One of the biggest worries for retirees is outliving their money. Nobody wants to be stuck in late retirement without enough income to cover basic needs.
Fortunately there’s a financial product that can help ease these concerns: annuities. Hand over a chunk of change, and you get guaranteed income payments for a fixed period of time—even until death.
Despite the prospect of annuities helping Americans better enjoy their golden years, few actually sign up—it’s what’s known as the “annuity puzzle.” Many would-be users don’t like the prospect of giving up a large portion of their portfolio, and they’re unsure about the prospect of high fees or indecipherable contracts.
“I have always said that for every investment out there, each one is good for someone and wrong for someone else,” said Nancy Butler, a certified financial planner who owns Above All Else, Success in Life and Business. “The key is to match the right person with the right investment, and annuities are no different.”
Here’s what you need to know to decide if an annuity is a good investment for you.
What is an Annuity?
An annuity is a contract between an investor and an insurance company.
The investor makes one payment or a series of payments to the insurance company. In exchange, the company guarantees income for a fixed period of time or until your death.
There are three main types of annuity available, although there are also various types within these broad categories.
- Fixed annuity. You receive a guaranteed fixed amount with each payment, such as a single premium immediate annuity (SPIA).
- Indexed annuity. This is a fixed annuity with a twist: A portion of your money is invested in a stock market index, such as the S&P 500, and the principal is guaranteed if you hold the contract to term. The trade-off, though, is that your returns on the index are capped.
- Variable annuity. You get the benefit of lifetime income, but the payments you receive depend on the performance of a portfolio of securities.
Why Annuities Might Be a Good Investment
Here are four reasons why an annuity might be a good investment for you.
Annuities Deliver Long-Term Income
An annuity can be a source of lifetime retirement income.
“Annuities function as an insurance product, and while some may have underlying investment options tied to the markets, they also offer guaranteed income and have features that offer protection during market fluctuations,” said Rona Guymon, senior vice president of annuity distribution at insurance giant Nationwide.
A Variety of Annuity Offerings
An array of annuities can be purchased, appealing to people from a range of age groups who have different savings and income needs and have different risk-tolerance levels, said Phil Michalowski, head of annuities at MassMutual.
“Annuity products offer tax-deferred investing for those looking to accumulate retirement savings with a range of solutions,” he said. “From simple low-risk products that offer guaranteed returns to higher-risk, investment-oriented products that have full exposure to equity markets, as well moderate solutions in between.”
Annuities Offer Tax Benefits
Payments that someone makes toward their annuity aren’t taxed until the money is withdrawn, noted Mark Stewart, the in-house CPA at Step By Step Business.
“Until the withdrawal is made, your annuity payment and its accrued interest remain non-visible to the government,” Stewart said.
Some Annuities Can Be a Good Inflation Hedge
One reason to choose a variable annuity rather than a fixed annuity is as an inflation hedge. Used right, variable annuities can maintain your purchasing power throughout retirement if your investment decisions—net of fees—boost your periodic payments to at least cover inflation.
Annuities Are Flexible
Butler emphasized a couple of the ways that annuities are flexible:
- You can transfer money from one annuity to another, even if they’re with different companies, through what’s known as a 1035 exchange. Using this method, your annuity earnings won’t be taxed.
- You can hold an annuity in a retirement plan, such as your 401(k) or individual retirement account (IRA), or can hold it outside a retirement plan.
Why Annuities Could Be a Bad Investment
While annuities provide retirees with a steady stream of income, there are some trade-offs to consider.
Annuities Can Be Complicated
Some annuities are too complex for many to understand without help from a financial professional.
“Unlike other retirement payment plans, an annuity has the most complicated structure,” Stewart said. “Generally, insurance companies might sell the most attractive package, which is the lifelong benefits; however, the high taxes and the payment calculations are grossly misunderstood by retirees.”
Some Annuities Charge High Fees
Owners of certain types of annuities can end up paying high fees. For instance, a variable annuity might charge fees between 2% to 3%, per Nationwide, which can shrink the value of your account and the return on your investment.
Among the costs you might encounter with a variable annuity are:
- Mortality and expense risk charges. An insurer imposes these charges to cover guaranteed death benefits.
- Administrative fees, such as recordkeeping.
- Charges for certain add-ons, like long-term health insurance or stepped-up death benefits.
Lack of Liquidity
Annuities can come with the certainty of lifetime income. But in order to get that benefit, you typically have to give up a lot of cash now.
Let’s say you’re a 65-year-old male living in Texas looking for $2,000 a month in income, and you want a simple, inexpensive option. This person could choose an SPIA.
You search online for an SPIA quote and see that you’ll need to plunk down a bit more than $350,000 right away. If you live to 80, you will get more than you put in, but the payments stop at your death.
If you invest in a variable annuity, you’ll owe a surrender charge if you sell the annuity or pull money out during the surrender period. This period typically lasts six to eight years after you buy the annuity.
Annuities May Have Tax Penalties
If you withdraw money from an annuity before age 59½, you’ll typically pay a 10% tax penalty on either the entire amount or just the earnings and interest.
Exceptions to the penalty may include circumstances such as death or disability, Butler said.
Are Annuities a Good Investment for You?
A hammer is a tool. Whether it’s a good tool or a bad tool depends on how you’re using it. The same is true of annuities.
“In any economy, and at all stages of the financial life cycle, annuities can provide protection and guaranteed income, helping clients prepare to navigate adversity now and in the future,” said Guymon.
On the other hand, financial advisor Corey Noyes, founder and owner of Balance Capital, isn’t sold on the value of annuities for his clients.
But it doesn’t have to be an all-or-nothing proposition. You can, after all, buy a big enough annuity to cover your fixed expenses (mortgage, food) and then invest the rest of your portfolio in higher yielding assets, such as stocks, to maximize your growth potential.
Consider talking with a fee-only financial planner to see if annuities, and which ones, make sense for your finances and risk tolerance.