An annuity is a contract that takes in cash and then pays a fixed income stream to its holder for a set period of time.
As retirement nears, the shift from a regular paycheck to living off of savings can be difficult.
People typically invest their savings, hoping to grow the balance and then take income. But all investment implies a risk of loss.
A balance of stocks and bonds in a portfolio can reduce the volatility of a portfolio. Owning certificates of deposit that pay regular interest is another way to create a steady income.
A third option is to buy an annuity. The investor gives up control of his or her cash but receives a measure certainty in exchange.
The income from an annuity is predictable and lasts for as long as the contract specifies, even for life.
As you near retirement age the problem becomes your own longevity. Outliving your money is a big problem.
Insurance companies seek to help retirees manage that risk by selling annuity contracts.
It works like a normal insurance contract but in reverse. For instance, if you owned fire insurance and your house burned down, you would expect a payout to cover the loss.
With an annuity, you make the payout first to the insurance company — some portion of your lifelong savings — and they take on the risk.
The risk is not that you might die. Of course you will. Everyone does.
Rather, the risk to the insurer is that you live for longer than they expect. If you have a lifetime annuity (as opposed to, say, a 10-year agreement), the insurance company has to pay you your monthly fixed check until you pass on.
Insurance companies control for this risk by using actuarial data to predict your likely life span. In addition, the company pools your savings with the savings of many other contract holders.
Some will die sooner, some will die later. As long as the actuarial averages hold, the insurance company comes out ahead and can profit.
In the meantime, the insurer invests your cash and attempts to grow it sustainably. If the stock market or bond market goes south, the contract holders are not exposed to that risk — at least not with a fixed annuity.
A variable annuity does expose the contract holder to potential market declines but also provides more upside if markets rise.
One of the major criticisms of annuities is cost. Commissions paid to the sellers of annuity contracts can be high, and the terms of many annuities penalize contract holders for leaving the agreement early.
Nevertheless, at the right price and under the right terms, an annuity can be a useful tool for retirement income.
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