Purpose and Uses of Annuities
Annuities are insurance products designed to provide income, typically during retirement. Understanding the purpose and uses of annuities is fundamental to the licensing exam and to serving clients effectively.
What Is an Annuity?
An annuity is a contract between an individual and an insurance company where the individual pays premiums (either as a lump sum or over time), and the insurer agrees to make periodic payments to the individual, either immediately or at some future date.
The Opposite of Life Insurance
| Life Insurance | Annuity |
|---|---|
| Protects against dying too soon | Protects against living too long |
| Creates an estate | Liquidates an estate |
| Pays a lump sum at death | Makes periodic payments during life |
| Premiums paid over time | Can be funded with lump sum |
Exam Tip: Think of life insurance as protection against premature death and annuities as protection against outliving your money.
Primary Purpose: Retirement Income
The primary purpose of an annuity is to provide a guaranteed income stream that the annuitant cannot outlive.
The Retirement Income Problem
| Challenge | How Annuities Help |
|---|---|
| Longevity risk | Guarantees income for life, regardless of how long you live |
| Market risk | Fixed annuities provide guaranteed returns |
| Sequence of returns risk | Income not affected by market timing |
| Inflation risk | Some annuities offer inflation adjustments |
Why Guaranteed Income Matters
Without annuities, retirees must:
- Estimate how long they'll live
- Decide how much to withdraw each year
- Risk running out of money or spending too little
With annuities:
- Insurance company assumes longevity risk
- Guaranteed payments continue for life
- No risk of outliving income
Key Uses of Annuities
1. Accumulation of Assets
During the accumulation phase, annuities help build retirement savings:
| Feature | Benefit |
|---|---|
| Tax-deferred growth | Earnings not taxed until withdrawn |
| No contribution limits | Unlike IRAs and 401(k)s, no annual limits |
| Safety of principal | Fixed annuities protect principal |
| Creditor protection | Many states protect annuity assets from creditors |
2. Retirement Income
During the payout phase, annuities provide income:
| Income Option | Description |
|---|---|
| Life income | Payments for as long as you live |
| Joint and survivor | Payments continue for surviving spouse |
| Period certain | Guaranteed payments for specified years |
| Systematic withdrawals | Flexible withdrawals without annuitization |
3. Tax-Deferred Growth
One of the most valuable features of annuities is tax deferral:
| Taxable Account | Annuity |
|---|---|
| Interest, dividends taxed annually | No taxes until withdrawal |
| Capital gains taxed when realized | Gains accumulate tax-free |
| Lower compounding due to taxes | Higher compounding due to deferral |
Example: Tax Deferral Advantage
$100,000 invested for 20 years at 6% annual return:
| Account Type | After 20 Years |
|---|---|
| Taxable account (25% tax bracket) | ~$262,000 |
| Tax-deferred annuity | ~$321,000 |
The difference is due to the compound growth of money that would otherwise have been paid in taxes.
4. Lifetime Income Guarantees
The mortality credits concept makes annuity income guarantees possible:
- Those who die earlier subsidize payments to those who live longer
- Insurance company pools longevity risk across many annuitants
- Enables higher sustainable income than self-managed withdrawals
Who Should Consider Annuities?
Good Candidates for Annuities
| Profile | Why Annuities May Help |
|---|---|
| Retirees seeking guaranteed income | Eliminates longevity risk |
| Those who have maxed out other retirement accounts | No contribution limits |
| Risk-averse investors | Principal protection in fixed annuities |
| Those concerned about outliving money | Lifetime income guarantee |
| People with longevity in their family | May live longer than average |
Poor Candidates for Annuities
| Profile | Why Annuities May Not Be Suitable |
|---|---|
| Young investors with long time horizons | Better options for growth |
| Those needing liquidity | Surrender charges limit access |
| People in low tax brackets | Less benefit from tax deferral |
| Those with short life expectancy | May not benefit from longevity guarantee |
| People who haven't maxed out tax-advantaged accounts | IRAs and 401(k)s may be better first |
Annuities vs. Other Retirement Vehicles
| Feature | Annuity | 401(k)/IRA | Taxable Account |
|---|---|---|---|
| Contribution limits | None | Yes | None |
| Tax treatment | Tax-deferred | Tax-deferred or tax-free (Roth) | Taxable |
| Required distributions | Varies | Yes (at 73) | No |
| Lifetime income option | Yes | No (unless annuitized) | No |
| Principal guarantee | Yes (fixed) | No | No |
| Early withdrawal penalty | 10% before 59½ | 10% before 59½ | None |
Key Takeaways
- Annuities provide guaranteed income that cannot be outlived
- They are the opposite of life insurance—protecting against living too long
- Key benefits include tax-deferred growth, lifetime income, and principal protection
- Annuities have no contribution limits unlike IRAs and 401(k)s
- Best suited for those seeking retirement income security and who have long time horizons
- Surrender charges and early withdrawal penalties limit liquidity
The primary purpose of an annuity is to:
Compared to life insurance, an annuity:
One advantage of annuities over traditional IRAs and 401(k)s is that annuities:
Which of the following individuals would be the BEST candidate for an annuity?
14.2 Parties to an Annuity Contract
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