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Annuities allow individuals to pay upfront or over time to receive a consistent income stream. Because they can provide predictable income, annuities are a popular approach to securing retirement income. This is especially true as pensions have become less common in the private sector. Like most financial products, however, annuities have their share of benefits and drawbacks, such as high fees and complex contracts.
Here’s how annuities work and what to consider before purchasing an annuity.
Key takeaways
- An annuity can help you save for retirement and has favorable tax benefits.
- Experts caution that annuities can be complex and risky, carry high commission fees and are difficult to cancel.
- Some alternatives to annuities include a traditional investment portfolio, managed payout fund or life insurance policy.
What is an annuity?
An annuity is a contract with an insurance company that provides a stream of income, typically in retirement, in exchange for money paid into the annuity. People often invest in annuities as part of their broader retirement strategy, including life insurance or traditional retirement accounts, such as an IRA.
Sold as an insurance product, annuities are constructed to pay out on a predictable schedule. You may purchase an annuity by depositing a lump sum or by funding the contract over time with a series of premium payments.
The annuity will pay out over whatever period is specified in the contract. Perhaps that’s a fixed period, such as 20 years, or perhaps it’s for the remainder of the client’s life. So the annuity can offer the certainty of income and the possibility of never exhausting that income.
Types of annuities
Individuals can broadly lump annuities together into three different types:
- Fixed: A fixed annuity guarantees you a minimum rate of return on your investment and will pay out over a fixed term.
- Variable: A variable annuity allows you to put your money into various investments, often mutual funds. What the annuity returns and pays out to you depends on how the investments perform and the expense ratios on any funds you invest in.
- Indexed: An indexed annuity offers a rate of return that tracks an index such as the S&P 500, which holds hundreds of America’s largest companies.
In addition to those three types, annuities can also be classified by when they pay out:
- Deferred annuities pay out at some specified time in the future, perhaps at some specific age in retirement.
- Immediate annuities begin paying out within a year or less of purchase.
An annuity has two broad periods in its life — the accumulation phase and the annuitization, or payout phase. In the accumulation phase, you’re putting money into the annuity as a lump sum or payments over time. In the annuitization stage, you’re taking payouts from the annuity.
Money deposited into an annuity is locked up for a time called the surrender period. If you decide you want out of the annuity early, you’ll pay a hefty fee called a surrender charge.
In the table below, you can see how the three main types of annuities compare based on critical benefits:
| Benefit | Fixed | Variable | Indexed |
|---|---|---|---|
| Provides income replacement during retirement | X | X | X |
| Guaranteed minimum rate of return | X | ||
| Fixed premiums over a certain period of time | X | X | X |
| Option to choose your investments | X | ||
| Tax-deferred growth | X | X | X |
Features of an annuity
Annuities can be structured in many different ways, depending on a customer’s needs. Some may guarantee you’ll receive a specific dollar amount of payments from the account over some period.
“` Many annuities offer a death benefit similar to life insurance, which can provide a payout upon your passing. Some annuities may have longer surrender periods, allowing you more time to cancel the contract. Others may offer survivor’s benefits for a spouse or additional “riders” that provide insurance-like benefits. However, the more benefits an annuity has, the higher the cost.
One major advantage of annuities is the tax deferral on growth until you withdraw the money. Qualified annuities offer tax-deferred growth, while nonqualified annuities are taxed only on the earnings upon withdrawal. Annuities can be beneficial for high-income savers who have maxed out other retirement accounts.
Despite the benefits, annuities come with downsides. Annuity contracts are complex, with many details to consider. Each contract may vary significantly, making it essential to carefully review the terms. Annuities also typically come with high sales commissions, which can reduce potential returns. Cancelling an annuity can be difficult and may involve surrender charges.
Overall, annuities can provide a guaranteed income stream and other benefits, but they require careful consideration and understanding of the terms and fees involved. It’s advisable to seek guidance from a financial advisor before investing in an annuity.
There are various reasons why you might consider selling your annuity payments, such as unexpected medical expenses or the opportunity to purchase your dream home. However, it is crucial to approach this decision with caution.
Lack of Liquidity
Once you invest your money in an annuity, it becomes tied up for a significant period. While you will receive regular income, accessing the principal can be challenging. This lack of liquidity can pose a problem in emergencies when your other sources of income or savings are insufficient.
Potential Risks
Variable annuities, in particular, can be risky as they are dependent on market performance for returns. This reliance on the market can result in minimal gains or even losses after years of saving. Additionally, variable annuities often come with high fees, including mortality and expense risk charges, fund expense ratios, administrative fees, and additional charges for special riders. Withdrawing money early can also lead to IRS penalties and taxes on investment gains.
Alternatives to Annuities
While annuities cater to various consumer needs, they may not be suitable for everyone. Consider these alternatives:
- Investment Portfolio: Strategic investments can offer additional retirement income and potential growth. A financial advisor can help build a portfolio that may outperform annuity returns.
- Managed Payout Fund: These mutual funds provide variable growth without a guaranteed rate of return.
- Life Insurance Policy: Certain life insurance policies can provide income during retirement and a death benefit for loved ones.
Frequently Asked Questions
Conclusion
Annuities can offer benefits for specific individuals and situations, but they also come with significant drawbacks. It is essential to carefully evaluate your financial goals and consider alternatives before committing to an annuity. Seeking guidance from a financial advisor can help you make an informed decision that aligns with your long-term plans.
Editorial Disclaimer: Investors should conduct thorough research and consider past performance before making investment decisions. Past performance does not guarantee future results.