What is a deferred annuity?

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A deferred annuity is a popular way to structure an annuity for those seeking retirement income. An annuity pays out money over a period of time, typically during retirement, helping ensure that retirees have a reliable income. In a deferred annuity, savers contribute money either in one lump sum or over time, and then defer their income stream until later — potentially decades later — depending on how far away they are from retirement.

Here are the details on a deferred annuity, its biggest advantages and who should consider one.

How a deferred annuity works

To understand what a deferred annuity is, you have to first have a good grasp of how annuities work.

An annuity is a contract, usually with an insurance company, that offers income for a period of time in exchange for money upfront. The annuity will pay out, typically monthly, according to the terms of the contract, often until the death of the customer and may pay survivor’s benefits. These benefits may include an income stream to certain beneficiaries who survive the client.

One of the most attractive aspects of an annuity can be the safety of it. In many cases, the insurance company may offer a specified return on the money in the account or guarantee you a minimum payout value. It may also offer death benefits on the annuity, which is typically a payout like life insurance on the passing of the account holder.

What turns an annuity into a deferred annuity is when the client – the annuitant, in industry language – receives the money. There are two major ways to receive your payments.

With a deferred annuity, clients may contribute over their whole working lives, adding a bit of money to their annuity from a work paycheck. Of course, they may contribute a lump sum, too. But the key point is that they’re agreeing to receive their benefit later, usually years later.

In contrast, with an immediate payment annuity, a client deposits a lump sum and begins receiving payments from the income almost immediately.

Annuities can also differ in terms of how they’re structured. There are three main types – a fixed annuity, a variable annuity and an indexed annuity. The risks and returns on these can vary markedly, and it’s important that clients understand what they’re buying before they buy.

These types of categories are not exclusive. Regardless of what annuity structure you choose – fixed, variable or indexed – you’ll need to select when it pays out. That is, you can have a deferred fixed annuity or a deferred variable annuity, for example, or even an immediate fixed annuity.

The advantages of a deferred annuity

A deferred annuity can offer several advantages to a retiree, some of which are shared with annuities as a whole. These advantages include:

  • Tax-deferred gains – Like all annuities, a deferred annuity allows a saver to amass wealth inside a tax-advantaged account. An annuity allows you to save on a tax-deferred basis, meaning that earnings in the account are not taxed until they’re withdrawn. And if you contribute to the account with after-tax money, any of your contributions come out with no additional income tax liability.
  • Unlimited contributions – Like all annuities, there’s no limit on how much you can contribute to the account. That can be a significant advantage for higher earners, who may max out their traditional 401(k) – which offers similar tax-deferral benefits – and still want to defer taxes on investment gains.
  • Range of benefits – Annuities may offer an array of benefits – survivor’s benefits, death benefits, a guaranteed minimum lifetime payout and other features. These are all baked into the price of the annuity.
  • The power of time – By delaying your payout, a deferred annuity gives your money more time to compound and that’s likely to boost the payout that you’ll be able to receive when it does come time to start withdrawing money. In general, the longer you defer your annuity, the higher the payout can be.

Who should consider a deferred annuity?

Annuities can fit the needs of many people, because of the guaranteed income stream when they’re no longer able to work. But they do have some notable drawbacks, too.

“Someone who is approaching retirement and will have a need for income in the near future may want to consider a deferred annuity for a portion of their assets,” says Chad Hamilton, CFP, director of practice management at Brown and Company.

Combine the deferral feature with a fixed contract – which promises a minimum rate of return on your investment – and this annuity offers a lot of security for a retiree, especially when paired with Social Security. (Here’s the average Social Security check for retirees.)

Those who might want some of the potential investment returns of stocks without some of the risks might consider a variable deferred annuity. In a variable annuity, the investor deposits money in stock mutual funds, among others, and may have a minimum guaranteed income.

“With a market environment like we’ve experienced this year, sometimes the guarantee of future income will enable an investor who would otherwise be inclined to sell at the wrong time – and miss the market recovery – to remain invested,” says Hamilton.

What are the drawbacks of a deferred annuity?

Despite its advantages, a deferred annuity has some clear drawbacks, some of which are substantial.

These drawbacks include:

  • Complexity – An annuity contract can be long and complex, with many important details hidden in the fine print.
  • High fees – The range of fees on your investment can be substantial, especially the sales commission, which can run up to 6 or 7 percent easily. But some annuities can be hit with even more fees. Read the fine print closely.
  • Illiquid – It can be tough, if not impossible, to get your money out of the annuity. You may be socked with more fees here – such as a surrender fee – if you cancel your contract.
  • Penalties for early withdrawal – You may lose the tax-deferral benefits of an annuity and even be hit with a bonus penalty for withdrawing your money before age 59 1/2.

“It’s important to really understand the product well before proceeding to invest,” says Hamilton.

“For example, in order to recognize the benefit of a guaranteed income product, you may need to make the decision to turn on income – or annuitize – the account,” says Hamilton. “Typically, that decision is irrevocable, and it means you can no longer access the principal of the investment account, but instead it is a stream of income to you.”

Bottom line

Deferred annuities can be a good decision for the right person at the right time, but they come with substantial downsides that would-be investors should understand clearly before they sign up. Despite these pricey downsides, annuities remain a popular investing vehicle for retirement, in part because they’re so lucrative for the agent selling them and in part because of the unlimited ability to put away income in a tax-deferred investing vehicle.

Featured image by Thomas Barwick of Getty Images.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.