When it comes to investing, what images first pop up. Is it the chaotic New York Stock Exchange trading floor? Maybe it’s the stock symbols you anxiously keep an eye on? Or, perhaps, it’s your annual mutual fund report that probably can help you drift off the sleep.
Regardless of what you exactly think of when it comes to investing, I highly doubt that you would lump in annuities. And, for good reason. An annuity is a long-term policy contract between you and an insurance company, not an investment.
At the same time, annuities sometimes have characteristics of investments. And, they may still be able to play a role in your investment portfolio. However, it’s ultimately determined by factors such as your investment goals, your age, lifestyle, risk tolerance, and time horizon for investing.
So, are annuities good investments or not? Well, let’s help you answer that question.
The concept of annuities is confusing for many people. In fact, according to a Secure Retirement Institute (SRI) study, only 25% of consumers managed to pass an annuity knowledge quiz (70%). As such, this can make it difficult to determine whether or not an annuity is a good investment.
With that in mind, before committing to an annuity, you should at least be familiar with the basics.
In the simplest terms, an annuity is simply a contract between you and an insurance provider. With an annuity, you can protect your principal, generate lifetime income, plan for your legacy, and pay for long-term care costs.
With annuities, you can make a premium payment to the issuer in one lump sum or through a series of over a period of time. Similarly, annuity payments can either be one lump sum payment or a series of recurring payments. Among the companies that sell annuities are insurance companies, banks, brokerage firms, and mutual fund companies.
The different types of annuities.
It’s also important to note that all annuities aren’t alike. In fact, there are many types of annuities, and they each have their own benefits and drawbacks. As soon as you know the types of annuities available, you can ask the right questions about them.
A deferred annuity begins paying out after a certain period of time, whereas an immediate annuity pays out immediately. Depending on the individual’s needs, annuities can also be structured differently. You can choose to payout over the course of a lifetime, or you can choose to payout for a set period of time.
There are also three other annuity structures;
- Fixed annuities. During the duration of a fixed-rate annuity, owners receive a fixed rate of interest. For example, every deposit you make with Due will earn you 3%. Therefore, this is the equivalent of a certificate of deposit. Despite the fact that the interest rate won’t change when the market performs well, it is a safe and predictable solution.
- Variable annuities. Variable annuities, in contrast to fixed annuities, fluctuate in value with the market. This makes it a riskier and less predictable option because gains and losses are based on performance.
- Fixed indexed annuities. This annuity combines the advantages of a variable and a fixed annuity in one package. As with a fixed annuity, it offers investors a guaranteed minimum rate of return. A fund may also follow a benchmark index, such as the S&P 500). If the market rises, the fund may enjoy greater gains. You should always read the fine print because caps, spreads, and participation rates will affect the upside.
Why do people buy annuities?
Most people decide to purchase an annuity because it offers the following perks;
- It can be comforting to have an annuity. This is especially true for retirees who are worried about stock market volatility or outliving their savings.
- It is possible to earn tax-deferred interest on an annuity.
- You can make unlimited annual contributions to an annuity — unlike 401(k)s or IRAs.
- When compared to traditional retirement accounts, annuities don’t require you to start withdrawing money at 70 ½.
- Generally, even if you haven’t withdrawn any money from your annuity, your beneficiaries can receive payments after you die.
At the same time, there are some valid criticisms regarding annuities. Most notably, they can be expensive and complex. What’s more, they aren’t federally insured. And, if you make a withdrawal before the age of 59 ½, you can expect a 10% penalty from the IRS, as well as a surrender charge from the annuity company.
When Annuities are Good Investments
An annuity can be a good addition to your portfolio depending on your financial plan and your grasp of the key differences between annuities and equity investments. Remember, annuities are insurance while equity investments are growth vehicles.
Nevertheless, the National Bureau of Economic Research states that “standard economic models of life-cycle spending patterns imply that the portfolio of a risk-averse individual should include a substantial portfolio share in life annuities as a hedge against uncertainty about length of life.”
Combined with the notion that annuities are investments, rather than insurance, this statement indicates that annuities can be a valuable addition to a balanced portfolio. But, again, this will depend on your specific financial situation and investment goals.
Need a starting point? First, you should understand how the different types of annuities and how they play a role in your investment strategy.
Annuities do not offer aggressive growth or capital appreciation.
The growth potential of certain annuities may be higher than that of securities and other growth investments, though annuities do not provide comparable returns to securities. In this case, you may lose your premium, negating the benefit that first attracted you to annuities.
