JoshA deferred annuity is an insurance product into which you pay a specified contribution so that you can grow the money and receive a stream of steady income in retirement. The money grows during what’s known as the accumulation phase, which immediate annuities don’t have.
When you purchase a deferred annuity, you have a choice between single-premium funding and flexible-premium funding, whereas immediate annuities are exclusively single-premium. Though both funding options will amount to the same principal, each functions differently and offers a unique set of advantages.
What Is a Single-Premium Deferred Annuity?
A single-premium deferred annuity is one that you fund with a lump-sum payment at the time that you establish the contract. Annuities typically involve large quantities of money to fund, so single premiums usually come from the sale of assets or by way of rollovers from other accounts, such as 401(k)s, IRAs, and other annuities. In rare cases, an annuitant may happen to have tens of thousands of dollars to spare and elect to put them toward a single-premium annuity.
What Is a Flexible-Premium Deferred Annuity?
With a flexible-premium deferred annuity, the funding arrangement involves a series of smaller contributions over time. There’s an initial contribution to start, but subsequent payments can come at your desired pace and in variable amounts. That’s what makes the annuity flexible, though you could set up scheduled transfers from your bank account if you want.
Single-Premium vs. Flexible-Premium Annuities
Single-premium and flexible-premium deferred annuities are similar in that they lead to the same outcome — tax-deferred growth on a large sum of money — while offering principal protection. Also, if you go with a fixed annuity, you get the added benefits of a guaranteed rate of return and the improved budgeting predictability that comes with it.
Single premiums and flexible premiums do differ in some of the advantages they offer annuitants, as well as the potential downsides they represent.
Pros and Cons of Single-Premium Deferred Annuities
The chief advantage that single-premium deferred annuities offer is the ability to optimize compound interest. Because you’ve injected your account with the entire funding amount, the initial interest accrual takes place at its full potential, as do all of the subsequent accruals. To illustrate, imagine you’ve opened a $20,000 fixed annuity for a 10-year term with an interest rate of 5%. Once interest hits, you’ll be gaining on the full $20,000, not just a portion of it, so you stand to realize more gains overall.
On the flip side, single-premium deferred annuities are less accessible than their flexible-premium counterparts because they require a tremendous up-front cost. Not everyone has valuable assets to sell or a large-sum account they can roll over. Even for those who do, placing the lump sum in a deferred annuity effectively ties up the money for years. One may have to pay penalties and other fees to access the money in case of an emergency.
Pros and Cons of Flexible-Premium Deferred Annuities
The greatest advantage that flexible-premium deferred annuities provide is their accessibility. Their forgiving nature allows you to purchase one even if you don’t have all of the funding money up front. They also provide you with more time to pay and generally have a low barrier to entry, with some requiring as little as $50 or $100 to get started.
Let’s revisit the example of a $20,000 fixed annuity to illustrate. Instead of funding the account in one swoop, you might put down $5,000 to start. Then, over the next 18 months, you transfer sums between $800 and $1,000 to complete your funding. The account has already begun to grow with the initial contribution, and growth only accelerates as you make additional payments.
Meanwhile, you don’t have $20,000 entirely locked into the annuity. As you fund your annuity over the months and years, you can have the freedom to use your money as you wish so long as you make some sort of contribution to your account.
You do run the risk of losing out on potential gains when you take out a flexible-premium annuity. That’s because the interest has less to work with throughout the life of your contract. If you’re starting with $5,000 and slowly climbing from there, the account won’t grow as exponentially as a single-premium annuity that has the entire funding amount from the beginning. The trade-off, then, is accessibility for earning potential, and you have to decide which one best suits your financial goals.
The best way to come to a sound decision is to speak with a financial adviser about the matter. They can help you see both the big picture and the minute details of your financial circumstances and then build an effective annuity strategy from there.