Pop quiz. What springs to mind when you think of investing?
You probably envision Wall Street and the frantic pace of the New York Stock Exchange floor. There are some of you who may visualize Fortune 500 ticker symbols. You could also think of the less exciting pie chart on your annual mutual fund report if you’re not much of a risk taker.
But, have you ever thought about annuities? Probably not. Financially speaking, annuities are not considered investments. Instead, annuities are insurance products that guarantee income at retirement.
However, this does not mean you should not invest in annuities. And, on the flip side, it doesn’t mean you should either.
I know. That sounds contradictory. However, your personal investment objectives will determine whether or not an annuity is a good investment for you. It’s also important to consider your age, time horizon for investing, risk tolerance, and lifestyle when determining your investment objectives.
However, if you’re unsure whether annuities make sense for you, the following guide may help.
What is an Annuity?
Annuities are confusing to a lot of people. In fact, only 25% of consumers passed an annuity knowledge test (70%) according to a study by Secure Retirement Institute (SRI).
Due to this confusion surrounding annuities, it can be difficult to decide if they are a good investment and worth adding to your retirement portfolio. But let us simplify it for you.
What exactly are annuities?
Annuities are simply contracts between a person and an insurance company. Annuities are best known for protecting principals, providing lifetime income, and planning for long-term care needs.
You might see annuities marketed as investments when you’re shopping for them. In retirement, this investment is aimed at generating income for you. It’s important to remember that this is a contract, not a retirement plan.
In the event of a breach of a contract, expect hefty penalties. Consequently, annuities are not as accessible as savings accounts.
How are annuities investments?
During retirement, annuities can provide income and growth that are tax-deferred. Annuities can be categorized into two types: fixed annuities and variable annuities. Variable annuities are based on the performance of a market index, such as the S&P 500, whereas fixed annuities pay a guaranteed rate of return.
The use of annuities as a retirement income supplement is becoming more and more popular. This is mainly due to the fact that pensions are becoming extinct like the Dodo. In fact, only 15% of workers in the private sector have access to one, according to the March 2021 National Compensation Survey from the Bureau of Labor Statistics (BLS).
However, those who have invested heavily in stocks or bonds may find annuities particularly beneficial. Why? Annuities provide a source of income independent of market fluctuations.
Annuities come in many forms, but a fixed index annuity is among the most popular. As well as providing tax-deferred growth, these annuities protect you from downside risk. In this regard, fixed index annuities can be an effective retirement planning tool.
As an example, you’ll earn 3% interest on every dollar you put into your Due annuity plan. And, that’s guaranteed.
How does an annuity work?
An annuity is an arrangement in which the owner of the policy transfers the risk to an insurance/annuity company. Through the premiums it charges, the company offers the annuity assumes the risk for the owner. Annuities can have a single payment or several payments, depending on the type. Premiums are paid during the accumulation phase.
As opposed to other types of insurance, annuities do not require continuous premium payments. As time goes on, you’ll no longer need to make annuity payments and will begin receiving payments instead. This is when the payout phase of your contract begins.
There are a number of ways in which annuities can be paid. You can design an annuity to provide you with payments throughout your lifetime or the lifetimes of your heirs. You can also combine a lifetime income stream with a guaranteed payout over a specified period.
How does a “life with a certain period” annuity work? It promises lifetime income. But, your beneficiary will receive the remaining value of the account if you die within a specific timeframe.
It is common for annuities to be paid over an extended period of time. Like Social Security, they are also based on life expectancy. As a result, if you begin receiving income much earlier in life or if the term is longer, you should anticipate smaller payments.
Annuities can be paid monthly, quarterly, annually, or even as a lump sum. Furthermore, they can be begun immediately or deferred for a long time.
The different types of annuities.
We briefly touched on fixed and variable annuities. But, there are actually five types of annuities that you can choose from. It’s like ordering a taco. Although pretty much the same, you have the choice between beef, chicken, pork, fish, shrimp, or beans. And, each protein slightly modifies your meal.
Fixed annuities.
Throughout the term of the contract, owners of annuities receive a fixed interest rate. With Due, for instance, you will receive 3% on all deposits. So, it is similar to a certificate of deposit. It is a safe and predictable option, even when market performance is good.
Variable annuities.