Variable annuities, for example, have characteristics of both stocks and bonds, with the exception that they possess the same features as fixed annuities. These periodic payments, tax deferrals, and mutual fund growth potential. Due to their varying payments, variable annuities are classified as securities in the United States and regulated by the U.S. Securities and Exchange Commission.
Unlike variable annuities, fixed index annuities offer a guaranteed minimum return. That makes them not as risky, but still riskier than a fixed annuity.
When Annuities are Bad Investments
Traditionally, annuities have provided higher returns than other conservative investments. The reason is that they’re backed by insurance companies. Why, then, do annuities make such poor investments?
- In the event of early withdrawal, annuities incur penalties. If you break an annuity, you’ll be subject to penalties. The reason is that they’re long-term contracts designed to last between 3 and 20 years. However, annuities may permit penalty-free withdrawals. Annuitants who withdraw more than the allowable amount will, however, incur penalties.
- Annuities can earn little interest or none at all. Certain annuities are not intended to provide sufficient growth potential. Therefore, you retire with less money in the retirement plan since its growth is too slow.
- Certain annuities do not keep up with inflation. Investing in annuities offers a steady income for life. Annuities do not all provide inflation-adjusted income, however. The earlier you start your lifetime income, the less money you will have in later years since the cost of living will increase too quickly.
- Your beneficiaries might not receive a death benefit from the annuity. In certain annuities, annuitants may choose to receive a higher monthly income in place of a death benefit for their beneficiaries.
- There is only limited liquidity offered by annuities, and sometimes none. You might only be able to access a limited amount of liquidity each year in an annuity without incurring penalties or fees. In some cases, annuities provide no liquidity at all.
- Fees can be high in investment-based annuities. In most cases, annuities don’t come cheap thanks to fees. As such, a cheaper alternative could be just as good.
- In order to withdraw annuity funds, you must be at least 59 ½ years old. If income is taken from an annuity too early, the IRS can impose a penalty.
How Do Annuities Compare to Other Retirement Options?
In terms of retirement planning, you have a number of possibilities. Generally, an annuity is a solid retirement planning option because it has specific benefits, like tax-deferred growth and guaranteed income.
An asset portfolio for retirement should, however, be diversified consisting of various financial instruments like the following.
Certificates of Deposit (CDs)
Certificates of Deposit (CDs) are similar to annuities in the sense that they are very low-risk investments. And, the interest rates on most CDs are guaranteed.
An important difference between CDs and fixed annuities is their tax treatment. CD earnings are usually taxed as capital gains by the IRS. Meanwhile, annuity payments are taxable as ordinary income. Furthermore, CD income is taxable in the year it is earned, regardless of whether the funds stay in the CD. On the other hand, annuities offer tax deferral, so you will not pay taxes until you withdraw your earnings.
Annuities are typically more advantageous than CDs. CDs, however, have the advantage of being offered for short- and medium-term times. For investors wishing to grow their money in a shorter timeframe, CD’s have the edge. Also, this makes CDs more liquid than annuities.
This is an employer-sponsored plan for retirement. Every month, a portion of your paycheck is deducted and invested. In some cases, they even contribute directly to your account.
But, how are 401(k)s different from annuities?
401(k)s are employer-sponsored, so if your company does not offer one, you may not be able to participate. The amount you can contribute is limited as well. If you’re trying to build up a significant retirement fund, that’s not the best strategy. In addition, your earnings are tied to your asset selection. As such, you might earn very little or even lose money depending on the performance of your portfolio.
Annuities, by contrast, aren’t tied to a specific employer — everyone can partake. Additionally, contributions aren’t capped. Additionally, you’ll receive steady earnings if you purchase a fixed annuity.
Some people confuse individual retirement accounts (IRAs) with annuities, but they aren’t the same.
IRAs do not qualify as financial products or investments. Rather, an IRA account simply holds your retirement savings and investments. You can also hold stocks, bonds, mutual funds, and even annuities via IRAs.
Tax advantages are given to these accounts by the IRS since they are intended for retirement savings. These accounts are subject to certain rules, however. According to the IRS, you must withdraw your money by a certain date, know what you are allowed to invest in, and how much you can contribute.
Another downside? IRAs, like 401(k)s, have contribution limits. If you recall, this is not true of annuities.
In addition, IRAs do not have a guaranteed minimum interest rate, as fixed annuities do. Furthermore, they cannot guarantee retirement income.
For investors who are looking for tax-advantaged retirement savings and investments, IRAs are an excellent option. Those who want a steady retirement income or to ensure their retirement savings grow should consider annuities.
