Weighing the Pros and Cons of Annuities

Due annuity agreement

When you’re pitched an annuity, the salesperson will definitely make it sound enticing. However, nothing in life is perfect. And, that certainly applies to annuities. 

While there are benefits to buying an annuity, you also need to be aware of the drawbacks. By weighing the pros and cons of annuities, you can determine whether or not it deserves a spot in your retirement portfolio

Pros and Cons of Annuities

The Advantages of Annuities 

The biggest knock against annuities is that can be complicated and expensive. To be fair, there is some truth to that. One reason for this is because of the various annuity types you can choose from. We’ve made this comparison before. But, it’s like when you walk inside an ice cream shop and have to select a flavor. Ultimately, you want to pick the flavor that your taste buds will enjoy, as well as other factors like allergies. 

To make things even more complex? You can also add different toppings to your ice cream. When it comes to annuities, these would be riders that you add on. And, an additional ice cream toppings, you’ll have to pay extra for annuity riders.

In short, you need to select the annuity type and optional riders that work best for you. Ideally, they should meet your unique financial and retirement needs. And, you might be able to find this out by taking a closer look at the benefits that an annuity presents. 

You’ll Receive Regular Lifetime Payments

The main selling point, without question, about annuities is that you’ll receive regular payments from an insurance company. These recurring payments can provide a supplemental income during your retirement in addition to Social Security and pension benefits. And, this will help put your mind at ease if you’re concerned that you haven’t saved enough or will outlive your savings to cover your regular expenses. Considering that outliving your savings is a worry for half of Americans, an annuity seems like an effective solution. 

While most annuities will provide you with a guaranteed lifetime income, you can opt to receive payments for a specific period of time. What’s more, the value and number of your annuity payments will vary. Usually, this depends on the type of annuity you’re bough and the terms of your contract.

Premium Protection

What exactly is premium protection? It simply means that you will never lose your purchase payment, aka the money that you started out with. No exception. 

For example, if you invest in a fixed annuity you’re guaranteed to earn a minimum amount of interest on your investment. You won’t be receiving the highest rates. But, it’s safe and predictable. At Due, you’ll get 3% on every dollar deposited no matter what. 

With fixed-indexed annuities, you not only have premium protection, which is clutch when the market is down, there’s also growth potential. That means when the market is up, you have the possibility of growing your investment. Overall, there is little risk with this type of annuity as shielded from market volatility. 

And, considering that investments like stocks place your principal at risk, this gives annuities a huge advantage.

Tax-Deferred Growth

The money that you contribute to an annuity is tax-deferred. That simply means you don’t have to pay income taxes on the earnings from your annuity investments until either you start making withdrawals or receive periodic payments. Just remember, that if you make a withdrawal prior to age 59½ you may be subject to an additional 10% tax.

What’s more, the money you invest compounds annually — without receiving a dreaded tax bill. Why’s that important? It ensures that the money you invest keeps working for, and not against, you.

Unlimited Contributions 

Generally speaking, there are no annual contribution limits with annuities — regardless of your income level or other sources of income. This gives annuities a leg’s up against other tax-deferred retirement accounts like 401(k)s and IRAs. 

In case you’re wondering the contributions for a 401k and 403b is $19,500 in 2021. There is an additional $6,500  “catch-up” contribution for anyone over 50, bringing the annual limit to $26,000. The annual contribution limit for the traditional and Roth IRA is $6,000 in 2020, and presumably 2021. But, if you are over age 50, the limit increases to $7,000.

As such, an annuity lets you put even more money towards your retirement — which is perfect for anyone hoping to catch up.

Choice of Investment Options 

As already discussed, fixed annuities offer a stated rate of return. Usually, this is for a specified period of time. Variable annuities, however, include a variety of investment options that you choose. These include stocks, bonds, and money market instruments that will fluctuate with market conditions.

Legacy Benefits

If you recall, adding a death benefit rider lets you pass your annuity to one or more named beneficiaries after your death. Depending on what is spelled out in your contract will determine how this will exactly work.

For instance, it may be stated in your contract that your beneficiaries will receive a minimum number of payments through a “life with period certain” annuity. The contract could also stipulate that the remaining principle be passed on to your heirs. You can even decide how you want the funds to be distributed — either as a lump sum or a stream of payments.

If you’ve bought a joint and survivor annuity, then your spouse will become the owner of the annuity. They will, however, receive the payments under the same terms that you agreed to.

Long story short, naming a beneficiary in your annuity contract provides an income for your heirs and prevents them from going through probate. For the uninformed, probate is a lengthy and expensive legal process of dividing a deceased person’s estate. 

No Mandatory Withdrawals 

As long as your annuity isn’t a part of an IRA or other qualified retirement plan, you are not required to begin taking minimum distributions after age 72. That can be a sigh of relief if you’re hoping for income later in your life. 

Long-Term Care

Another topping that you want to add to your ice cream cone is a long-term care rider. It’s similar to life insurance in that it can help shelter you against the expenses of long-term care if you ever need it. Unlike life insurance, a long-term care annuity has a growth component and can be passed on to your heirs.  

