The life expectancy in the United States is on a steady upward trend. This means that more people are living longer lives. Longer lives translate to longer retirements. And with longer retirements to look forward to, it is essential that we are backed by steady income sources so we don’t end up being burdens.
Annuities are one of the financial instruments designed to help make that happen. On the surface, they make sense. Along with a 401(k) and IRA, they seem like a steady and guaranteed source of income to help fund your retirement. What’s not to like?
A lot, actually, if you ask the critics. Annuities are a very polarizing topic, and they have a fair share of fans and detractors.
Before making a decision on annuities, it is important that you have a basic understanding of what they entail, as well as the pros and cons. This will help guide you on what direction to take when it comes to an annuity.
But before we jump into the pros and cons, let’s quickly consider what annuities are and the different types.
What is an Annuity?
An annuity is a contract that is set up between you and an insurance company. This contract requires that you make a lump payment or a series of payments to the company with the expectation that you get paid in return.
Basically, you hand over some or all of your pension funds to the insurer, and in return, you get a guaranteed income in the future. The payments include the interest earned on the pension funds you paid, and they are usually received as a series of payouts.
They can be set up to generate income for an agreed number of years, or for the rest of your life. Yes, that means that irrespective of the age that you live to, you will continue to receive monthly or annual income to help support your golden years.
When you make an annuity payment, the insurer assumes certain risks on your behalf. These risks include:
- The inflation rate, especially if you purchase an annuity with an escalating payout
- Your life expectancy
- The market performance
Types of Annuity
There are four major types of annuities, with each coming with pros and cons. Let’s look at each of them briefly in turn.
Fixed Annuities Vs Variable Annuities
With fixed annuities, the insurer will pay a specified payment on the premium that you have paid. A guaranteed rate of return over a number of years is agreed on in the annuity contract. This period can be a fixed number or the rest of your life.
Fixed annuities are relatively safe and are suitable for people with low-risk thresholds. The payments are predictable because you know what to expect. Due to the nature of this form of an annuity, the payments also tend to be uninspiring. Because they are fixed, they get significantly influenced by inflation rates.
Fixed annuity premiums are invested in low-risk financial vehicles. The reverse is the case with variable annuities. Here, you choose the investments, such as mutual funds, that have high earning potentials. The insurer goes on to invest the funds in these portfolios.
The amount of money paid to you will vary and depends on the performance of the subaccounts.
Variable annuities come with the potential for higher rates of return on the premium. But as expected, they also come with more risks. However, depending on your deal, the insurer may structure the annuity to offer you different alternatives.
An indexed annuity is a version of a fixed annuity but combines features from both fixed and variable annuities. Here, your returns do not depend on the performance of your investment. Instead, they depend on a stock market index, such as the S&P 500. There are limits to that dependence, though.
Immediate Annuities Vs Deferred Annuities
Annuities can also be immediate or deferred. As hinted by the terms, this classification has to do with when you begin to receive payments from the insurer.
If the annuity is immediate, you pay the insurance company one lump-sum contribution. The insurer converts this sum to an ongoing stream of income and depending on the contract, payments are received for a specified number of years.
On the other hand, the deferred annuity is one where the insurer agrees to make payments at a future date. Unlike an immediate annuity, where you begin to receive payments almost immediately, a deferred annuity is long-term in nature. The income expected can be deferred for decades, depending on how far away from retirement you are.
Pros and Cons of Annuities
Annuities inspire sharply contrasting sets of opinions. A full understanding will expose you to the chances they present, as well as the risks that you face when it comes to annuities.
1. Regular Retirement Income
This is the basic benefit that comes with annuities. An annuity is set up to produce a steady stream of income to supplement your retirement income. Depending on the terms of the contract, an annuity may continue to provide a flow of income for the duration of your lifetime.
At its core, this is a compelling incentive for an annuity. Most other investment types cannot promise or guarantee this kind of regular supply of income, especially if you do not have a huge sum of money to invest.
2. Guaranteed Returns
This is an advantage attached to fixed annuities. When you invest in this type of annuity, you can expect guaranteed returns from your investment. The returns are independent of market volatility or the economic situation. Either way, you will continue to receive your payments from the insurer.
The interest rates on fixed annuities are usually low, and so the payments tend to be limited. Still, this type of annuity presents an excellent deal for risk-averse investors.
3. Tax-Deferred Contributions
Another perk that comes with annuities is that the money you contribute towards the annuity is tax-deferred. What this means is that your contributions grow tax-free until your retirement.
Annuity interest is not taxed until it is withdrawn. When you eventually make withdrawals, you pay tax on the earnings made. This advantage of annuities allows you to benefit from compounding. You can make money and reinvest your earnings until it is time to make withdrawals.
4. Death Benefits
Most variable annuity contracts include a component that provides a death benefit to a beneficiary that the investor chooses. Variable annuities can be risky because they depend on the market situation, but this is a nice perk that comes with it.
Death benefits are triggered by the demise of the investor. The investor designates a beneficiary who gets to inherit the remaining annuity payments after they have passed away. The beneficiary receives at least the amount of money that has been put into the annuity.
1. Annuity Fees and Commissions Can Be Heavy
When compared to other financial instruments like mutual funds, the fees and commissions that come with annuities tend to be quite hefty. The fees vary from insurer to insurer, but you are almost certainly going to encounter costs that represent a significant percentage of the annuity’s overall value.
The different costs that may come with annuities include:
- Annual administrative fees
- Investment expense ratios
- Mortality and expense risk charges
- Commissions to insurance agents
- Annuity riders
- Surrender charges
2. Tax Rates on Withdrawals
One of the significant advantages that are touted for annuities is the tax-deferred benefit on your contributions. However, when you do make withdrawals, those payments are fully taxable.
The taxes are at your ordinary income tax rate, not at the capital gains rate. Still, depending on your income tax bracket, this can be higher than what you would have paid for capital gains tax.
3. Surrendering an Immediate Annuity May Be Impossible
Generally, immediate annuities are irrevocable. What that means is that you cannot surrender the contract after the free look period. After you pay your lump-sum premium, the insurer converts it to a monthly income source for you.
But you may change your mind about the investment. Unfortunately, even if you do, you will find that escaping is virtually impossible. You will not even be able to pass on the annuity to a beneficiary.
Q: What is an annuity?
An annuity is a contract entered into by an investor and an insurance company. In exchange for a premium paid by the investor, the insurer agrees to pay out income. This income can come in the form of a lump sum or a series of payments. It can also be paid out for a specific number of years, or over the lifetime of the investor.
Q: Are annuities a good idea?
An annuity provides regular income that may last out your lifetime and even fall to a beneficiary. Still, it is far from the perfect financial instrument. While annuities certainly have a few pros, there are cons that you should watch out for. You should speak to a financial advisor before deciding whether or not it is a fit for you.
For some people, annuities present a welcome financial instrument. They get to receive regular payments to supplement their retirement income for the length of their lives, together with other benefits. For other people, annuities are simply not worth the trouble.
Either way, it is important that you do your homework before taking a step in that direction. A chat with an investment adviser may be just what you need.
For more guides on financial instruments and general money guides, be sure to check out the Walletorama website.