Understanding Life Insurance Annuities: A Comprehensive Guide

The information and content provided herein is for informational purposes only, and it is not to be considered legal, tax, investment, or financial advice, recommendation, or endorsement. You should consult with an attorney or other professional to determine what may be best for your individual needs.

As you think about financial planning, one of the product categories that you’ll come across is life insurance annuities. They are promoted as offering a unique blend of life insurance coverage and investment benefits that provide you with a versatile option to help safeguard your financial future. 

Though there can be some complexities with life insurance annuities, they are growing in popularity. Limra’s U.S. Individual Annuity Sales Survey found that annuity sales reached $385 billion in 2023, which is a new record.

Learn more about what life insurance annuities are, how they function, and how they compare to regular life insurance policies to decide if it’s a good move for you.

What are life insurance annuities?

Life insurance annuities are a hybrid product that combines elements of life insurance and annuities. At its core, a life insurance annuity is a contract between an individual and an insurance company. The policyholder pays premiums to the insurance company, and in return, the insurer promises to provide a stream of income or a lump sum payment to the policyholder at a later date, typically during retirement. Some life insurance annuities also offer a death benefit.

How does a life insured annuity work?

Life insurance annuities work by accumulating funds over time, either through regular premium payments or a lump sum contribution. These funds are invested by the insurance company, often in a variety of assets such as stocks, bonds, and real estate. The accumulated funds grow tax-deferred until the annuitization phase begins.

You can fund an annuity using a single premium payment, which means you purchase it in one lump sum. This is common with immediate annuities, when you want to begin receiving income immediately or at a near future date.

The other option is to make periodic premium payments, or regular contributions over time to fund the annuity. This is typical with deferred annuities, where the accumulation phase precedes the annuitization phase.

During the annuitization phase, the policyholder can choose to receive regular payments for a specified period or for the rest of their life, providing a steady stream of income during retirement. Alternatively, they may opt for a lump sum payout.

Life insurance annuity example

Here’s an example of how an annuity from life insurance might work. Let’s say you have a 45-year-old professional named Brenda who is diligently planning for her retirement. She has a stable job and a family to support, and she wants to ensure that she and her loved ones are financially secure in the future.

Brenda’s goals:

• To help supplement her retirement income with a guaranteed stream of income.
• To help protect her family financially in case something happens to her.
• To have a tax-efficient way to grow her retirement savings.

Brenda chooses a life insurance annuity with a fixed-income option, as well as a guaranteed death benefit for her beneficiaries and a guaranteed stream of income during retirement. Once the policy documents are signed, Brenda begins making premium payments. These payments accumulate cash value over time, which grows tax-deferred.

During the accumulation phase, Brenda’s premiums are invested by the insurance company in a diversified portfolio of assets. The cash value of her annuity grows steadily over the years, benefiting from market growth while being protected from market downturns.

When Brenda reaches retirement age at 65, she decides to annuitize her policy. She chooses to receive a fixed monthly income for the rest of her life. This income supplements her other retirement savings, including her 401(k), life insurance, and Social Security benefits, providing her with a comfortable lifestyle during retirement.

In the event of Brenda’s death, her beneficiaries will receive the guaranteed death benefit from her life insurance annuity, providing them with financial support and security.

Comparison to Regular Life Insurance

While traditional life insurance policies primarily focus on providing a death benefit to beneficiaries upon the policyholder’s death, life insurance annuities offer additional benefits during the policyholder’s lifetime. Here’s how life insurance and annuities compare:

Life insurance:

Main purpose: To help protect loved ones with financial security if you pass away.

Death benefit: Included, and generally not subject to federal income tax.

Cash value: Traditional life insurance policies may offer cash value accumulation, but it is typically less flexible and may incur penalties for early withdrawals. Term life insurance does not have cash value.

Retirement income: Not included.

Underwriting: There are no-medical-exam policies and policies that require getting checked out by a physician.

Life insurance annuity:

Main purpose: To provide you with income during your retirement years.

Death benefit: May be included, but tax treatment of the death benefit varies.

Cash value: Accumulate cash value over time, which can be accessed by the policyholder through loans or withdrawals, providing a source of liquidity.

Retirement income: Provide a guaranteed stream of income during retirement. This can help supplement other sources of retirement income, such as pensions, Social Security, and personal savings.

Underwriting: Most annuities do not have underwriting requirements

Depending on your financial situation, it could make sense to use both products in tandem. By combining regular life insurance with a life insurance annuity, individuals can address both short-term protection needs and long-term income goals, creating a comprehensive insurance strategy tailored to their financial objectives.

Pros and cons of life insurance annuity

If you’re considering a life insurance annuity, it’s important to think about the strengths and potential drawbacks.

Pros

• Financial security: Life insurance annuities help provide a layer of financial security by offering guaranteed income during retirement, helping individuals maintain their standard of living.
• Tax-deferred growth: The tax-deferred growth of funds within a life insurance annuity can help maximize investment returns over time, as taxes are only paid when funds are withdrawn.
• Flexibility: Life insurance annuities offer flexibility in how income is received, allowing policyholders to choose between receiving payments for a specified period or for the rest of their life.

Cons

• Fees and charges: Life insurance annuities may come with fees and charges, including administrative fees, investment management fees, and surrender charges for early withdrawals.
• Complexity: Understanding the various features and options of life insurance annuities can be complex, requiring careful consideration and financial planning.
• Inflation risk: The purchasing power of the income provided by a life insurance annuity may be eroded over time due to inflation, potentially impacting the policyholder’s ability to meet future financial needs.

Is a life insurance annuity good for you?

To be a good candidate for a life insurance annuity, you should prioritize financial stability, having guaranteed income during retirement, and tax-efficient growth of your savings. Some people who might like this type of product include:

• Pre-retirees and retirees: Individuals who are approaching retirement or have already retired can benefit from a life insurance annuity. These individuals often seek to supplement their retirement income with a guaranteed stream of payments, providing financial security during their golden years.
• Conservative investors: Those who prioritize capital preservation and are risk-averse may find life insurance annuities appealing. Annuities with fixed-income options offer stable returns and protection against market volatility, making them suitable for conservative investors.
• Individuals with longevity concerns: Individuals who are concerned about outliving their retirement savings may opt for a life insurance annuity. Annuities with lifetime income options ensure that they receive payments for as long as they live, alleviating longevity risk.
• Individuals with pension gaps: Individuals who do not have access to traditional pension plans or face pension shortfalls may benefit from a life insurance annuity. An annuity can supplement other retirement income sources, such as Social Security.
• Charitable individuals: Individuals who want to support charitable causes may use life insurance annuities to make charitable donations. Annuities with charitable giving options allow policyholders to designate charities as beneficiaries, providing support to their favorite causes while enjoying tax benefits.

By understanding how life insurance annuities work and weighing the pros and cons, individuals can make informed decisions that align with their long-term financial goals. Consulting with a financial advisor can help determine whether a life insurance annuity aligns with your financial goals and circumstances.