The returns on a variable annuity differ from those on a fixed annuity since they are linked with the stock market. In other words, its performance determines how much it will gain or lose, making it a less predictable and riskier option.
Fixed indexed annuities.
An annuity of this type combines the advantages of both a variable annuity and a fixed annuity. It provides investors with a minimum guaranteed rate of return, similarly to a fixed annuity. However, it also tracks an underlying index (e.g. the S&P 500). Therefore, rising stock markets can result in higher gains. You should always read the fine print, as there are caps, spreads, and participation rates that can impact the upside.
Immediate annuities.
Basically, you pay a lump sum to the insurance company and start receiving income payments right away. After the payment has been made, payments are usually made within 30 days. Lifetime payments are available in some immediate annuities, while fixed payments are available in others. In general, interest rates affect annuity income, which will impact payouts.
Deferred annuities.
In this case, there is also an upfront payment involved. Annuity payments will, however, be issued later. Since deferred annuities have more time to grow, they may offer higher payouts than immediate annuities. In exchange, early withdrawals are difficult.
How Do Annuities Benefit Investors?
A key benefit of investing in annuities is that they provide regular income before or during retirement. Moreover, your contributions are tax-deferred. Annuities are also exempt from a contribution limit or required minimum distribution (RMD).
There are several additional benefits, including:
Guaranteed income source.
Having a guaranteed income source reduces the worry that retirees and pre-retirees will lose retirement savings in a downturn or outlive them. You fund the account with an annuity and typically earn a predetermined amount of interest, regardless of market conditions. With variable annuities, this can be different as they’re exposed to the market.
Premium protection.
In my opinion, this cannot be emphasized enough. An insurance company guarantees a minimum interest rate and principal in a fixed annuity. Therefore, the value of your fixed annuity will not decrease as long as the insurance company is financially sound.
Tax advantages.
Contributions to an annuity are tax deductible as well. It has no contribution limit, unlike IRAs and 401(k)s, which do have a limit on how much you can contribute annually. In the event that you have maxed out your other retirement accounts, annuities may be a good option for tax-deferred savings.
The right annuity can help you hedge against inflation.
Variable annuities are better suited to inflation hedges than fixed annuities. When used properly, variable annuities can guarantee you maintain your purchasing power throughout retirement if you boost your periodic payments by at least the cost of inflation based on your investment decisions.
Long-term care. Many retirees overlook this costly expense.
But, it is possible to insure against some of these costs with an annuity.
No RMDs.
Traditionally, withdrawals from retirement accounts must be made by the age of 7 ½. In contrast, retirement annuities do not carry that stipulation, so the funds may grow until needed.
Flexibility.
Through what’s known as a 1035 exchange, you can transfer money from one annuity to another, even if they’re with different companies. Taxes are not applied to your annuity earnings when using this method. It’s also possible to hold an annuity in a retirement plan, such as a 401(k) or IRA, or outside of one.
Are There Any Risks Associated with Annuities?
Yes. There are risks associated with annuities, just as with any investment. As such, despite the fact that annuities promise retirees a steady income, they also come with some sacrifices.
Annuities are complex.
The complexity of some annuities makes them difficult to understand without professional assistance. In fact, the structure of an annuity is the most complex of all retirement payment plans. Most insurance providers offer lifelong benefits as their most attractive selling point. However, retirees are grossly misled about the high taxes and the payment calculations.
There is a missing income benefit.
Annuities provide a lifetime income stream by saving money now. At the same time, you would lose that long-term benefit if you passed away suddenly. A beneficiary can be designated with some annuities, but there may be an additional charge.
Locking up money you may need.
If you suddenly need those funds, it can be difficult to access your annuity investment or cash it out. In some immediate annuities, after investing your principal, you lose access to it even though payments begin immediately. In some cases, you may be able to withdraw your principal or select time periods during which you can do so. But your monthly payment may be smaller. Also, you will usually have a 10% penalty if you withdraw from a deferred annuity before you turn 59 ½.
Annuities can be pricey.
Depending on the type of annuity, owners may have to pay high fees. Variable annuities, for instance, can charge fees between 2% and 3%, decreasing the value of your account and your investment return. You may also run into mortality and expense risk charges, administrative fees, and charges for add-ons like stepped-up death benefits.