While this may not be on the top of your mind, the fact is 7 in 10 people will require long-term. Moreover, the cost of long-term is rising. Case in point, a private room in a nursing home costs $290 per day ($8,821 per month). Semi-private rooms average $255 per day ($7,756 per month).

Will long-term care annuity riders won’t cover the entire cost of care? No. Do they offer the same level of reimbursement that traditional long-term care insurance does? Nope. However, they’re less expensive than insurance policies — according to the American Association for Long-Term Care Insurance in 2020, the annual premium estimates for a 55-year-old couple is $3,050.

A long-term care annuity will most likely boost your annuity payout. Usually, this is by some multiple for the duration of time that you require long-term care. For example, your normal income stream may double for five years as you recover from surgery. Another option, if you require long-term, is being able to make large withdrawals for free. 

One more thing. Annuities with long-term care riders have less demanding medical underwriting when compared to traditional long-term care policy. And, even if you do not need long-term care, you can still the annuity if you need the income.

 

The Disadvantages of Annuities 

Are you sold on annuities? Well, hold your horses. 

While annuities definitely have their perks, you must also take into consideration the drawbacks. If not, you’re going to be swayed by the insurance salesman or financial advisor who is selling you the annuity. And, as a reminder, since they want to earn a commission, they will only focus on the pros while glossing over the cons. 

Illiquidity

A major criticism regarding annuities is that you have limited access to your money. This is especially true when you attempt to make a withdrawal during the surrounder period. Usually, you’re only allowed to take out around 10% of the annuity’s value annually. And, some companies also may include a surrender fee. 

If you attempt to make an early withdrawal, meaning before the age of 59 ½,  you may be charged a penalty of anywhere between 5% to 20%.

Also, when you start receiving payments you can no longer withdraw from your account. As such, the only way you’ll be able to access your money is through the scheduled payments. 

High Fees and Penalties

In addition to surrender charges and early withdrawal fees, annuities have a number of fees attached to them including administrative fees, commissions, investment expense ratios, and mortality & expense risk charges. 

And, if you add-on annuity rider like a death benefit or long-term care, expect to dish even more money for your annuity. 

Misleading High Yield Rates

Have you ever signed a contract for internet or phone service? The company will draw you on with an incredible. Then, after a year or so, your bill suddenly increases. Annuity companies engage in a similar trick. 

When you go to buy an annuity, you may be offered an initial teaser rate. Typically, this promises a high yield rate. The catch is that this is only for the first year or so. From there, the returns are determined by how the market performed in that first year. 

In other words, you may get duped into purchasing an expensive, long-term plan with the assumption of a high yield for the lifespan of the plan. In reality, the returns fluctuate and are based on the market performance following the first year.

Difficulty Passing On and Getting Out Of

As you know, in the unfortunate event that you pass away, you can pass on your annuity benefits to someone else. But, it can be a challenge to pass on the benefits of an annuity to someone close to you as there are numerous legal and financial considerations. Additionally, plans that allow your payments to continue to a beneficiary are usually more expensive with lower monthly payouts.

Moreover, if you decide that you want to get out of an annuity, your contract may not let you — this is must true with an immediate annuity. If you do cash out, you most likely will have to pay a fee. 

Financial Risks

The biggest risk with an annuity? You’re putting all of your faith in the financial health of an insurance company. So, if the company fails and you have 30-years left of payments, you’re out of luck. There’s a chance you might able to recover some of your money through your state’s insurance guaranty association. And, remember, annuities are not FDIC-insured. 

With that being said, only work with an insurance company who has is has received a high rating for its financial strength. You can use third-party rating agencies like A.M., Moody’s, Fitch, and Standard & Poor’s.  

Taxes, Taxes, Taxes

It is true you do not pay taxes on an annuity during its growth phase,” writes Greg DePersio for Investopedia. “The money you earn during this period is tax-deferred. However, when you start taking distributions, not only are you taxed, but the rate is higher than for many investments.”

In other words, gains from annuities “are taxed as ordinary income, not as long-term capital gains.”

“This is especially bad news for wealthy investors in the top tax bracket, which is 37% for 2020 and 2021,” adds DePersio “By contrast, the profit from investments that receive capital gains treatment is taxed at a much lower 0%, 15%, or 20%.”

Missed Opportunity Costs

The main perks of purchasing an annuity are that you’re reducing risk and guaranteeing a lifetime income. But, at what cost? Annuities are a long-term investment plan. As such, they have poor liquidity which doesn’t make them ideal to handle an emergency or pursue a better investment opportunity when the market takes off.  

Annuities Are Complex

And last, but certainly not least, annuities can be difficult to understand. For example, payout terms wildly vary on how and when you decide to withdraw your money. Also, the actual return on your investment has so many fees attached that you may not be able to predict your payment. And, if you add annuity riders, this only makes an annuity even more complex. 

 

The Bottom Line

Overall, annuities have a lot of desirable traits. What’s more, they could make a worthy addition to a diversified investment portfolio. This is particularly true if you’re worried about not having enough saved for your retirement or outliving your savings. 

However, annuities are not without fault. They can be complicated, expensive, and prevent you from investing in high-quality dividend-paying stocks. And, they can also be difficult to access or leave to someone else. 

The final verdict? Annuities can be a good investment. But, only if they fit into your long-range financial plan.