You may be attracted to the idea of receiving a lifelong income after retirement. Unfortunately, pensions are disappearing. Only 31 percent of Americans currently retire with defined benefit pension plans. While 84% of people receive Social Security Old Age, Survivors, and Disability Insurance (OASDI) benefits, it was never intended to be their sole source of income after retirement.
The above reason may explain why some investors seek annuities to secure their retirement income. However, despite their touted benefits, annuities may not be the best option for reaching your goals. In this case, you may want to seek out alternatives to annuities.
Let’s Talk Annuities
Annuities are generally designed to protect against longevity risk by providing a monthly income benefit during retirement, preventing a retiree from going broke. Moreover, an annuity guarantees that you won’t outlive your retirement savings.
At the same time, there can be a lot of costs associated with that guaranteed income.
The fees charged by annuities include commissions (up to 4%), mortality expenses, guaranteed income fees, and other optional add-ons called riders. In addition, variable annuities typically charge a fee to manage investment accounts. You may see a significant return drop with these fees combined, as they can reach 3% or 4% of your annuity’s value.
Also, a contract for income cannot be annuitized, such as an immediate annuity, so the principal is lost. So instead, the insurance company owns it.
Therefore, you may be entitled to a guaranteed payment stream, but your annuity’s value will be zero upon your death. In contrast, stocks, bonds, and mutual funds retain their value throughout your lifetime and can be passed down to beneficiaries. In the case of variable annuities, the contract’s value isn’t guaranteed to grow. Instead, you might receive a percentage of your annuity’s returns.
And, most income payments are not keeping pace with inflation. A rider for inflation can offset this factor, but you receive lower payments at first and eventually receive more income. Additionally, every optional benefit comes with an additional fee.
Additionally, an annuity might not make sense for you if:
- In the event of a significant expense or an emergency, you need to be able to access funds quickly.
- When you retire, you will have other sources of income to cover all your expenses.
- Your goal is to increase the potential return on your investment by using an aggressive investment strategy.
Best Alternatives to Annuities
In addition to annuities, you should consider several financial security alternatives. These alternatives are available in various shapes, sizes, and risk levels, just like annuities. There are also fixed and variable options available.
A bond is a fixed-income investment. In most cases, you are lending money to a government or corporation with specific terms for payments, interest, and timeframes. Bonds have a clear return on investment, so you know exactly what you’re getting.
The general consensus is that bonds are a safe and liquid investment. However, in addition to U.S. Treasury bonds, corporate and municipal bonds have different yields based on the lender’s creditworthiness and the loan’s length.
Bonds offer stability, which is one of their benefits. In other words, your interest rate will remain the same regardless of what happens in the economy. So, in an otherwise unpredictable world, this can be an excellent option for those approaching retirement.
I would be remiss, though, if I also didn’t mention the disadvantages of bonds as well.
- Bonds do not provide high returns like stocks or other high-risk, high-reward investments.
- Since bonds are a long-term investment, they may not be the best option if you need your money right away.
- Some investors may not find bonds as exciting as other investment options due to their predictability and stability.
- Because bonds must be purchased through the Treasury, the buying process can be a little complex.
- The process of purchasing bonds by yourself, without using a financial service, will also require you to manage the paperwork and track your purchases yourself.
Despite the difficulty of comparing annuities to bonds, many experts say annuities generate more income than bonds. The reason? According to research, retirement portfolios with annuities tend to outperform those with bonds.
Certificates of Deposit
A certificate of deposit (CD) is a savings account provided by a bank or credit union. CDs are interest-bearing accounts with higher interest rates than traditional savings accounts. The catch? You give up access to the account for a certain period of time in exchange for receiving interest.
At the same time, CDs aren’t the most exciting investments. However, they’re safe and predictable. As such, it makes them attractive in uncertain times.
In the case of individual CDs, the Federal Deposit Insurance Corporation (FDIC) offers up to $250,000 in coverage. In addition, the principal and rate of return of CDs are guaranteed, just as they are with fixed annuities as well.
