An annuity can be a good investment for retirees if it fits with the goals of their financial plan. There are many types of annuities, and they come with numerous variations that can be tailored to each person’s unique financial situation.
Here are the basic types of annuities, how they work and the advantages and disadvantages of each one.
What Is an Annuity?
An annuity is a contract between an insurance company and an individual. It guarantees a regular stream of income payments in the future in exchange for payments that you make now.
Annuities have two phases. In the accumulation phase, you make contributions either in a series of payments over time or in a single lump-sum upfront payment. The distribution, or payout, phase is when you begin to receive payments according to the terms of your annuity contract.
The income on the funds invested in an annuity accumulates tax-deferred. The gains are not taxed until you start making withdrawals.
Annuities can be either immediate or deferred. With an immediate annuity, you make a lump-sum payment, and the insurance company begins, usually within a month, to pay a regular income per the contract terms. The payments can be for the rest of the investor’s life or for a fixed period of time, such as five or 10 years.
With a deferred annuity, the issuer agrees to pay the owner a fixed income or a lump sum at some time in the future. The income from deferred annuities can be either fixed, indexed or variable.
Annuities are regulated by the SEC and sold by licensed agents, who charge fees, which can be substantial, for their advice and services. You can also buy no-load annuities directly from the insurance firm that issues them, but you must do all the research yourself to learn the advantages and disadvantages of the various types of annuities available in the market from other companies.
Different Types of Annuities
Annuities can be either fixed or variable.
Fixed annuities: With a fixed annuity, the insurer agrees to pay the annuitant a specific and guaranteed interest rate based on the amount of their contributions to the annuity.
Variable annuities: Variable annuities provide the opportunity for long-term growth. The funds are placed into a portfolio of stocks and bonds, but the rate of return can vary, depending on the trend of the markets. In some cases of a market downturn, the rate of return on a variable annuity could be close to zero. On the other hand, the insurer may put a cap on the maximum amount of return allowed.
Pros and Cons of Annuities
These are the pros and cons of annuities.
- Financial security: Annuities provide a guaranteed minimum retirement income without worrying about the volatility in the stock market.
- Lifetime income: An annuity is a hedge against living longer than you expected and still being able to receive income, rather than using up all of the funds in your portfolio to support your living expenses in retirement.
- Tax-deferred growth: Like an individual retirement account (IRA) or a 401(k), income grows tax-deferred in an annuity, and you don’t pay taxes on the interest income or capital gains until withdrawals begin.
- No contribution limits: Unlike an IRA or 401(k), annuities don’t have contribution limits imposed by the IRS.
- No mandatory withdrawals: You can start receiving income from an annuity whenever you want; you don’t have to start at age 70 ½.
- High fees: The insurance companies and sales agents charge fees that can be higher than other investment products, such as mutual funds.
- Limited access to your funds: Once you put your funds in an annuity, you’re not able to withdraw your money quickly to cover a large expense, such as an unexpected medical bill, and you may have to pay surrender charges or an early withdrawal penalty.
- Returns are modest: After paying the annuity fees, returns on annuities could be less than simply investing in a stock market index fund.
- Can be complicated: Because of the large number of available annuities and the various riders that can be attached, it can be difficult and complicated to understand the fee structure and how they work.
- Fixed income: Although an annuity provides a guaranteed fixed income that will never decrease, it will never increase or adjust for inflation.
- Not Insured: Unlike a certificate of deposit or an account with a broker, annuities are not protected by the FDIC or the SIPC.
Why Buy an Annuity?
The underlying purpose of an annuity is to provide income in retirement in case you outlive your retirement savings. They are also highly customizable with additional riders, such as a rider that provides a death benefit to the owner’s heirs when they die.
An annuity is another way to add to your retirement fund after you have maxed out your contributions to your IRAs and 401(k). Let’s say you’ve calculated your budget for your retirement living expenses, and you feel that you need additional income to provide for long-term care. You could purchase an annuity to make up the difference.
Purchasing an annuity can be a good investment to add to your financial plan and provide a guaranteed, fixed income for life.
How Much Do Annuities Cost?
A frequent criticism of annuities is the high cost of their fees. The commission paid to the insurance broker can be as much as 10 percent.
In addition, if you are purchasing a value of variable annuity, the insurance company will have an annual administrative charge of 1.25 percent or more plus investment management fees, which can range from 0.5 percent to more than 2 percent. Riders can add another 0.6 percent or more.
In total, you could find yourself paying a huge upfront commission to the broker, in addition to paying another 2 percent to 3 percent a year or more to the insurance company. These fees and charges will significantly reduce the amount of capital invested in your annuity and, as a result, reduce the rate of return.
You can compare these charges to the fees for a mutual fund, which run an average around 1.5 percent a year or just a simple stock index, like the Standard and Poor’s 500 index, which may charge less than 0.5 percent each year.
Annuities and Your Retirement Plan
If you’re concerned you might outlive your savings and want a guaranteed income that isn’t affected by the markets, a fixed income annuity could be the answer. The combination of income from Social Security and a fixed-income annuity might be enough to cover your needs and living expenses in retirement.
One way to set this up would be to purchase a deferred income annuity that begins payments later in your life. The income from this annuity could pick up after you have exhausted your investment portfolio.
If you are considering purchasing an annuity, you should consult with your investment adviser to make sure it meets your long-term financial goals.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.