annuities is a complex one, and there are many different types to choose from, such as:

• Fixed Annuities: Payments are fixed at a given amount outlined in the investment contract. Fixed annuities offer the least risk, as the interest rate won't fluctuate beyond the terms of your contract.
• Deferred Annuities: Payouts begin at some point in the future, typically after a set date. Typically the date coincides with your retirement date. Because it is deferred, your investment grows without being taxed during this period.
• Immediate Annuities: Payouts are guaranteed monthly income that starts between one month and one year after you purchase the annuity and make the initial payment.
• Variable Annuities: Payouts are periodic; accumulations vary with the market and are not fixed. They operate similarly to mutual funds. Payments vary based on how well the sub-accounts are doing at any given time.
• Indexed Annuities: You can share in investment market earnings while also getting a guaranteed return. Annuities that are indexed will give you a prospectus.

Different annuity types are suitable for various financial situations. When you work with a qualified financial advisor, they will assess your financial situation and help you choose the annuity that best meets your needs.

Common Misconceptions About Annuities

Annuities offer multiple benefits to investors, but several persistent misconceptions cause people to miss out on these advantages. Below are some common misconceptions that cause investors to bypass annuities.

Myth: All Annuities Are Bad

"There is a common misconception that all annuities are bad," Young explains. "That is false."

While it's true that some annuities have high fees and low returns, choosing the right annuity and using it strategically can enhance your retirement strategy, helping you reach retirement goals such as:

• Income that is guaranteed, predictable, and inflation-adjusted
• Growth with no risk of market loss
• A maximized death benefit for your loved ones

Knowing which annuity to choose and how they can gain from it can be confusing and overwhelming for many. This is where a financial advisor comes in. A qualified financial advisor will learn about your goals and needs to help you select the right annuity.

Myth: All Annuities Have High Fees

Each annuity is different, with different payment and fee systems. Many people will avoid annuities because they are misinformed and believe they all have high fees. While it is true that some carry high fees, the best annuities have no annual fees at all. A financial advisor can guide you to an annuity that will ease your concerns about fees.

Myth: Your Money Will Be Locked Up Forever

The best annuities offer generous liquidation options; many have a set percentage you can withdraw annually. This is why it is essential to look at the liquidity options of each type of annuity before choosing an annuity and signing the contract. The contract you must sign will include this in its conditions and terms. If the terms and conditions are unclear to you, your financial advisor can clarify this further for peace of mind. You do not have to worry about being unable to access your money once you've invested it.

Myth: Annuities Always Have Low Returns

Annuities have a reputation for offering very low returns. Being a low-risk investment, it's natural to believe they won't generate the same returns as a high-risk stock investment.

That being said, some annuities can actually outperform the stock market when it comes to returns. When you combine that with the fact that you're completely protected from any market losses, it's no surprise so many people are increasingly turning to annuities when planning their retirement portfolios.

Are Annuities Right for You?

Retirement investing looks a little different for everyone. Whether you're nearing retirement age or just getting started with retirement planning, it helps to have a knowledgeable financial advisor at your side.

With their expertise and knowledge, a financial advisor will guide you through the steps you must take to set up an annuity.

Step One:

First, your financial advisor will review the different annuity types. After assessing your financial situation, your advisor will help you decide which annuity best meets your needs and retirement goals. This is the most essential step and will need careful consideration before proceeding any further. As stated earlier, there are several different types to choose from, but your financial advisor can break them down. A solid understanding of each annuity is key to choosing the one that is right for you.

Step Two:

Annuities are customarily sold by insurance companies. You should choose an insurance company you feel comfortable with. Some factors to consider when selecting an insurance company are its financial stability, customer support, and annuity products. As this is an important step in the process, a good financial advisor will give you time to review this information and decide. The benefit of having a financial advisor is that they can show you recent financial ratings of insurance companies from Moody's and S&P Global. This will assure you that you are choosing the right insurance company to meet your needs and goals.

Step Three:

Annuities are contracts between you and the insurance company you purchase them from. Like any contract, you will want to review it carefully before signing. Your financial planner will review the contract to ensure you understand the terms and conditions and the fees applied to your account.

Step Four:

Once you are confident in the insurance company you have decided to purchase your annuity from, you will need to make the initial payment upon signing the contract. The contract will state whether this is paid in a lump sum or a series of periodic payments.

Step Five:

This is also the time to set up riders or additional features vital to your needs and circumstances. Examples of this are death benefits which can protect loved ones, and long-term care benefits, which can protect you from exorbitant medical costs. This is also vital for individuals who may not have someone to act as their caregiver. Death benefits can ensure that loved ones are taken care of.

Monitor Your Investment Over Time

Once your annuity has been set up, it is important to keep track of your balance and any transactions you make. Your annuity is an integral part of your retirement plan. If you have questions or concerns about your annuity at any time, your financial advisor can provide guidance and offer you peace of mind as you approach or during your retirement years.

Image: Kampus Production; Pexels