In a Nutshell
While annuities can provide a steady stream of income during retirement, they may also come with a variety of pitfalls and rules that are important to understand.Annuities are one of the investment options available to help consumers fund their golden years.
And while some types have the potential to provide regular income during retirement, they’re not right for everyone. If you’re considering putting some of your hard-earned money into an annuity, it’s important to understand both the advantages and disadvantages of this financial product.
Before we dive into the pros and cons, let’s quickly review what an annuity is and some of the different types available.
What is an annuity?
An annuity is a financial product that a consumer might use to help manage their money during retirement. When you purchase an annuity, usually from an insurance company, you enter into a contract with the company and make a payment (or multiple payments).
When it’s time to pay out the funds, the insurance company pays you. These payments may also include interest earned on your money, which grows tax-deferred until payout. The type of payout — generally a lump-sum or series of payments — you’ll receive varies based on the payment structure outlined in the contract with the insurance company and the type of annuity you purchase.
There are three main types of annuities.
Fixed
Fixed annuities are investments that provide a guaranteed rate of return for a set number of years.
Variable
Variable annuities allow consumers to choose from investment options that may have greater earnings potential than a fixed annuity. But unlike a fixed annuity, they may lose value depending on the performance of the investments you select. For an additional fee, you can often purchase optional features, called riders, that can provide income guarantees, which can give some stability when there’s market volatility.
Indexed
Indexed annuities earn a return based on the performance of a stock market index, such as the S&P 500. But there can be limits to how much of your annuity is based on the index, as well as how much it can earn. For example, if the index is up 10% and your earnings are capped at 5%, the value of your account may increase by only 5%. However, if the market declines, the value of your account won’t.
Pros of an annuity
As with any type of investment, there are pros and cons to putting your money in an annuity. Here are some of the benefits.
You can get retirement income for life
If you’re worried about outliving your money during retirement, an annuity can provide a steady stream of income for a set period of time, which may extend and help to avoid that from happening.
“That’s the fundamental reason why you buy an annuity. It hedges against longevity risk,” says Michael Menninger, CFP and president of Menninger & Associates Inc.
It may also help you increase your tax-deferred retirement savings after hitting contribution maximums on your 401(k) or IRA.
Fixed annuities offer guaranteed returns
When you invest in a fixed annuity, you’re guaranteed to earn a minimum amount of interest on your investment. While interest rates tend to be lower, they’re somewhat predictable.
You can receive some protection from market volatility
While there’s an inherent amount of risk in just about any investment, certain annuities can help protect the money in your annuity from downturns in the market. If the market declines after you purchase a fixed or indexed annuity, the value of your account won’t. But because interest rates on fixed annuities tend to be lower and earnings are typically capped on indexed annuities, you might not earn as much as you could with other investments.
On the other hand, variable annuities provide the upside potential of the market, while offering optional benefits that can help relieve the loss from the downside. But the fees associated with them can minimize your returns.
Cons of an annuity
Although annuities can help you manage your income during retirement with the added bonus (even if minimal) of investment returns, there are several things to watch out for if you’re considering investing in one.
You’ll have limited access to your money
Many annuities have a surrender period, during which you can’t withdraw money without incurring hefty fees. And once you choose to start receiving annuity payments from your investment, many companies will no longer let you withdraw money from your account. So you’ll only have access to any annuity payments already scheduled.
They can come with fees and penalties
Many annuities have fees attached to them that can minimize the return you earn on your investment. Common ones include …
- Surrender charges, if you withdraw your money during the surrender period
- Administrative fees
- Mortality and expense fees for variable annuities (typically around 1.25%)
- Additional fees if you choose to purchase optional features, like riders
You may also be subject to a federal tax penalty of 10% if you make a withdrawal before you’re 59½.
They’re taxed as ordinary income
The interest you earn on your annuity investment grows tax-deferred, which may be considered a benefit of annuities. But when you withdraw your money, those funds, including earnings, are taxed as ordinary income (similar to distributions from your 401(k) plan). For most individuals, their ordinary income rate is higher than the long-term capital gains rate, which is the tax rate you’d pay if you invested in individual stocks or mutual funds on your own and held onto them for more than a year.
They may only be as good as the insurance companies that sell them
While annuities are often sold with the promise of guaranteed income, the insurance company may not be able to make your payments if they experience financial difficulty or go under. If you have a fixed or indexed annuity, you could lose your entire investment. If you have a variable annuity, you’ll likely get to keep your underlying investment, but you could lose any returns or optional benefits (i.e., income, withdrawal, death benefits) the annuity provides.
So if you decide to invest in an annuity, it’s important to work with a reputable company that’s financially stable, and find out if the annuity will be insured.
Are annuities insured?
Unlike most bank deposits, annuities are not insured by the FDIC. However, if the insurance company that sells you the annuity cannot make payments, you may be able to recover some of your money through your state’s insurance guaranty association. But beware that depending on the value of your annuity contracts, they might not be able to reimburse you for the full amount you invested.
They’re complex
According to Menninger, many consumers have difficulty understanding annuities even after they’ve been explained. Payout terms often vary based on how and when you decide to withdraw your money. And the actual return on your investment can be difficult to assess because of the fees associated with the product.
Is an annuity right for you?
Deciding whether an annuity is right for you will depend on your personal financial situation. If you’re looking for access to a guaranteed stream of income — to supplement other income sources you have available for retirement — an annuity may be a good choice.
“If used properly, an annuity is a very good thing … [But] it should be carefully designed as part of a retiree’s long-range financial plan,” Menninger says.
He doesn’t recommend putting all your assets into an annuity, because if you need money during the surrender period, you likely won’t be able to access it without paying a fee. Plus if you ever need more than what the annuity pays out, you may not have enough left over to cover additional expenses, he adds.
On the other hand, an annuity may not be a good choice if you think you’re going to need the money you plan to invest at some point down the road.
“Generally speaking, when you put money into an annuity, you should assume those assets are not going to be needed except for their desired purpose of retirement income streams,” Menninger cautions.
In addition, if you’re looking for an investment product to add to your portfolio, and not necessarily a guaranteed stream of income for retirement, an annuity may not be your best bet. There are other, arguably simpler, ways to invest your money that may be less expensive, taxed at lower rates, have a potential for greater returns, and have fewer restrictions. Some examples include CDs, bonds, stocks and mutual funds.
Bottom line
If you want the peace of mind of having a guaranteed stream of income that can last through retirement, annuities may be worth looking into. But be sure to do your homework so that you understand the terms and conditions of the contract, especially what your payout will be. Consider working with a fee-only financial planner if you need extra help understanding whether an annuity is right for you. And if you do decide to put your money into an annuity, be sure to work with a stable company that has a solid reputation.
If you’re looking for more-flexible ways to invest money for retirement, you may be better off choosing a different type of product that’s less complex and has fewer fees associated with it.