Annuities are getting a lot of attention these days. As more people become responsible for their own retirement savings, banks and insurance companies are marketing annuities an attractive option. They are a private sector pension that provides a guaranteed retirement income if you don’t have a traditional pension plan. An annuity is basically a fixed sum of money you will receive every year. It typically runs for the rest of their life, although they can also be set-up to expire after 25 years. To get one, you turn over your nest egg to a financial institution. In turn, they provide you with regular monthly or annual payments until your death.
Like any investment option, there are both positives and negatives to be found with annuities. Depending on your financial situation, you may want to be cautious about using your savings to purchase an annuity. Here are the pros and cons to be aware of with annuities.
First, some of the positives.
The main reason to buy an annuity is that it will provide a lifetime income once you retire. In fact, that’s the primary selling point. It’s much like a defined benefit pension plan that you might receive through your employer. Annuities are often attractive if you are concerned about outliving your savings. They typically provide income in retirement that you can not outlive. You could potentially outlive a traditional retirement fund, unless it’s quite large. This is one of the reasons many people are delaying retirement, or un-retiring altogether. If you have modest savings, an annuity can provide a monthly income stream to supplement your Social Security.
Guaranteed Rate of Return
This positive benefit does not apply to all annuities. There are what’s known as “variable annuities” where the rate of return depends on the performance of the stock market. However, there are also “fixed annuities.” They provide you a guaranteed rate of return (say, 2% annually) over a specified period of time, regardless of the ups and downs of global markets. This type of guaranteed return can be attractive to seniors who would rather have a predictable income stream in retirement. You might favor it over weathering the fluctuations of equity markets.
Another strong selling point of annuities is that they generally come with tax-deferred status. With other retirement investments, you are often stuck paying taxes on capital gains or when the investment reaches a set maturity date. With annuities, however, you don’t pay any tax until you withdraw the funds. This provides you with some control over when they pay your taxes. Leaving money in a deferred annuity can help reduce the amount of tax you pay on Social Security benefits. You will have less taxable income when you delay withdrawals.
Now, let’s go over some of the negatives of annuities.
Nothing Goes to Your Heirs
The main sales pitch for annuities is that they provide a regular income stream in retirement that lasts for the rest of your life. If the money you invest in an annuity is depleted before you die, you will continue to receive the same amount of income. For many retirees, the idea of receiving predictable and guaranteed payments for the rest of their life is comforting.
However, there is a flip side to that coin. If you pass away before your original investment has been repaid, the leftover money typically goes to the bank or insurance company. It cannot be reclaimed for your heirs or estate. The payments simply stop. That means you face the risk of your spouse or children having less inheritance.
Some annuities do offer an option to leave a survivor benefit, but you’ll pay extra for it. It can be expensive too. Also, annuity payments made to an heir are typically half the amount you received while alive. Remember that the annuity provider is banking on you passing away before your investment amount is fully repaid. That’s how they make more money.
Fees and Extra Costs
Annuities often come with large upfront fees. They are typically in the form of sales commissions, which can be as high as 10% of the lump sum you’re depositing. You might also see charges as high as 7% if you tap your funds before a “surrender period” has expired. Surrender periods usually range from two years to more than 10 years.
Other fees and costs associated with annuities include administrative fees and management fees. There’s also a host of expensive add-ons (or riders) for items such as the aforementioned survivor benefit. Each of these can cost as much as 1% of the policy’s value per year. These extra costs can hurt your annuity payments in one of two ways. Some riders lower your monthly payments at the outset by a fixed dollar amount. Alternately, the cost of other riders are taken from a percentage of your annual investment returns. Either way, the fees and extra costs on annuities will overall diminish your retirement income.
Not Adjusted to Inflation
Most annuities are not adjusted for inflation, which means you’ll receive the same level of income at age 85 that you did at age 65. Never mind that the cost of living will continue to rise. Consider what could happen to your standard of living in retirement as prices for groceries, medication, and fuel continue to rise while your annuity income stays the same. Your purchasing power and standard of living will slowly be eroded.
