Last Updated: January 2021
Life insurance and annuities are two completely different products that can both help you to protect your assets, income, and families. It’s important to understand the differences in how they can help you and your family financially.
In order to have know which makes the most sense for your situation, you first need to understand the key benefits of both the annuity and life insurance policies. This will help determine which one has the best chance of providing the benefits specific to your needs, your retirement, and, ultimately, your future.
In this brief post, I am going to break down the annuity vs. life insurance and display the significant factors you need to understand about each of them before ultimately adding them to your financial plan.
Here is a quick overview of the content in this article:
- Life Insurance vs. Annuity: A Brief Overview
- What is Life Insurance?
- What are Annuities?
- Should I Choose an Annuity or Life Insurance?
- Where Should I Begin Looking for Annuities and Life Insurance?
Life Insurance vs. Annuity: A Brief Overview
Annuities and life insurance policies are both issued by life insurance companies.
In many situations, both products are sold by life insurance agents. Especially some of the larger insurance companies, such as New York Life and Northwestern Mutual.
It’s important to understand that although these are both products offered by most life insurance companies, they vary significantly with the benefits they can offer, what they are protecting against, and when they make the most sense to include in a financial plan.
Let’s start by looking at a brief overview of life insurance.
What is Life Insurance?
Life insurance is focused on the main principle of protection against death. It is an investment that can give you peace of mind and your family the ultimate protection that, unfortunately, you will never live to see.
One of the most desired benefits of using life insurance as a financial protection and planning tool is the tax-free death benefits that pass to your designated beneficiaries which will most commonly be family such as the following:
Term Life Insurance is the Most Common Type of Life Insurance
Life insurance is offered in many forms and options, with term life insurance being the most popular, most affordable, and most straightforward option to choose.
Term life insurance is going to let you purchase the most significant death benefit amount (amount of money provided to your beneficiaries at death) for the smallest price and will expire at the end of the term duration.
Common term durations typically include:
- 10 Years
- 15 Years
- 20 Years
- 25 Years
- 30 Years
What exactly does this mean?
Assume you purchase a 1-million dollar life insurance policy and name your spouse and kids as your beneficiaries if god forbid something happens to you. The insurance company charges you $55.00 per month. You will pay $55.00 per month every month for 30 years.
If you do happen to pass away during this 30-year term, your family would be provided the full 1-million-dollar benefit. If, however, you live 31 years, you will no longer need to pay $55.00 per month for coverage, and the policy is no longer in force and valid.
Term Life Insurance Can Help Cover Debts
In a roundabout way, it is essentially betting against the insurance company. Unfortunately, betting your family’s wellbeing is not worth the risk, and it is much easier to sleep at night, knowing that If something happens, your family is protected. At least for the duration of time specified on the policy you choose.
Most of the time, the person insured will choose a duration for the term life insurance policy that allows them to cover significant debts such as a home, vehicles, children’s colleges, etc. This ensures that if they were to die prematurely, the other spouse and the kids would not be out of home and financially devastated by the loss.
Term life insurance is also frequently used to protect income and replace income for the primary income provider in the family. Term life insurance is a great planning tool for protection, not investing, and again, it is primarily used to protect against premature death.
The other option frequently purchased through life insurance companies is designed to cover the exact opposite scenario. Living too long.
What are Annuities?
Annuities are another popular choice for retirement planning and protecting wealth well into your retirement years.
Annuities are the exact opposite of life insurance. An annuity is designed to protect an individual from living too long and running out of retirement funds. This is done by taking a lump sum of cash to create a stream of monthly payments, also referred to as “annuitization.”
How Annuities Work
For example, if you take $100,000 dollars and enter an annuity contract with an insurance company, the insurance company will pay you $10,000 per year for 20 years due to their ability to invest that $100,000 and earn interest on the account during the annuitization phase.
The numbers illustrated above are nothing more than an example and not necessarily accurate figures based on any annuity product.
Benefits & Drawbacks of Annuities
There are both pros and cons of annuities. Annuities can be beneficial because of their tax-deferred savings element.
However, a downfall of annuities is that when a death benefit is attached to an annuity either through the product itself or a product rider, the beneficiary does not receive the death benefit tax-free in the same fashion they would experience in choosing life insurance.
Once again, this is because it is not designed to protect against death but protect against living too long.
Three Types of Annuities
Individuals who need to protect against running out of money as opposed to the chance of premature death will typically choose an annuity in one of three forms:
A deferred annuity is designed to collect interest and the premiums that you pay into the annuity and build interest until a later specified date in time.
You can purchase a deferred annuity that is either fixed, fixed-indexed, or variable. All these annuities will still defer taxes on the earnings inside of the annuity but the way the annuity is invested varies between the 3 products.
The fixed income annuity will be your safest bet with the lowest returns.
In contrast, an indexed annuity and variable annuity will be invested more aggressively into the market, such as the S&P 500, to provide larger gains. While the safety is not as guaranteed with indexed and variable annuities, the reward is higher.
In recent years, it has become possible to purchase additional riders that will allow you to still place a guaranteed floor or lowest return possible on the annuity itself, typically at 0%.
Simply put, if the market has a -15% year, instead of losing 15% of your investment and premiums invested, you would simply break even and earn 0% on your investment for the additional cost of the rider being attached to the annuity at the time the contract begins.
An immediate annuity is going to behave the exact opposite of a deferred annuity. They are often purchased with a lump sum of cash to begin the annuitization period either immediately or within 12 months. Hence the name “immediate annuities”
A circumstance would rarely exist that you would ever consider an immediate annuity without the need to protect income and receiving monthly payments for life as opposed to having a lump sum of cash sitting inside of a cash account earning next to nothing in interest.
This kind of annuity serves a specific purpose when it comes to protecting and safeguarding retirement income. It is designed to prolong payments and defer annuitization for the most extended period compared to your other options. Up to 45 years.
In most situations, this annuity will be used to supplement or replace the income that is lost or on the steep decline from other retirement sources such as pension plans.
Longevity annuities also are designed for beginning much later in life and protecting you in your final years and ensure you still have monthly income streaming in to cover what expenses you have remaining each month.
In most circumstances, the first year of payments or annuitization for this kind of annuity will begin at age 80.
Should I Choose an Annuity or Life Insurance?
Choosing correctly between an annuity and life insurance is relatively simple when you take a step back and determine what is truly needed in your financial plan. It is not uncommon that a financial plan will include both options.
You need to determine if you are wanting to protect your family and dependents from financial hardship if something occurs to you prematurely. This is most often going to be the case during your working years or when children are living at home, and debt is still is substantial in your life.
On the other hand, if, after analyzing your situation, you determine that your most significant fear or financial pitfall is the chance of running out of money too soon, then you are likely better suited to choose an annuity as opposed to life insurance.
Where Should I Begin Looking for Annuities and Life Insurance?
Once you have determined which of these products are going to be a better fit for you, it is time to start searching for the best insurance company to work with.
Comparing your rates with independent sources is likely your best bet to see how rates stack up between each company.
Nearly all life insurance companies are going to offer both annuities and life insurance. The key is speaking with a professional to get a full-scope overview of your financials.
After you know which direction you plan to go, all that is left is finding the best life insurance company to protect your assets and protect your retirement income.