Some parts of this blog were updated on March 14, 2018
If you could purchase one product that promised to give you a steady income for life and take the worry out of outliving your assets, would you jump at the chance? While it sounds like an easy decision, this type of product, called an annuity, may not be appropriate for everyone.
An annuity is an insurance contract that is typically used to provide a guaranteed income for life. In the world of finance, however, “guarantees” usually carry hefty price tags, and annuities are no exception. You should fully understand the pros and cons of this product before you decide whether an annuity is right for your investment portfolio. (It may be in your best interest to consult a fiduciary financial advisor before purchasing one of these.)
Types of Annuities
There are many different types of annuities that come with myriad options, riders, disclaimers, footnotes and contingencies.
There are many different types of annuities that come with myriad options, riders, disclaimers, footnotes and contingencies. A financial professional can comb through all the details to help avoid any big pitfalls, as they do get very complicated. Make sure the person you are speaking with is a true financial advisor and not and insurance representative.
The two basic types of annuities are immediate annuities and deferred annuities. An immediate annuity will begin providing an immediate income stream, but you’ll need a lump sum up front to pay for this product. A deferred annuity is more commonly sold to investors who are saving for a future retirement.
The income you receive depends on the annuity subtypes you choose. Three common options are fixed annuities, variable annuities, and indexed annuities.
If you own a fixed annuity, the insurance company sets a fixed interest rate that is paid on the money you put into it. A variable annuity means money will be split into sub-accounts (depending on your risk level) and invested in stocks, bonds and other investments. In both cases the level of your income depends on the value of the annuity once you start to annuitize. In a fixed annuity, your income will not likely change; in a variable annuity, your income will have a minimum amount and could potentially increase if the sub-accounts perform well. (In many cases this doesn’t happen because the sub-accounts would have to outperform what you withdraw as well as the costs of the annuity.)
Indexed annuities are a cousin of the variable annuities, but their performance is linked to an index and they usually force you to hold on the annuity for a longer period.
For risk-averse investors, annuities can be reassuring. Locking in an income stream and skipping the worry of outliving your assets is appealing to many. You can also make unlimited contributions, unlike tax-advantaged retirement accounts.
There are many drawbacks to annuities. Some of these include the fact that annuities are costly; the list of fees associated with them is lengthy. You usually face penalties if you withdraw money early. Additionally, annuity earnings are taxed as ordinary income when you start drawing payments, which could be a significant issue depending on your future retirement income level.
It’s important to keep in mind that by buying an annuity, you are signing a contract with an insurance company to make payments for a period of time or for your lifetime. The insurance company can make changes to the interest they pay, returns, investment options and payouts. Locking your money up for a long time will take away flexibility and it’s important to think through what your true needs are.
Learn more about taxes and how they fit into your holistic financial life by reading our free Personal Capital Tax Guide for Holistic Financial Planning.
This blog is for informational purposes only and is intended to offer guidance; not specific legal or tax advice. Clients are advised to consult their personal estate attorney and CPA before taking action based on this advice.