Annuities Explained, and its Pros and Cons

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Retirement annuities have a very broad spectrum of investment products. The idea behind these products is to provide streams of income upon retirement. While there are numerous benefits associated with annuities, there are some drawbacks too. Before signing any option, ensure you understand its pros and cons of annuities clearly. 

What is an annuity?

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In simple terms, an annuity is an agreement or contract between an individual and an insurance company. You buy the annuity by paying a lump sum, which is then invested in mutual funds. You will receive the earnings from investments in a lump sum or periodically. The terms and payments vary depending on the type of annuity purchased.

Annuities offer more benefits when compared to other forms of retirement investments.

Types of annuities

Annuities are classified into 3 major types: Fixed, variable, and indexed.

A fixed annuity guarantees a specified interest rate of your money and a set number of periodic payments. A variable annuity gives you the option to choose different securities such as mutual funds to invest your funds, and payments are based on the performance of your investments. An indexed annuity combines the aspect of fixed and variable annuities. The payments are based on how your money performs in the Stock Market Index, like the S&P 500.

Your annuity can be immediate or deferred. An immediate annuity is where you pay a lump sum and begin receiving payments on retirement. The deferred annuity is paid in a lump sum or in a series of payments, and payments start years later. This gives your money a chance to earn interest from investments.

Pros of annuities:

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Life income

An immediate lifetime annuity contracts guarantee periodic payment as long as you live. The insurance firm bears the risk of living long and happily.

Pensions and Social Security also offer retirement income protection, but their amount is limited. The amount you buy an annuity for determines the periodic payouts. The older you are, the higher the amount you receive.

Inflation protection

Inflation can be devastating on your assets. Annuities are customized to keep up with inflation, which affects the cost of living. It will cost more to have add-ons to protect you from inflation.

Principal protection

With fixed and equity-indexed annuities, the value of the annuity is higher than the amount invested. The money will be paid to you or your heirs.

Tax efficiency

Purchasing an annuity using 401(k) or IRA funds can save you tax, unlike paying with a lump sum. You can roll-over into a qualified annuity without taking tax penalties and only pay tax on income from the annuity.

Predictability

According to Towers Watson Retirement Survey, having a predictable amount of retirement income helps you live happier. Lifetime annuities provide you with this predictability, unlike other forms of retirement investments.

Deferred distributions

Tax-deferred status is another perk of annuities. You do not have to pay taxes to the government until you withdraw the money. Leaving money on the deferred annuity can reduce your social security taxes since you have less taxable income.

Guaranteed rates

With fixed annuities, you receive a guaranteed payment. Variable annuities payments vary depending on how your investments perform in a certain period. Fixed annuities are the best forms of investment for seniors.

Variable annuities offer a death benefit

The death benefit is the payment the insurance company makes to your heirs if you die. Variable annuities are risky because you can lose your money. You can also get extra income if your investments do well.

For a basic variable annuity, the death benefit is equal to the amount contributed. If your annuity is worth $100,000, then your death benefit is $100,000.

You can get a variable annuity with enhanced death benefits. The insurance company records the value of each annuity investment on the anniversary of your annuity’s start date. If you die, the insurance company pays a death benefit equal to the highest recorded value of your annuity.

For example, if you have an annuity contract worth $100,000 and invest it in different performing portfolios. At the start of the anniversary, the investments are worth $125,000. Your death benefit will be $125,000.

If you are looking for a death benefit, an annuity is not the best choice. You can help your beneficiaries get a suitable life insurance policy.

So, what are the cons of annuities?

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Not all annuities are created equal

Fixed annuities are deemed ideal since they provide guaranteed income. However, other annuities are termed as “snake oil” since they are unnecessary and expensive.

Lower returns on your investment

While you accept the returns from fixed or equity-indexed annuities, you forego the chance to make bigger returns from other money assets like stocks, which fluctuate in value. A fixed annuity is a safe but conservative form of investment since you cannot get possible gains available in riskier investments.

High costs

High sales commission and management fees are common complaints by annuity holders. Shop around and find an insurance company with the least fees.

Inflexible

An annuity is less flexible as compared to other retirement plans. Once you purchase the annuity, you cannot access the money.

Hefty fees

Annuities have hefty fees as compared to CDs and mutual funds. They are sold through agents whose commission is quite high. You can avoid the high upfront fees by purchasing the direct-sold products.

Nevertheless, you are still faced with a 2% annual expense. You will pay more if you have an actively managed mutual fund.

Lack of liquidity

Many annuities come with a surrender fee, which is implemented if you withdraw within the first few tears (usually between 6-8 years). It is hard to back out once you have signed the contract.

Annuity growth might not match stock market growth

The stock market makes huge gains in a year. Your investment, however, grows by a slightly lower margin because of the annuity fees. Investing in an indexed annuity means the insurance company puts your money in a specific index fund. Your earrings are capped using a participation rate. If the participation rate is 85%, your investment grows by 85%. You could still be missing some returns.

The best way to invest in the stock market is by choosing an index fund and do it on your own. You can get some assistance from a Robo-advisor on managing your account at a fee lower than an annuity. You will pay lower taxes when you invest by yourself. Contributions are tax-deferred, and you pay taxes on the withdrawal and not the capital gains tax.

Getting out of an annuity may be impossible

Once you contribute your money to an immediate annuity, it is impossible to withdraw the funds. You can only move it to another plan, and the process is subject to high fees. If you die, the benefits are not passed to your heirs, and they disappear.

Bottom line

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Hundred dollar bill under a paper umbrella with Annuity text

An annuity is perfect for supplementing your retirement income. It provides regular payments, tax benefits, and death benefits.

The shortcoming of an annuity is the high cost. Some annuity plans will cost almost half of your contributions.

If you do not understand the annuity clearly, do not hesitate to consult a financial advisor.

Things to consider when looking for an annuity

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