Some annuities offer the ability to index your payments to inflation, but that requires you to tack on an inflation protection rider. That’s an optional feature that raises your payouts on the anniversary date of your annuity contract each year. Basically, you can arrange to have the payments you receive increased by the annual inflation rate. However, inflation protection riders can be expensive. They will reduce the amount of income you receive from an annuity at the very start, to make up for the increased payments over time.
A Few More Things
Now that we’ve gone over the basic pros and cons, let’s go over a couple more things that can help you decide whether annuities are right for you.
Your Overall Health
In some ways, buying an annuity is like betting on yourself. Or to be more specific, you’re betting that you won’t pass away before getting paid back. The best-case scenario when buying an annuity is that you outlive your original investment, and continue to receive “free” payments until you die. So if you’re in good health and don’t have a long family history of medical problems, you should consider them.
However, if you have a pre-existing condition or are genetically likely to not live into your 80s or 90s, you might want to reconsider. Remember that your annuity payments aren’t typically able to be left to a surviving partner or children. That makes them a bad bet if, for example, men in your family don’t typically live past 70.
The Rich Need Not Apply…
Annuities are attractive if you’re worried about outliving your retirement stash. However, if you’re in the opposite boat, they aren’t for you. If you managed to amass so much savings before your retirement (via hard work or luck, or a bit of both) that you wouldn’t run out if you lived to be 150, then you’re set. You can close this article right now and move on with your life. You’re going to be fine.
Take the time to calculate your retirement fund and how much it will cost you to live every year. Then figure out how many years you can life that way before the money is gone. If the money doesn’t stretch as far as you would like, consider looking into an annuity. If you have way more money than years left, then don’t bother.
…And Maybe The Poor Shouldn’t Either
This may seem counter to our previous points, but hear us out. While annuities can be good if you’re worried you didn’t save enough for retirement, they have downfalls too. Namely, their finality. Once you buy an annuity, the money is tied up forever. While you’ll definitely receive your monthly payment until you are gone, you’ll never be able to tap into a larger lump sum in the case of an emergency.
Whether it’s a sudden medical expense, family emergency, or natural disaster, tying up your retirement money in an annuity means you won’t be able to make a lump sum withdrawal if you desperately need it. If you have other sources of emergency money, then hopefully it’s not a problem. But if you don’t, well, pay close attention to our next point.
Best Used in Combination
Financial experts advice that annuities should never be your only source of retirement income. If you’re considering buying one, make sure you’re not putting all your eggs into one basket. Annuities can work well as part of a larger retirement plan. So yes, continue to invest your money in stocks, bonds, or GICs. You’ve definitely heard the term “diversify your assets” before. Adding an annuity to your retirement plans is just another way to do this. You will have to trade a bit of potential growth for some guaranteed retirement income. Only you can decide on how much of that trade-off you’re comfortable with.
When To Buy
When you should buy an annuity is a tricky question. Their payout rates are impacted by current interest rates. Right now, in 2020, those rates are at almost historic lows. On the other hand, annuities pay more if you buy them when you are older. Remember, that companies who provide annuities make extra money if you pass away before exhausting your initial investment amount.
If you wait until you are 70 (instead of 67, for example), your annuity payments will be a bit higher. You’re also three years closer to the end of your life, so now you have to circle back to how your overall health is. Some financial advisors suggest buying annuities in stages. For example, buy $50,000 of annuities when you’re 70, then again at 72, and once more at 75. That will slightly reduce your risk.
The Last Word
There are many types of annuities, each with its own sets of pros and cons. Many annuity contracts are complex and often confusing to the layman. While the promise of a guaranteed income for life might sound appealing, be sure to read the fine print of an annuity contract. You’ll see why many people find these to be bad long-term investments. If you don’t feel confident judging the potential annuity terms by yourself, recruit a more money-savvy friend or relative to help you decide.
In the end, you may be better off holding onto your investments. There are plenty of ways to continue investing your retirement funds after you’ve left the work force. Of course, there is no one-size-fits-all solution. Whether an annuity is right for you will depend on your own financial circumstances. Regardless, retaining control over your financial future in retirement may, in the end, provide the most peace of mind.