A lot of financial experts and bloggers don’t recommend annuities or even like to talk about them very much. They are more likely to recommend and want to talk to you about investments in stocks, bonds, and mutual funds for growing your wealth and prepping for retirement. That may leave you to wonder what annuities really are and whether you should you invest in them for your retirement years.
I chose to purchase an annuity about 20 years ago (when I was 50) with qualified money I used from a 401(k). Then, about 5 years ago, I took that money and used it to purchase a 5-year deferred annuity that will start paying me beginning in January of 2020. Those payments are guaranteed to me or a beneficiary (my wife who is 20 years my junior) for 20 years, or for my entire life as long as I live (even if I live to be 100 or more). This made good sense for my situation. But, before you decide that an annuity is either a good or bad choice, ask yourself this: Have you taken a really good look at annuities and do they make any sense for you?
The Annuity Reputation
Annuities have a reputation and to a lot of finance people it isn’t a very good one. Sales brokers who sell annuities can earn more than 10% commissions on annuities and there is normally a substantial surrender fee should the investor decide to cash out early. However, there are some annuities that don’t have any sales charges, and therefore don’t have any early surrender fees. That is good reason to find out about them before making any investment decisions.
A good financial advisor will talk with you about participating in a 401(k) plan and your Social Security benefits, pension, as well as a brokerage account for your retirement program. But they will often leave out annuities. So, what do you know about annuities?
It is wise to consider an annuity or at least examine them and understand what they are and why and how you’d use them before you rule them out. For some people, it can actually be a real complement to their financial security and retirement plans, but for others, perhaps not.
Annuities can be a little confusing. The choices you can make each have their own advantages and disadvantages to consider.
An annuity is a cross between an insurance product and an investment. In some ways it is like a life insurance policy in that you can collect money when you die and you can name a beneficiary to get the money when you pass away. But, it is different from life insurance in many other ways. You invest money upfront in an annuity. You collect money from an annuity when you reach the agreed upon date and time of its maturity and continue to collect from it while you are alive. And that’s the point. It provides income for your retirement, year after year.
Unlike life insurance, the good news is that you don’t have to provide any medical information and you are never turned down for it. Also, you should understand that the money you’ll be getting back is primarily your own money that you invest plus any interest and/or earnings that it has made. The gains here are smaller than other “investments”, but so is the risk.
Types of Annuities
There are basically two kinds of annuities: fixed rate and variable rate.
Fixed rate annuities have rates that will not vary and you will know exactly what you are going to have at the contract end. The interest rates you earn are lower here. They are best for long term contracts that have time on their side to grow.
Variable rate annuities are invested based on activity in actual stocks and funds (or are tied to an index) and therefore may gain or lose money regularly and even dramatically. They have more reward potential (upside) along with greater risks (downside) and are unpredictable.
While you don’t pay any premiums on annuities like you do for insurance, there are costs to all annuities and they are different in the fixed and variable types. With variable contracts, there will be management fees that can run up to 3% annually and come right out of the value of it. That’s the fee that the issuers charge for managing it as they alter the investments when the market changes for both your and their own benefit. If you could do it yourself, it would require lots of your time and knowledge and that’s why you pay.
There are also several options when you do finally withdraw money or “annuitize” at the end of a contract. You pick the payout terms like a certain number of years for your payout, or you can take a lump sum or even have it portioned out monthly or annually for as long as you may live (even if you live to be 100 or more!). It becomes part of your income for life. Some annuities even have an immediate payout if you purchase that type or a deferred payout of say 5 or 10 years from the purchase date if you choose that kind of option. The 5 year deferred option is what I have right now that will start paying me in just a few months.
Every variation of the type of payout will alter the amount of money you will receive either monthly, quarterly, semiannually, or annually, and that is a decision that you make. Having a steady stream of income that is predictable and supplements your other retirement income is a real confidence booster in retirement.
The Pros of an Annuity
Annuities should be only a supplemental item to a retirement plan and only about 20%-25% of your portfolio at most if you have it. They are funded with money that is tax deferred and the big plus is that there are no limits on the amount you can use for this tax deferment unlike 401(k), IRA, and IRA CD plans. This feature alone makes them very attractive to high earners who want to reduce their current taxes and invest more in their retirement while they are still in their peak earning years. But remember, you will pay taxes when you receive the money from an annuity just like with a traditional 401(k) or IRA plan.
Another advantage is that you also have the flexibility to exchange annuities if you like. You also have the advantage (in the case of fixed annuities) of knowing exactly what you will get in a predictable way 10, 20, even 30 years from now as your payment.
Also on the pro side, annuities are very well suited for those who are closer to retirement age and can be issued for an immediate payout or deferred for only a few years (5 years is a popular choice and the one that I myself made).
Most importantly, they’re the only instrument that can offer a guaranteed lifetime income stream no matter how long you may live.
The Cons of an Annuity
One of the most confusing parts of an annuity can be figuring out how much it actually costs. Fixed annuities have costs built in making them difficult to identify. Variable annuities have management fees and also have hidden costs.
Another problem with annuities is that interest payments on fixed rate contracts are not very high. Often you see numbers like 2% or 3% annual return on the annuities.
Investments in annuities may require larger opening contributions than a typical account might like an IRA CD or investment brokerage account. Right now annual annuity interest rates may equal or even exceed the ones that banks in the U.S. offer, but beware that bank rates frequently change and annuities rates may not.
And be very careful about this one: Often, in annuity ads, the annual payout rates are expressed as just that, and a payout is not the actual interest rate it will earn. If you see something saying that you will get a payout of 6% annually for 20 years when you “annuitize”, keep in mind that is interest earned plus it includes part of your principal that is being paid back to you. It is not 6% interest as you may think at first. Be cautious and ask questions if you don’t fully understand what’s being offered.
Caution About Insurance Companies
I feel very comfortable about my decision to purchase an annuity and soon I will be getting those monthly deposits. But, annuities are only as good as the companies that are offering them, so it’s important to do your research on them before you make any investment.
An annuity is not FDIC-insured and does have some risk. That risk is the safety of the company itself. But many of these insurance companies have been in business for decades and decades without any problems. There are places like Moody’s and Standard & Poor’s as well as A.M. Best who rate them all regularly. Make sure that you check to be sure they have good ratings, but look specifically for AA++ through to AA– before you buy.
So are annuities good or bad for your retirement? That very much depends on your situation and the particulars of the annuity you are considering. It’s worth looking at whether an annuity can be one component of your retirement plan, but make sure you understand all the details of what you’re being offered. And if you find your advisor is pushing annuities hard, particularly as a large part of your portfolio, it may be time to find another advisor.
Do you have an annuity as part of your retirement planning? Do you understand them and do they appeal to you? Why do you like or dislike them?