Before we get started, let me state that this post on annuities will be general in nature, and will not cover every single detail of them. They are simply too complex to cover everything in this post. Also: I am NOT recommending them. And you should absolutely work with an independent, objective financial professional (who won’t receive a commission from a sale) to discuss whether one of these products is right for you.
With that out of the way, the first question we want to ask is…
What Is An Annuity?
An annuity is a contract you enter into with an insurance company. You pay the company via a lump-sum or through a series of payments and in turn get regular disbursements at a certain point in time (which you can control depending on the type of annuity that you buy). Those are known as immediate annuities or deferred annuities.
You can buy an annuity within your retirement accounts, or outside of them in a taxable account.
Further, you will receive payments from your annuity depending on the policy. Some offer payments for a fixed period of time (like 10, 20, or 30 years) while others offer payments for the length of your life. Others offer annuity payments to married couples for as long as one of the spouses is alive (also called the Joint and Survivor Annuity).
As you can tell, there are a lot of variables, and the variables depend on the type of policy that you purchase.
While there are several different types of annuities, three of the most common ones are: fixed, variable, and fixed indexed.
- Fixed Annuities. These annuities pay a guaranteed rate of interest and generally tend to attract people who are more conservative with their money, and would rather have a guaranteed* (see disclaimer below) rate than the potential for a higher (but not guaranteed) return.
*Annuity Guarantees* Insurance companies can offer a guaranteed rate of return on their products, like on a fixed annuity. However, there is NOT a guarantee that the insurance company will, for the length of your lifetime, remain solvent and have the money to pay all of their claims. So I do recommend that you make sure that the insurance company you purchase from is in good financial health.
When you purchase a fixed annuity, you can start receiving the annuity payment immediately or you can opt for deferred disbursement. While there are differences, a fixed annuity is similar in some ways to a CD, which also offers a fixed rate of return.
Example: Based on data from Schwab’s Income Annuity Estimator, a 65-year-old man could currently expect to receive monthly payments of about $481 in exchange for purchasing a $100,000 annuity. (Source: Morningstar)
- Variable Annuities. In a variable annuity, you choose a mutual fund to invest in. The value of your annuity will depend on the performance of the mutual fund you select. So unlike the fixed annuity, which offers a guaranteed* rate of return, your variable annuity does not have a guaranteed rate of return, as it is dependent on the mutual funds you choose and their performance.
It is possible to purchase something called a rider (an addition to the normal policy) to guarantee an income stream regardless of performance (in the case your mutual fund does poorly).
Further, variable annuities can have quite high fees – so you will want to make sure you know the total cost. Some typical expenses include: Account fees, investment fees, mortality fees, rider fees, and more! These fees are required to be disclosed on the contract, so please understand them before purchasing.
You are able to have an immediate variable annuity or a deferred variable annuity.
- Fixed Indexed Annuities. An indexed annuity is, in my mind, much more complex than the previous two types mentioned. The index annuity you purchase has its value tied to a specific stock market index, like the S&P 500. However, you do not technically own shares in the S&P 500 index.
Rather, your annuity value earns a percentage of whatever gain the index earned. This is called the participation rate. For instance, if the index you choose earns 10% in a year, and your participation rate is 80%, then your annuity will be credited with an 8% return.
However, there might be something called a cap rate, which limits the return that can be credited to your account. If a contract has a 7% cap rate, and the index tied to that contract earns 10%, then the maximum your account will be credited is 7%, even though the index earned more than that.
On the other end of the spectrum, if your index loses value, your principal will stay the same. If your index is down 10%, your annuity value will stay even. So these annuities offer downside protection that some people find attractive.
These annuities also might offer some type of minimum guaranteed return, although some do not.
When it comes time to start receiving the annuity, you can generally choose to receive lifetime payments, or you can choose to make discretionary income withdrawals. The amount you receive on each of these options depends on the value of the annuity at the time you start your distributions.
Lastly, be aware of all the fees that are included, as these contracts can get quite costly.
It’s important to remember that some annuities are complex, and we have not discussed all the details in this post.
Also: some annuities may have very high sales commissions for the agent who sells it to you.
Some annuities might also have something called a surrender period – i.e. you can’t get out of it for 5 to 10 years without paying a “surrender charge”. Those charges depend on the policy, but they can be steep, and they lower the value of your account.
Before you opt for an annuity as a source of income for your retirement, it’s best to talk with an objective, independent financial professional to make sure it is truly in your best interest to purchase one.
Pros and Cons of Annuities
Let’s start with the pros:
1. Reliable, stable income stream. For a product like a fixed annuity, you will know exactly what dollar amount you will receive in monthly income.
2. Lifelong income. Depending on how you structure your annuity, this income can last for the length of your life.
3. Not at risk of market losses. This is especially true of fixed annuities and fixed index annuities.
However, there are some significant cons that we need to consider as well:
1. Lack of inflation growth. For some annuity products, the income they provide does not adjust for inflation. Which means the $1,000 you receive in annuity income in 2021, will still be $1,000 per month in 2035. So when you consider what inflation does to your purchasing power, that can really put a damper on your retirement lifestyle.
2. Hefty, and hidden fees. To put it mildly, many annuity contracts are quite complex. And inside of that complexity, there are lots of fees hidden throughout the contract. While you might like the idea of that stable income, you have to first discover all the fees, and then determine if it’s actually worth it.
3. Lack of flexibility. We discussed before something called surrender periods, which ties up your money for certain periods of time in the annuity. However, for certain products, you are locked into that contract and that product for life. With annuity products, you simply have less flexibility than you ever would with traditional investments in a stock/bond portfolio.
4. Your returns could be lower than market returns. Since you are paying this insurance company to give you this income stream, you are giving up the chance to earn market returns with your money. Which means that you could be giving up much higher potential returns by putting this money into an annuity and getting that stable income.
5. Your beneficiaries may not receive anything at your death. Again, this point depends on the type of annuity you pick. Some annuities do allow you to name death beneficiaries, and they may receive some kind of inheritance at your passing from the annuity. However, there are a lot of annuity contracts that simply end at your life. So when you die, whether that is 2 years, 5 years, or 30 years after buying this annuity, your beneficiaries will not receive anything.
Wrapping Up
So we’ve really gone over a lot today. We covered the three main types of annuities, as well as their pros and cons. If you’re still on the fence about purchasing an annuity, do yourself a favor, and please go talk to an independent financial or insurance professional so you can make the best decision for you and your retirement.