Morningstar’s Guide to Annuities

For many investors, annuities are the investment you’ve heard of but likely turned down.

With IRAs and 401(k)’s commanding the most investor attention, annuities may seem an obscure or confusing choice for income. Yet annuities are a unique product well suited to specific investor needs.

Annuities, which are usually sold by insurance companies, are frequently used as an addition to other retirement funds as a hedge against outliving your money.

The idea is simple: You put down a lump sum, and in return, you receive a guaranteed income stream for life. However, annuities can offer a variety of features—as well as complexities and costs.

What Are the Types of Annuities?

Spencer Look, Morningstar’s associate director for retirement studies, breaks annuities into two types:

• Income annuities provide the annuity owner a steady stream of cash flows for a set period or for the rest of their life.
• Savings annuities are an accumulation-focused product with an account balance. While all savings annuities allow the owner to convert the account balance into a stream of cash flows, this is rarely done. Look explains, “These vehicles are often referred to as ‘deferred annuities,’ but I prefer the term ‘savings annuity’ because it better describes how these types of annuities are used in practice.”

What Should I Consider When Choosing an Annuity?

There are several key points to keep in mind when evaluating annuities:

• Irrevocability: With some annuities, the purchase decision is irrevocable. This is a significant commitment because you are exchanging the value of your current assets for a future income stream.
• Withdrawal rules and charges: Annuities have varying rules about withdrawals. Typically, there will be charges on “savings annuities” (that is, those with an account balance) if you access your funds within the first several years of purchase. Some annuities let you withdraw a portion of your funds each year, but this can carry penalties and tax implications, especially if you are less than 59.5 years old. There wouldn’t be withdrawal rules or charges on “income annuities,” which have already been converted into a stream of income cash flows.
• Tax implications: For “savings annuities,” you will owe ordinary income tax on any investment gains from the annuity, and possibly an additional 10% penalty if you withdraw funds before age 59.5. If the annuity was funded with pretax dollars, the entire withdrawal amount will be taxable. For “income annuities,” the taxable amount is based on the exclusion ratio (which represents the portion of the payment that is a return of principal).
• Complexity and costs: Fixed-income and fixed-rate annuities are generally straightforward and carry lower fees. In contrast, fixed index and variable annuities tend to be more complex and come with higher costs.
• Financial strength of the insurer: The financial strength of the insurance company issuing the annuity is crucial, as it ensures the company can meet its future payment obligations.

Below, explore our latest research about annuities from Morningstar’s experts.

Is An Annuity a Good Option for Retirement Income?

Annuities can be a strong choice for both preretirees and retirees who want the reliability of guaranteed income. They can protect retirees from longevity risk and provide tax-deferred growth.

These resources can help you navigate how an annuity may fit into your retirement plan.

How to Use Annuities in Your Portfolio

Annuities can be a useful addition to a diversified investment portfolio. The products that are right for you will depend on factors like your goals, time horizon, and risk tolerance.

Morningstar’s research can help you find the right assets and investing style, so you can build a portfolio to handle any market condition.