• Retirement Planning

Your Guide to Annuities: Is an Annuity Right for You?

May 16, 2018 | Amin Dabit, CFP®

Many people are familiar with savings accounts, 401(k)s, and other types of retirement planning — however, if you ask them what an annuity is, you will probably get some shrugs.

Annuities can provide guaranteed income throughout retirement, which sounds great, but annuities are complex products and may not be appropriate for everyone.

What is an Annuity?

An annuity is an insurance contract that is typically used to provide a guaranteed income for life and prevent a situation in which someone outlives their retirement assets. In the world of personal finance, however, “guarantees” usually carry hefty price tags, and annuities are no exception. You should fully understand the pros and cons of these products before you decide whether an annuity is right for your investment portfolio. Consulting a trusted financial advisor before purchasing an annuity can help you determine how annuities might (or might not) fit into your overall retirement strategy.

What Types of Annuities Are There?

There are two basic types of annuities – immediate and deferred.

  • Immediate Annuities: If you need a guaranteed stream of income right away, you can convert a lump sum to an immediate annuity that pays out monthly, quarterly or annually. You can opt to get payments for a fixed number of years or until you die.
  • Deferred Annuities: If you are still several years away from retiring but want to make sure that you have a fixed income when the time comes, you can opt for a deferred annuity. You would invest tax-deferred money in the annuity to receive payments at a later date, and until you are ready to start receiving those payments, your money will grow tax free like your 401k.

Each of these annuities can have multiple options including:

  • Variable: Your money will be split into sub-accounts depending on your risk level, and be invested in stocks, bonds or other investments. The annuity pays a minimum income which could go up depending on performance, but the downside is it has substantially higher fees than mutual funds.
  • Fixed: Your money will earn a fixed interest rate set by the insurance company. When you begin receiving income, a fixed payment is guaranteed.
  • Equity-Indexed: A variation of a fixed annuity where the interest rate is based on an outside index, such as a stock market index. Similar to variable annuity this product pays a minimum rate which might go up if the index performs better.

The Advantages of an Annuity

For risk-averse investors, annuities can be reassuring. A few potential benefits of investing in annuities are:

  • Peace of mind: With an annuity, you won’t outlive your retirement assets.
  • Controlling risks: A variable annuity will let you take risks (via the underlying investment options) while giving you some control of the outcome (via the option of guaranteed minimum income).
  • Tax deferral: When you buy a deferred annuity, the earnings are tax deferred. If you are in a high tax bracket now and expect to be in a low tax bracket at retirement, this can add a good chunk of money to your nest egg.
  • Unlimited contributions: Unlike the tax advantaged accounts like IRA or 401k, there is no yearly contribution limit for an annuity.

Disadvantages of Annuities

Annuities are complex, and can have several drawbacks including:

  • Expense. Here are just a few extra costs associated with annuities:
    • Annual contract fee: This fee is either a fixed dollar amount or an expense ratio. For high value annuities, this fee may be waived.
    • Mortality and expense fee: This fee is for the insurance company to carry the risk that you will live longer than expected.
    • Investment management fees: These are similar to fees you would pay an investment manager.
    • Optional rider fees: Each added rider will be an additional fee.
    • Commission: You will have to pay your broker a commission, which generally ranges from 1 to 10%.
    • Withdrawal or surrender charges: These are fees for withdrawing cash from the annuity prior to the specified date.
  • Reduced liquidity
  • Annuity earnings when you start drawing the payments are taxed as ordinary income
  • Lack of transparency – annuities are very complex insurance products

Should You Get an Annuity?

You shouldn’t consider getting an annuity if you are not already taking maximum advantage of the tax advantaged accounts (401k or IRA) — these plans provide the same tax advantages without as many fees. If you have maxed out all your tax advantaged accounts, however, then annuities could be something worth looking in to.

It’s also important to keep in mind that by buying an annuity, you are signing a contract with an insurance company to make payments for a set period of time or for your lifetime. Any type of “guarantee” comes with a high cost, and not everyone actually needs one.

Additionally, annuities are extremely complex, so if you are considering one, make sure you have done your research and know exactly what you’re buying. Locking your money up for a long time can compromise flexibility so it’s important to think through what your needs actually are. Not all annuities are created equal, so talking to a trusted financial advisor can help you determine if an annuity is the right fit for your retirement goals.

Before You Buy an Annuity

When considering an annuity, it is crucial to do your research and ask targeted questions to ensure you understand what you’re buying, that you’re purchasing from a reputable source, and that it’s a good fit for your needs. Here are some questions you might want to ask when considering an annuity:

  • How will an annuity help my retirement?
  • Is the annuity adjusted for inflation?
  • What are the guaranteed retirement income benefit?
  • What is my risk tolerance? How will buying an annuity influence my risk tolerance vs. investing in a mutual fund?
  • How much money should I put into an annuity? What percentage of my assets should I have in an annuity?
  • What is the rating and strength of the annuity issuer?
  • What are the fees? What are the upfront purchase fees? How much will it cost me every year?
  • How will I be taxed? Will I be taxed when I draw the money? Or when I pay into an annuity? Or both?
  • What if I need to cash out my annuity; how much will I get? What are the surrender charges and penalties? Does my contract have vesting?
  • If my needs change, can I exchange this annuity for another one? How much will it cost? How much money will I lose in the transfer?
  • Is there a free look period and how long is it?
  • What is you commission for selling the product?

Our Take

If you are considering purchasing an annuity, make sure you are aware of the potential benefits and drawbacks, and how it fits into your overall retirement planning. Being fully informed is crucial, so it’s best to consult a trusted financial advisor to help you tease out the complex world of annuities.

Additional Resources

To learn more, contact a financial advisor.

Contact a Financial Advisor


Disclaimer: The information on this website is for informational purposes only and does not constitute a complete description of our investment services or performance. No part of this site nor the links contained therein is a solicitation or offer to sell securities or investment advisory services, except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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