Conservative payouts.
Even though annuities offer security and predictability, their returns aren’t as high as other investment options.
Insolvent insurance companies.
It is important to ensure the company you purchase an annuity from is around for the long haul since annuities are long-term investments. An investor should research annuity providers’ credibility, history, and credit standing.
Annuities: When They’re a Good Investment
Let’s be crystal clear. Annuities are insurance products. This means you buy it to mitigate some of the investment risks.
At the same time, not all annuities are alike. With some annuities, such as variable annuities, you can choose from stocks and bonds as investment options. In other cases, they are true insurance rather than investments.
There’s one thing an annuity does extremely well. It can protect you from longevity risk. For those unfamialir, this is the risk of living a lot longer than you expected.
Basically, annuities are ideal if you’re healthy and look forward to living a long and meaningful life. If this is the case, annuities ensure you won’t outlive your money. So, an annuity can be a wise investment if you are buying it for this reason.
The right annuity might be right for you if you know what you want out of retirement. Aside from that, you should find out how the annuity will help you achieve those goals, as well as what fees and restrictions the product has.
Having an understanding of how annuity income is taxed, what investment options are available, and how annuities work with other investments is also important to know.
A good rule of thumb for determining whether you are a good candidate for an annuity is:
- Your retirement savings goal is to grow steadily at a low level of risk.
- As a retiree, you want to earn interest on your nest egg in a safe manner.
- In addition to your other income sources, you would like to supplement your retirement income.
- Long-term investing is important.
Finally, a white paper published by 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.”
When viewed along with the notion that annuities are investments rather than insurance, this statement supports the notion that annuities can be a valuable addition to a balanced and diversified investment portfolio.
Annuities: When They’re a Bad Investment
Do not purchase an annuity without checking your entire financial picture first. There are some people who sell them with good intentions, but they may not have a complete understanding of what they’re selling. For instance, their understanding of tax issues might be limited. In addition, they cannot see how the product fits into your retirement plan if they haven’t done any planning for you.
It is also important to be aware of the fees associated with annuities. After all, your returns will be lower if you pay high fees. And, in most markets, you will not earn a lot of money from some annuities due to high fees.
If you do not have a plan in place, never buy an annuity. So, until you have done your research on annuities, you shouldn’t feel pressured or obligated to buy one.
You might hear from a sales agent that an annuity’s sale will be short-lived. There are times when insurers stop selling specific products, which could explain this. Even so, you should not rush into making a decision. And, always remember that a similar product will likely be available elsewhere.
The Bottom Line
There are a lot of controversy surrounding annuities. But, in the end, whether an investment is sound for a particular individual depends on various factors. At a minimum, your age, current retirement savings, and retirement goals.
In addition to their fees, annuities have some disadvantages compared to other retirement accounts. Even so, you may decide that an annuity is a smart investment option. Primarily, it may make sense if you want a lump sum distributed over a longer period of time. Or, if you have already maxed out other retirement accounts like your 401(K) or IRA.
If not, you might be better off investing elsewhere for your retirement.
FAQS
1. How can annuities be invested?
Unlike variable annuities, fixed-rate annuities offer a predetermined return determined by the insurance company. With a variable annuity, though, you determine how to invest your money within the subaccounts.
2. Do annuities have high fees?
Despite the misconception, there are some annuities with low fees. There are some annuities sold by investment companies without sales commissions or surrender charges, known as direct-sold annuities. Also, annuities can be purchased from a variety of brokerage firms at a low price. For more information, you should contact a financial advisor.
3. What are the drawbacks to annuities?
The majority of people can benefit from annuities. But they also have some drawbacks to be aware of.
The major concerns are long-term contracts, losing control over your investment, and low or no interest earned. Other possible disadvantages are the fees and complexity. In addition, annuities have fewer liquidity options, and you have to wait until age 59 ½ before withdrawing money from them.
4. What happens to my annuity after I die?
Your annuity account can be assigned a beneficiary, but doing so may come at a cost. In other annuities, the payout only lasts until you die, and payments stop after you do. Prior to investing, find out what payout options are available for beneficiaries.
5. Who shouldn’t buy annuities?
Generally, individuals seeking short-term investments to invest around frequently and those with little or no liquid assets should not purchase annuities.