However, comparing annuities with CDs is not fair. The interest on CDs is taxed annually, and they are generally seen as short-term investments. On the other hand, annuities offer tax-deferred growth over a more extended period.
While CDs do have advantages, there are some drawbacks to be aware too:
- Limited liquidity. If an unanticipated need arises, CD account holders cannot easily access their money. In addition, early withdrawals typically result in a penalty, which eats up interest and can even lead to principal loss.
- Inflation risk. When inflation rises, CD rates lag behind it. But when inflation drops, they drop faster. So your money could lose purchasing power if inflation overtakes your interest gains.
- Comparatively low returns. Despite CDs’ higher yields, CD returns are typically lower than those of stocks and ETFs, which are higher-risk assets. Therefore, we face opportunity risk.
- Reinvestment risk. Investors may find that yields have dropped when they lock in a CD rate. So if they choose to reinvest, the APY will be lower due to reinvestment risk.
- Tax burden. CD investors also have to pay taxes on the interest they earn.
Retirement Income Funds
A retirement income fund is a simple way to build income — either to save for retirement or to spend after you have retired. A fund provider may send you a monthly check or manage your assets conservatively for growth and income.
A retirement income fund typically has a conservative asset allocation and is actively managed. Management expenses usually do not exceed 1% for these funds. As a result, retirees who seek professional money management for less than a traditional financial advisor may find these investments useful.
Moreover, retirement income funds don’t all look the same. Similarly to reverse target-date funds, income replacement funds gradually return the money, plus any income or capital gains, until they are liquidated in a predetermined period.
Retirement income funds do not guarantee a specific payout, unlike annuities. The reason is that the asset mix and investment methodology will be determined by each fund. As a result, amounts of payouts and returns vary as well.
These funds save the investor from managing investment portfolios in retirement since they are professionally managed and rebalanced.
Cash is distributed for living expenses by the investment firm for managed payout retirement income funds. With IRA retirement income funds, you don’t have to worry about figuring out how much to withdraw or from which accounts.
But retirement income funds aren’t flawless either.
- It is essential to consider the management expense ratio. This is because the fees charged by retirement income funds are generally higher than those charged by index funds.
- You may not need the asset allocation. For example, investing too much in stocks in retirement income funds may not be a good idea.
- Investing in retirement income can’t replace tax, financial, and estate planning advice. But, in this case, a financial advisor can help.
Are you looking for a high-yield investment for retirement? If so, dividend-paying stocks are an excellent choice. Dividends are payments made by a company to its shareholders every quarter. A dividend is often paid to shareholders as a reward, but it can also attract new investors.
As dividend-paying stocks offer high yields, they can make you a lot of money in retirement. In addition, they have lower volatility than other stocks, meaning they are less likely to lose value.
However, such steady payments come at a cost. “Firms that pay dividends are usually older, well-established companies that aren’t expected to experience blockbuster growth,” explains FINRA. “Accordingly, their shares are less likely to see big jumps than, say, shares from promising young companies.” In contrast, young companies rarely pay dividends because they need to invest their cash in growth.
Other concerns include:
- You are also investing in a company, so you risk losing everything you invest if the company goes bankrupt.
- In general, dividend-paying stocks are highly inefficient when it comes to taxation. As a result, you might end up paying more taxes than if you invested in other investments.
However, dividend stocks have historically outperformed other stocks as investors flock to “safer” investments during market downturns.
Variable Life Insurance
Variable life insurance policies, like annuities, are contracts with insurance companies that allow for tax-deferred growth. The plan provides income to your family or other beneficiaries after your death.
You pay premiums into these policies, and the money is then invested. Based on the performance of the underlying investment, the cash value of the policy will fluctuate. Death benefits are paid to your beneficiaries, usually your family, when the policy matures.
For various reasons, variable life insurance policies can be a great retirement investment.
- In the first place, they offer the potential for growth. Because the policy’s cash value will fluctuate based on the performance of the underlying investment, there is the potential for long-term growth.
