June is Annuity Awareness Month, a good time to review how annuities work and where they may fit in a retirement income plan. Annuities are often misunderstood, and like any financial product, they come with both potential benefits and trade-offs. This article explains what an annuity is, how it may help address certain retirement risks, and what costs and limitations to consider.

What Is an Annuity?

An annuity is a contract between an individual and an insurance company. The individual makes a lump-sum payment or a series of payments, and, in return, receives regular disbursements beginning immediately or at some future point.

A primary purpose of many annuities is to provide a stream of income in retirement, which can help address the concern of outliving one's assets.

Annuities come in three main types: fixed, variable, and indexed.

· Fixed annuities - Credit a guaranteed interest rate for a set period. A multi-year guaranteed annuity (MYGA) locks in a fixed rate for a specific term, such as three to ten years.

· Variable annuities - Invest in subaccounts that hold securities, so values and payments rise and fall with market performance, including the possible loss of principal. Variable annuities are securities and are sold by prospectus.

· Fixed Indexed annuities - Credit interest based partly on the performance of a market index, such as the S&P 500, without investing directly in the index. Credited interest is typically limited by caps, participation rates, or spreads, and principal is generally protected from index declines.

How Annuities Address Market Risk

In volatile markets, certain annuities may offer some protection. Fixed annuities credit a guaranteed rate, and fixed indexed annuities generally protect principal from index losses, though growth is limited in exchange. These guarantees are based on the claims-paying ability of the issuing insurance company.

Variable annuities remain subject to market fluctuations. Optional riders, such as enhanced death benefits or guaranteed income benefits, may provide some protection, but they add cost and come with specific terms and limitations.

Annuities and Longevity Risk

Another risk annuities may help address is outliving one's savings, commonly known as longevity risk. Annuities that are annuitized, or that include a lifetime income rider, can provide income for life. As people live longer due to advancements in healthcare, the risk of outliving savings becomes increasingly significant.

For some retirees, pairing guaranteed lifetime income with Social Security and other savings can make it easier to cover essential expenses. Lifetime income guarantees depend on the claims-paying ability of the insurer and may come at the cost of reduced liquidity or access to principal.

Annuity Awareness Month is a good reminder to understand how annuities work before deciding whether one fits your retirement plan. For some retirees, an annuity's potential for predictable income and protection from certain risks may make it worth considering, while for others, the costs and limitations may outweigh the benefits.

Before purchasing an annuity, individuals should carefully consider their circumstances and retirement income needs and consult with a financial professional to determine whether it is suitable. Annuities typically include a free-look period, which varies by state, during which a new contract can be canceled.

Costs and Limitations to Consider

Annuities are long-term contracts, and they aren't right for everyone. Before purchasing, consider:

· Surrender charges – Withdrawals above a set free-withdrawal amount during the surrender period, often several years, may incur charges.

· Fees – Variable annuities typically include mortality and expense charges, administrative fees, and fund expenses, and optional riders add cost.

· Limited growth – Caps and participation rates on indexed annuities limit how much interest can be credited.

· Taxes – Earnings grow tax-deferred but are taxed as ordinary income when withdrawn, and withdrawals before age 59½ may incur a 10% federal tax penalty.

Annuity FAQs

What is a MYGA?

A multi-year guaranteed annuity (MYGA) is a fixed annuity that credits a guaranteed interest rate for a set number of years. Rates, terms, and surrender charges vary by insurer.

Can I withdraw money from an annuity early?

Many annuities allow a limited free withdrawal each year, often around 10% of the contract value. Larger withdrawals during the surrender period may incur surrender charges, and withdrawals before age 59½ may also face a 10% federal tax penalty.

· Inflation – Fixed income payments may lose purchasing power over time unless an inflation rider is purchased.

· Liquidity – Money committed to an annuity may be less accessible than in other savings or investments.