Retirement Annuities: Know the Pros and Cons

Retirement Annuities: Know the Pros and Cons

They can be a secure way to avoid outliving assets—but watch out for fees

Retirement Annuities: Know the Pros and Cons

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Reviewed by Anthony BattleFact checked by David Rubin

Retirement Annuities: The Basics

The basic idea behind these insurance products—a guaranteed stream of income, often for a lifetime—sounds pretty appealing. However, critics are quick to point out that they also have a lot of drawbacks, not least of which is their cost compared with other investment options. Before signing a contract, make sure you understand both the pros and cons.

Key Takeaways

  • Retirement annuities promise guaranteed income for a retiree until their death, and sometimes after their death, as a benefit for their spouse.
  • These annuities are often funded years in advance, either in a lump sum or through a series of regular payments, and they may return fixed or variable cash flows later on.
  • While annuities are perceived as having large up-front costs and early withdrawal penalties that make them somewhat illiquid, they can serve as a secure income stream in retirement.

Before discussing the advantages and disadvantages of annuities, it’s important to understand that they’re not all the same. These days they seem to come in an almost limitless number of varieties, but there are four basic choices, based on the two decisions listed below.

Fixed vs. Variable Retirement Annuities

Individuals can typically buy into a retirement annuity with either a lump-sum payment or a series of payments. With a fixed product, you know ahead of time how much you’ll receive once the annuitization phase begins—that is, when the insurer starts making payments back to you. That’s because the rate of return is fixed for a predetermined number of years, or for life. Other fixed annuities, called income annuities (deferred and immediate), depending on your age, can offer fixed income with greater safety than bonds.

Variable annuities work differently. Your return is based on the performance of a basket of stock and bond products, called subaccounts, that you select. There’s a bigger opportunity for growth compared with a fixed annuity, but there’s also more risk during recessions. However, the insurer may allow you to purchase a rider that offers a guaranteed minimum withdrawal, even when the market does poorly. 

Immediate vs. Deferred Retirement Annuities

With an immediate annuity, you pay the insurer a lump sum and start collecting regular payments right away. Some older adults, for example, may choose to put some of their nest egg into an annuity once they hit retirement to ensure a regular income stream.

A deferred product, by contrast, is more of a long-term tool. After paying in, you don’t collect until a specified date. Before you get to that date, your money has the opportunity to either accrue interest (fixed annuities) or benefit from market gains (variable annuities).

Pros

  • Annuities can provide lifelong income.

  • Taxes on deferred annuities are only due upon the withdrawal of funds.

  • Fixed annuities guarantee a rate of return, which translates into a steady income stream.

Cons

  • They’re complex and hard to understand.

  • Fees make annuities more expensive than other retirement investments.

  • Net returns on withdrawals are taxed as ordinary income.

The Pros and Cons of Annuities

There’s much to consider when discussing annuities’ pros and cons.

Pros

Annuities can be attractive for a variety of reasons, including the following:

Income for Life—Perhaps the most compelling case for an annuity is that it generally provides income that you can’t outlive (though some only pay out for a certain period of time). That’s not necessarily the case with traditional investments, unless your nest egg is particularly large. For folks with more modest means, an annuity ensures you’ll have something to supplement Social Security, even if you live to be very, very old.

Deferred Distributions—Another nice perk of annuities is their tax-deferred status. With other popular retirement investments, such as CDs, you’ll have to pay Uncle Sam when they reach the maturity date. With annuities, though, you don’t owe a penny to the government until you withdraw the funds. That aspect gives owners some control over when they pay taxes. Leaving money in a deferred annuity can also help reduce your Social Security taxes, as you have less taxable income when you delay withdrawals.

Guaranteed Rates—The payout from variable annuities depends on how the market performs, but with the fixed type, you know what your rate of return will be for a certain period of time. For older adults looking for a predictable income stream, that may be a better alternative than putting money into equities or even corporate bonds.

Cons

Critics cite the following problems with annuities:

Hefty Fees—The biggest concern with annuities is their hefty cost compared with mutual funds and CDs. Many are sold through agents, whose commission you pay through a considerable upfront sales charge. Directly sold products, which you buy straight from the insurer, can help you get around that big upfront fee.

Still, even then you could be faced with sizable annual expenses, often in excess of 2%. That rivals the cost of an actively managed mutual fund. And if you take out special riders to increase your coverage, you’ll be paying even more.

Lack of Liquidity—Another concern is the lack of liquidity. Many annuities come with a surrender fee, which you incur if you try to take a withdrawal within the first few years of your contract. Typically, the surrender period lasts between six to eight years, although they’re sometimes even longer. These fees can be on the large side, so it’s hard to back out of a contract once you sign on the dotted line.

2% to 3%

The typical cost of annual expenses on an annuity—and it can go even higher.

Higher Tax Rates—Insurers often cite the tax-deferred status of your interest and investment gains as a main selling point. However, when you do take withdrawals, any net returns you received are taxed as ordinary income. Depending on your tax bracket, that could be a lot higher than the capital gains tax rate.

Complexity—One of the cardinal rules of investing is to not buy a product that you don’t understand. Annuities are no exception. The insurance market has exploded over the past few years with a slew of new, often exotic variations on the annuity. Some, such as the equity-indexed annuity, come with fees and limitations that are so complex that some investors don’t fully understand what they’re getting into.

Are Annuities a Good Idea for Retirement?

It depends on your short-term and long-term goals, as well as your comfort with fees and your appetite for risk. It’s wise to weigh the pros and cons. An annuity offers a guaranteed income stream for a set number of years, often for the rest of your life or even beyond it, as a benefit for your spouse. But it’s a complex contract, and it does come with comparatively high fees.

What Is the Downside of Annuities?

Annuities often mean a relatively high level of complexity and fees. The fees can be the same as or even higher than a managed portfolio.

Who Should Not Buy an Annuity?

If your retirement savings are on track to last your lifetime, or even longer, then an annuity might not be necessary. People often buy annuities for peace of mind, to ensure that they don’t outlive their savings. But if that’s not an issue for you, you might want to skip annuities to avoid the complex contracts and high fees.

The Bottom Line

For some people—especially those who are uncomfortable with managing an investment portfolio—a retirement annuity can be a secure way to make sure they don’t outlive their assets. Others may be better off maximizing their 401(k) plan or individual retirement account (IRA) before putting money into an annuity. If you do go for one, just make sure you pay close attention to the fees, avoid the more exotic variations, and don’t take out a bigger contract than you really need.

Read the original article on Investopedia.

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