Creating income for retirement is one of the biggest challenges American workers have in planning for how they will be able to live comfortably once they stop working. One of the most common ways to create this income is to buy yourself an annuity. New research from investment analysis firm Morningstar, though, shows that if you’ve managed to save a sufficient amount of money during your working years, an annuity isn’t actually the best choice for you.
If you want help determining the best course of action for your own retirement, consider working with a financial advisor.
Annuity Basics
Annuities are not the simplest investment to understand, so let’s start off with a bit of a crash course in what they are and how they work.
Essentially, an annuity is an insurance contract. You pay an insurance company a monthly premium now, and in return, you get a payout at a later date. There are two basic types of annuities — fixed and variable. A fixed annuity has a predetermined payout and the performance of the premiums you pay in the market doesn’t have any impact. A variable annuity, on the other hand, will have a payout that depends on how the investments made with your premiums perform. There will generally be a minimum payment that guarantees you don’t lose your principal, but it’s possible that the money won’t grow at all, which is not a concern with a fixed annuity.
When it comes time to collect your money, you will often have the choice of a lump sum or annuitized payments. Some annuities pay out until death while some only pay for a predetermined length of time. All of this is determined when you buy your annuity contact.
Who Should and Shouldn’t Use Annuities?
When you retire, the amount of money you have coming in each month will likely go down drastically. Depending on your age, you may have Social Security payments, and some may have pension payments, but for the most part you won’t have income being deposited into your bank account like you did when you were working. Annuities seek to remedy that.
If you’ve saved enough money while you are working, though, an annuity may actually not be a good choice, according to a recent report from Morningstar:
“In particular, if a participant’s wealth is more than 36 times their needed annual retirement income (defined as the difference between annual deterministic expenses and Social Security income), there is little room for an annuity to meaningfully impact their retirement,” the report reads. “This is because higher-wealth participants can more or less self-insure against longevity risk”
According to Morningstar’s calculations, someone with 36 times his needed annual retirement income saved will succeed in funding his retirement soundly 95% of the time with a portfolio-only strategy. That percentage only ticks up to 95.9% if you use an annuity, not enough of a difference to justify using an annuity.
The report notes that annuities are also not the best option for those who have enough income through a combination of an inflation-adjusted pension and Social Security.
Social Security Bridge – Another Option
Morningstar also details an alternative plan for making sure you have enough money in retirement without having to buy an annuity, a strategy known as the Social Security Bridge.
Here’s how it works: when you retire, don’t immediately file to get Social Security benefits. Instead, take a bigger portion of your retirement savings than you’d normally take in the first several years after you stop working.
When you turn 70, you file for Social Security. By waiting until that age, you actually get significantly higher payments — more than 40%, according to the report. Once you start taking these payments, you can reduce the amount of money you take out of your retirement accounts each year.
The Bottom Line
Annuities are useful tools for retirement saving, allowing you to create guaranteed income after you retire. Morningstar analysis, though, shows that if you have at least 36 times your needed annual income saved at the time of retirement, you likely don’t need to get an annuity.
Retirement Planning Tips
- The best way to go about planning your retirement is often to get professional help. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Saving in a 401(k) is how most people accumulate money for retirement. If your company offers an employer match program, make sure you take advantage and not leave any money on the table.
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