How Do Annuities Work for Retirement?

Annuities work in retirement through contractual guarantees.

That is the key.

They should not be purchased because of hopeful returns, hypothetical projections, or market-growth promises.

They are insurance contracts designed to transfer certain risks to an insurance company.

For retirees, their most common uses are principal protection and lifetime income.

Key Takeaways

• Annuities work best in retirement when used for contractual guarantees.
• The primary uses are Principal Protection and Income for Life.
• Annuities can also provide Legacy and Long-Term Care solutions.
• Guaranteed lifetime income can help create a retirement income floor.
• Annuity income can reduce the need to sell investments during market declines.
• Annuities should not be purchased primarily for market growth.

The PILL Framework

Annuities generally solve four contractual objectives:

• Principal Protection
• Income for Life
• Legacy
• Long-Term Care

Those four goals make up the PILL framework.

For most retirees, the first two are the biggest priorities.

How Annuities Create an Income Floor

Your retirement income floor is the amount of dependable income you need every month.

Social Security may already cover part of that amount.

A pension, if you have one, may cover another part.

An annuity can potentially fill the remaining gap.

For example, if your household needs $7,000 per month and dependable income sources provide $4,500, you have a $2,500 monthly gap.

That is the amount you can potentially solve for contractually.

Why Lifetime Income Matters

Annuities are designed to provide lifetime income.

That means payments can continue for as long as you live.

If the contract is structured jointly, the income can continue for as long as either covered spouse is alive.

That makes lifetime income annuities useful for people worried about outliving their retirement assets.

Annuities and Market Downturns

One benefit of establishing an income floor is that you may not need to rely entirely on selling investments for monthly expenses.

If the market drops significantly, a contractual annuity payment does not depend on selling assets at that moment.

That can provide stability while the investment portion of the portfolio continues to fluctuate.

Annuities for Principal Protection

Principal protection is another major retirement objective.

Fixed annuities can provide contractual protection from market losses.

MYGAs, for example, provide a guaranteed interest rate for a specified period.

That can be useful for money you do not want exposed to market risk.

Annuities for Legacy

Annuities can also be used for legacy planning.

MYGAs can grow and compound tax-deferred.

Other annuity structures can include beneficiary protections.

For someone who cannot qualify for additional life insurance, annuity guarantees may be another way to create a future financial benefit for family members.

Annuities and Long-Term Care

There are also annuity products that can address certain long-term care needs.

Some are guaranteed issue and can provide benefits when qualifying health conditions are met.

Those products should still be evaluated according to their actual contractual provisions.

Annuities Transfer Risk

This is one of the most important concepts.

When you buy an annuity, you are transferring a specific financial risk to the insurance company.

That may be:

• longevity risk
• principal risk
• income risk
• certain legacy concerns
• certain long-term care risks

The insurance company accepts that risk according to the contract.

What About Inflation?

A fixed annuity does not magically solve inflation.

There is no one annuity product that automatically provides the perfect inflation solution for every retiree.

A more practical approach is to monitor your income floor and address future gaps when they actually occur.

That allows you to solve for the amount of additional income needed at that time.

What About Upfront Bonuses?

An upfront bonus should not determine whether you buy an annuity.

The bonus is part of the overall contract.

It is not free money.

If the annuity provides the strongest contractual guarantee for your goal and also happens to include a bonus, fine.

But the bonus should not drive the decision.

How Much Should You Put Into an Annuity?

Use the least amount of money necessary to solve the contractual objective.

If you need an additional $2,500 per month of guaranteed income, determine how much premium is required to create that amount.

The rest of your assets can remain available for investments, liquidity, travel, emergencies, and other goals.

Annuities and Social Security

Social Security is already lifetime income.

Think of private annuities as potentially supplementing that foundation rather than replacing it.

The goal is to determine how much total dependable income you need.

Start With Your Retirement Lifestyle

Before choosing an annuity, determine what your retirement actually costs.

Ask:

How much money do I need every month?

How much dependable income do I already have?

What is the gap?

Once you know that number, you can determine whether an annuity is needed.

Where to Compare Retirement Annuities

Use our annuity calculators to compare current contractual guarantees from multiple insurance companies.

You can calculate how much lifetime income a certain premium may provide or determine how much premium may be required to fill a specific monthly income gap.

The Bottom Line

Annuities work in retirement by providing contractual guarantees.

They can protect principal, create lifetime income, support legacy planning, and address certain long-term care needs.

For many retirees, their most important role is creating an income floor that continues regardless of market conditions or how long they live.

The annuity should solve a specific retirement problem. It should not be purchased because of a hypothetical growth story.

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