Retirement annuities are perhaps the most popular investment product. These insurance products offer a guaranteed stream, sometimes for a lifetime, of income. This sounds pretty appealing. Critics quickly point out the many drawbacks of these insurance products, including their high cost relative to other investment options. Everybody wants the best performing retirement annuity. However, before you sign a contract, be sure to understand the pros and cons.
Before we get into the pros and cons of annuities, let’s be clear: they are not all created equal. They seem to be available in an almost endless number of variations, but there are only four options based on these two choices.
Fixed vs. Variable retirement annuities
A retirement annuity can be purchased with either a lump sum payment or a series. Fixed products allow you to know in advance how much you will receive when the annuitization phase starts. This is the time that the insurer begins making payments back. Because the rate of return is predetermined for a set number of years, or for life, it can be difficult to predict what you’ll receive. The rate of return is generally in the same range as a certificate or deposit (CD), so they are usually conservative. Other fixed annuities, called income annuities (deferred or immediate), can offer rates significantly higher than CD rates, most bond coupon rates, and greater safety than bonds.
Variable annuities are different. The performance of subaccounts (stock and bond products) determines your return. While there is more growth than a fixed annuity you also have to take on more risk. The insurer may permit you to buy a rider that guarantees a minimum withdrawal even if the market is performing poorly.
Immediate vs. Deferred Retirement Annuities
An immediate annuity allows you to pay a lump sum to the insurer and begin receiving regular payments immediately. To ensure regular income, some older adults may decide to invest a portion of their retirement nest egg in an annuity.
Deferred products, on the other hand, are more of a long-term investment. You don’t get your money until you pay in. Your money can either earn interest (fixed annuities), or gain market gains (variable and annuities).
Annuities: The Pros and Con
When discussing the pros and cons of annuities, there are many things to take into consideration.
Pros
Annuities are attractive for many reasons.
Income for life–Perhaps the best argument for an annuity, aside from the fact that it provides income you can’t lose (though some only pay for a specific period). This is not the case for traditional investments unless you have a large nest egg. An annuity is a good option for those with less income. It will provide you with supplemental Social Security even if your life expectancy is very low.
Deferred Distributions–Another nice perk of annuities is their tax-deferred status. You will have to pay Uncle Sam at maturity for CDs and other popular retirement investments. Annuities don’t require you to pay any taxes until you withdraw your funds. This gives the owner some control over when taxes are paid. Deferred annuities can help you reduce Social Security taxes because you have less taxable income if you wait to withdraw.
Variable annuities have guaranteed rates. The market’s performance will affect the payout, but the fixed type gives you a predictable rate of return for a set period. This may be a better option than investing in equities and corporate bonds for older people who want a steady income stream.
Cons
Critics point to the following issues with annuities
Hefty fees–Annuities are more expensive than mutual funds or CDs. This is the biggest problem. Agents sell many annuities, and you have to pay a substantial upfront sales fee. You can avoid that large upfront fee by buying directly from the insurer.
Even so, you might still have to pay large annual expenses, sometimes exceeding 2%. Even for mutual funds that are actively managed, this would be a high amount. You’ll pay even more if you add special riders to your coverage.
A lack of liquidity–This is another concern. A lot of annuities have a surrender fee. This is if you withdraw from your contract within the first few year. The surrender period typically lasts six to eight years. However, they can sometimes be even longer. These fees can be quite high, so it is difficult to cancel a contract after you sign the dotted line.
Higher Tax Rates – Many investors cite the tax-deferred status for your investment gains and interest as a selling point. Any net returns received after you withdraw are subject to ordinary income tax. You may pay a higher tax rate depending on your tax bracket.5 Young people should maximize their 401(k) or individual retirement accounts (IRA), before investing in variable annuities.
Complexity–Investing is all about understanding the product. Annuities are not an exception. In the last few years, the insurance market has seen a surge in popularity with many new and often more exotic annuities. Some, like the equity-indexed annuity have fees and limitations that are so complicated that few investors truly understand what they’re buying.