Stock Mutual Funds
You can invest in stocks using mutual funds rather than choosing individual stocks. Instead, money managers are responsible for choosing stocks within each mutual fund and generally select a diverse group of holdings to maximize interest rate returns.
Unlike annuities, mutual funds can lose money, and they don’t guarantee a minimum rate of return. In addition, they charge annual fees called “loads,” which is not the case with most annuities.
The market has averaged a 10% return since 1976. As such, this makes stocks a valuable component of an overall retirement plan. TD Ameritrade and Schwab are just two examples of public platforms that allow you to invest directly in stocks. And, as a stockholder, you become a partial owner of the company.
It is, however, time-consuming and risky to buy stocks. Unlike minimum returns and state guarantee associations, there are no provisions for safety.
Some retirees receive supplemental income from social security, a government program. Although this is a useful assistance program, we can’t stress the word “assistance” enough. In other words, Social Security is not meant to be the sole source of an individual’s retirement income.
In the first place, not everyone is eligible to receive social security benefits. What’s more, many people receive only about 40% of what they earned before they retired. As a consequence, you might struggle to survive on that amount.
In order to maintain their standard of living in retirement, many retirees have additional savings. With that in mind, an annuity can provide supplemental income to what you receive from Social Security.
Does It Make Sense to Add an Annuity to Your Retirement Portfolio?
You may want to consider an annuity if you are consistently making the maximum contribution to your 401(k), IRA, or other retirement accounts, as it may provide you with another way to save for retirement. You may be able to find steady income in this way if you are nearing retirement.
If you choose to purchase an annuity, be sure you know exactly what you’re getting into. Different annuities invest and payout funds in different ways. Also, annuity charges tend to have higher fees than a 401(k) — or other retirement investments that compose your portfolio.
Annuity Invest FAQs
1. Are there disparities between the potential sources of retirement income and retirement expenses?
Assess projected retirement expenses and unexpected costs (e.g., medical expenses) against retirement savings and portfolio investment mix. Retirement expenses may exceed income in retirement, in which case an annuity might be useful.
In the event that you outlive your savings, an annuity may provide some protection. By paying into an annuity, you receive a guaranteed income stream from the insurance company. In some types of annuities, the guaranteed income continues throughout the annuity owner’s life despite market fluctuations.
You may be able to apply for an annuity to help fill gaps in your retirement income plan with the help of a financial professional.
2. What kind of annuity is it?
Depending on the type of annuity you choose, you’ll experience different volatility levels and receive different returns. Every investor must analyze risk and return, so this is an important consideration. Generally, you will choose between a fixed, variable, or indexed annuity.
3. Are annuities suitable as investments for elderly people?
As an elderly person’s principal and interest rate are protected, fixed and fixed indexed annuities deserve consideration. In addition, beneficiaries can avoid probate by receiving a death benefit.
Moreover, nursing homes, assisted living facilities, and home health care expenses are a fraction of the cost when long-term care annuities are purchased. And, for married couples with an elderly spouse who needs long-term care, Medicaid annuities can be an excellent investment. This is because the married couple can still have assets while drawing Medicaid benefits.
As for variable annuities, they might not make sense for the elderly. Mainly, this is because they can lose money if the market performs poorly. And, due to the fact that the contract owner must surrender control over their money, immediate annuities also don’t make sense.
4. Do additional tax-deferred options make sense?
Retirement savings vehicles like IRAs and 401(k)s provide tax-deferred growth of money without triggering an income tax bill until the money is withdrawn. You can also invest in annuities to earn tax-deferred income in retirement.
Take deferred annuities as an example. There are funded with after-tax money. That means any growth that’s generated is tax-deferred until it’s withdrawn. It’s also taxable as ordinary income. And, always remember, there may be a 10% federal tax penalty for withdrawals from an annuity prior to age 59 ½.
Work with a financial professional to identify the best tax-favored options for your retirement savings.
5. How can you reduce the impact of negative market performance within your financial portfolio?
Market downturns can significantly impact retirement savings, especially early in retirement when people are beginning to withdraw. Afterward, it may be difficult to regain the account value – and the account value may never catch up to what it would have been if the market had not fallen.
Annuities can mitigate the volatility of the markets. How? Because annuities typically guarantee a minimum annual return or minimum income rate. Even better this is regardless of market performance. Or, at the very least it can cushion the account value from a portion of market losses.
It is impossible to find one solution for planning for retirement income. If you are using an annuity as part of your overall financial plan, your financial advisor can assist you.