An annuity is an insurance product. It is designed to pay out a steady stream of income, which is usually desired as part of a retirement strategy. You make an investment into the annuity, then it provides payments to you in the future on a schedule you approve now. Annuities can be structured on several different payout schedules.
There are two general types of annuities from which to choose: fixed and variable. On a fixed annuity, you would receive a guaranteed payout that is based on the amount of money you put into the product. On a variable annuity, your payout is tied to the performance of the investments which support the product’s health.
For some people, an annuity is a wise investment choice. For others, it can be a terrible retirement planning option. That is why a full evaluation of these annuities pros and cons must be done before finalizing any agreement.
List of the Pros of Annuities
1. You can receive an income for the rest of your life.
Some annuities offer what is called an “immediate lifetime contract.” With this product, you are guaranteed to receive your scheduled periodic payments for the rest of your life. It is a process that is similar to a pension or Social Security, though annuities typically provide higher periodic payments. Under such an arrangement, the limit of your payout is based on the amount placed in deposit.
2. Annuities can rise with inflation.
You have the option to customize your annuity to provide cost-of-living increases that are based on the current levels of inflation. Over the long-term life of an annuity, inflation can dramatically reduce the actual value of the payments you would receive, especially on a lifetime contract.
Here’s an example of how inflation reduces the value of an annuity over time. In 2000, using a standard inflation calculator, a product that cost $20 would cost $29.10 in 2018. That means, in less than 20 years, the value has decreased by 45% due to inflation. If your annuity still paid the same amount, you’d have less overall money to spend.
3. Annuities protect your principal investment.
No matter what type of annuity you prefer for your financial wellbeing, all of them guarantee that the value of your deposit or investment will be at, or above, the amount provided. That means you will always receive back the amount of money you invested into the annuity, even when fees are involved.
4. There can be some tax benefits as well.
Purchasing an annuity can provide some individuals with a tax advantage, especially when purchased with an IRA or a 401k. You can rollover qualifying funds into your annuity without paying a tax penalty. That can make your tax responsibilities be much lower when compared to lump-sum payments you may be required to take by the retirement account. You will, however, still be asked to pay taxes on the income provided by the annuity.
5. They offer a predictable outcome.
One of the greatest worries of retirement is not having enough income to make it through. With an annuity, your retirement income becomes predictable. You’ll know how much you have each month, quarter, or year. You can even take some annuities in a lump-sum payment if you prefer. That means you have less overall anxiety compared to those who withdraw money from other types of investments during their retirement.
6. Annuities can be sold to third parties.
Although this option isn’t the first choice most people would choose, you can sell an annuity if you need access to cash quickly. Third parties will exchange a lump-sum payment for the fixed income payments that are received from the annuity. You will not receive the same amount of capital you invested into the annuity taking this option. If you have a large, unexpected expense, however, this benefit can help to keep you financially afloat while you recover from what occurred.
7. Variable annuities let you select your investment options.
Most, though not all, variable annuities give you some discretion in how your money is invested. These options are similar to investing in mutual funds or managing the performance of a 401k. You direct how conservative or risky you want your portfolio to be and the rest is done without you needing to think about it. That means you spend less time choosing your investments, though you’ll be paying someone in the middle to take care of that work on your behalf.
List of the Cons of Annuities
1. Annuities can provide a lower investment return.
The tradeoff with an annuity is that you sacrifice investment potential for predictability. Many other types of investments can provide a higher return for the investment being made. You are guarding against the loss of your principal by taking this investment. For some, such a conservative approach may not provide enough meaningful income during a retirement, which puts some households into a disadvantageous financial position.
2. There are high fees and commissions associated with annuities.
The most common complaint receive about an annuity is their high management fees and commission rates. Annuity commissions can be as low as 1% or as high as 10%. There are 4 different types of annuity fees to consider as well. Insurance charges, which are M&E (mortality and expense) fees, are automatically included in the annuity. Surrender charges limit the number of withdrawals that can be taken without penalty during the first years of the annuity. Investment management fees are based on the investment options provided within variable annuities. Rider charges, which manage inflation, can have a negative impact as well.
3. Not every annuity is a good investment choice.
Fixed annuities are often treated as an ideal solution for those looking to retire with a predictable income. You receive a guaranteed outcome, which means the annuity product typically has a good reputation. Some annuity products are very expensive, may offer unnecessary items, and might not even meet your personal financial needs. That is why it is so important to review every item and feature offered within an annuity product.
4. Annuities can be inflexible.
Once you purchase your annuity, the cash you’ve used for the investment into this product is usually tied-up with it over a long time period. You generally do not have access to the whole deposit once the investment is made. Should a large, unexpected expense occur after the annuity contract is finalized, it may be difficult to meet those financial obligations. Annuities are designed for income support only.
5. It requires a large deposit to offer a meaningful income.
Let’s use a 65-year-old couple as an example here. If the couple purchases a $200,000 annuity for a fixed income, then they will receive a monthly income of around $1,000 per month. That means about $12,000 per year will be distributed from the annuity. The average check from Social Security is about $1,400 per month. If both received Social Security and the annuity payment, they’d have a retirement income of about $3,800 monthly. Without Social Security, an annuity contract of $500,000 would be required at the very least.
6. A lump sum is not provided upon death.
The money which is sent to an annuity becomes money that can no longer be given directly to your heirs. Your estate would gain control of the annuity upon your death. Then your estate could direct the monthly payments to the appropriate heirs. It is always possible that you could die within a couple years of beginning your annuity, which means the large lump-sum payment required to start it becomes difficult to access for some time.
7. Some annuities may come with higher tax rates.
Investment gains and interest are received in a tax-deferred manner with an annuity. That can give it some unique advantages for some taxpayers. It also means that the returns received from the annuity are taxed as ordinary income. For high-income households, that means the taxes paid on an annuity payment could be over 10% higher than if it had been taxed at the going capital gains rate. For some, a 401k or an IRA is a better option for retirement.
8. Annuities can be very complex.
There are many different variations of annuity products available today. In the past few years, some options, such as an equity-indexed annuity, are complex enough that only those who sell the product are fully familiar with the investment choice. There are good, simple annuities available, so only purchase a product you fully understand to safeguard your wealth.
These annuities pros and cons are important to review because this insurance product is not right for everyone. If you have extra cash and desire a guaranteed income for retirement, it could be a good option to consider. If you like to stay in control of your finances and are a savvy investor, your wealth could grow more outside of an annuity. It really depends upon your unique financial needs and the amount of risk you’re willing to accept.