As you get closer to retirement, your focus typically shifts from saving for the future to generating income from what you’ve saved. One tool to consider as part of that transition is an annuity that provides a protected income stream for life. But what exactly is an annuity, and how might it fit into your overall retirement income strategy?

An annuity is a contract with an insurance company designed to provide income for life. Think of it as a way to create your own “pension-like” income stream. Historically, retirees generated their paycheck from the “three-legged stool” of retirement income: Social Security, pensions and their investment portfolio. However, with traditional employer pensions becoming increasingly rare, annuities can help replicate this leg of the stool and provide reliable income stream throughout your retirement years.

Two broad categories of annuities

While annuities come in many forms, most protected lifetime annuities fall into two broad categories:

1. Income annuities

Income annuities — including single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs) — allow you to exchange a lump-sum investment for a guaranteed stream of income that lasts for life.

2. Fixed and variable annuities with a guaranteed lifetime withdrawal benefit (GLWB)

With fixed and variable annuities that offer a guaranteed lifetime withdrawal benefit, you retain ownership of your assets. Your initial withdrawals are drawn from your own balance, and once those assets are depleted, the insurance company continues providing a guaranteed minimum withdrawal for as long as you live.

Benefits and trade-offs of annuities

Adding an annuity to your retirement strategy can offer meaningful advantages, but it’s equally important to understand potential drawbacks.

Key benefits

Predictable lifetime cash flow — Annuities can provide income that doesn’t depend on market performance, offering stability no matter how long you live.

Higher initial payout potential — Compared with a 4% initial withdrawal rate (a general rule of thumb for someone retiring in their mid-60s), an annuity may provide a higher initial income as a percentage of your investment.

Lower portfolio reliance — Producing income from guaranteed sources may reduce how much you must withdraw from your investment portfolio. This may be especially important early in retirement when market downturns can have a greater impact.

Key trade-offs

Higher fees and expenses — Guarantees come at a cost, which can make annuities more expensive than other investment options.

Inflation risk — Most annuity payments don’t rise with inflation, meaning the purchasing power of those payments will likely decline over time.

Lower liquidity and flexibility — Exiting or altering an annuity contract can be costly, cumbersome or altogether not allowed, which reduces flexibility.

Is an annuity right for you? Consider these factors

You should consider several key factors when determining whether an annuity fits your retirement income strategy.

1. Strategic planning considerations

• Availability of other income sources: If Social Security and other income cover most of your necessary expenses, you may not need additional guaranteed income.
• Spending flexibility: The less flexibility you have in your retirement budget, the more appealing a protected lifetime annuity becomes.
• Life expectancy: The longer you expect to live, the more a protected lifetime annuity can make sense.

2. Pricing considerations

• Interest rate environment: Higher interest rates typically lead to higher annuity payout rates and the more favorable annuities generally become relative to portfolio withdrawals.

3. Emotional and value-based considerations

• Legacy priorities: If leaving assets to heirs is a primary goal, an annuity may be less appealing.
• Comfort with relying on portfolio income: The less comfortable you are with relying on your portfolio for income, the more a protected lifetime annuity makes sense.
• Discipline during downturns: If guaranteed income helps you stay invested during volatile markets, a protected lifetime annuity may make sense.

How much to allocate to an annuity

Edward Jones typically recommends limiting your annuity allocation to no more than about 35% of your overall portfolio. The recommendation amount can vary from up to 25% for income annuities to up to 35% for fixed and variable annuities with guaranteed lifetime withdrawal benefits.

How an Edward Jones financial advisor can help

Because annuities involve important trade-offs and vary widely by type, the most effective next step is to talk with your Edward Jones financial advisor. They can help you evaluate whether an annuity aligns with your goals and determine how this strategy might fit into your broader retirement income plan.