- There is also some death benefit protection provided by these policies. As a result, your beneficiaries will receive the death benefit if you die before the policy matures.
- Additionally, these policies provide tax-deferred growth. As a result, you won’t have to pay taxes until you withdraw the money from the policy.
It’s also important to remember that variable life insurance policies typically have high fees. In other words, you may not find them the best investment option if you are looking for a low-cost option. Moreover, the policy’s cash value is subject to market fluctuations so it could fluctuate both up and down.
Variable life insurance policies are most beneficial when you hold on to them for an extended period of time. This is because the more time the policy has to grow, the greater its cash value will become.
1. What is an annuity?
Investing in annuities is a simple contract between an investor (you) and an insurer (the company). Basically, you pay an insurance company money, either as a lump sum or over time. Insurance companies invest your money, so you get a guaranteed series of payments in return.
Unlike other insurance contracts, payments aren’t tied to unfortunate events or accidents. Instead of filing a claim, the customer determines how their payouts will be delivered.
Whatever your retirement plan, there are some essential factors to consider. One of the biggest concerns of retirees is running out of income. However, Social Security is the number one concern for retirees, according to SimplyWise’s Retirement Confidence Index.
There are also concerns about the unexpected death of a spouse, high medical costs, and investments that do not keep up with inflation. The purchase of an annuity, when combined with other retirement income sources, can make addressing these concerns easier, even though there is no one-size-fits-all solution.
2. Why should an annuity be a part of your retirement?
As part of someone’s retirement portfolio, annuities can provide the following benefits:
- Protection and growth. Growing your money with an annuity is possible without risking your capital.
- Tax-deferral. Taxes are not due until you receive the annuity payments.
- Long-term security. These future costs are covered by long-term care annuities, which also provide supplemental retirement income.
- Inflation adjustments. If you purchase an inflation-protected annuity (IPA), you’ll earn a real rate of return that’s above inflation,
- Death benefits for heirs. If your annuity allows death benefit riders, you can leave your annuity balance to your heirs or spouse.
Furthermore, research has shown that retired people with a guaranteed income are happier and live longer.
3. Why do some people not benefit from annuities?
For some people, annuities do not work for several reasons.
In the event of an emergency, you can’t cash them in because they’re not liquid investments. As a result, you will not benefit from any market growth since they offer a fixed rate of return. In addition, annuities are taxed as income. As such, you could end up paying more taxes than you would if you invested in other investments.
Aside from that, annuities don’t usually earn a lot of interest. They’re indeed somewhat stable. But, even with guaranteed income, annuities can’t keep up with inflation or can be inferior to other types of investments.
4. What is a better investment than annuities?
Depending on your individual circumstances, there might be a better option than annuities. For example, stocks and mutual funds might be good investments if you’re looking for growth. Investing in these options can provide you with retirement income through capital gains.
Money market accounts or certificates of deposit are better investment options if you want something more liquid than annuities. This is because you can easily access these options if you need the money, and they offer relatively high rates of interest.
Lastly, you might want to consider bonds if you seek a less risky investment than annuities. In retirement, bonds provide some stability by offering a fixed rate of return.
5. What is the best age to buy an annuity?
There is no one-size-fits-all when choosing the right age to buy an annuity. Annuities are a good choice for anyone, regardless of age. A variety of factors affect this, such as the type of annuity. In addition, several factors could influence when you need that extra retirement income, including your lifestyle, health, inflation, and the state of your retirement pension.
Even though each investor’s situation will differ, immediate lifetime fixed annuities are generally the best choice for retirees in their mid-70s. Those in their 40s, however, are better off with deferred fixed income annuities.
Conversely, variable annuities are suitable for young investors who don’t mind taking risks. In addition, MYGAs are an excellent choice for investors of all ages, especially those planning to invest in CDs.
You should, however, consult with a financial advisor before making any investment decisions. You can sift through the many options available to you with their help.