Annuities: Why I Should Consider Guaranteed Income Options
Annuities often get a bad rap because they can be confusing, and some types come with loads of fees that aren’t always transparent. But the truth is annuities are neither inherently good nor inherently bad. And the best annuities offer a guaranteed retirement income stream with low, fixed costs that are presented upfront.
Whether one is right for you depends on a variety of factors, including how much you’ve saved for retirement, how many sources of retirement income you’ll have and your comfort level with managing your savings to make it last. But an annuity is at least worth considering since according to the Alliance for Lifetime Income’s Protected Income Index Study, nearly 60% of non-retired Americans believe they won’t have enough money to last through retirement.
What is an Annuity and How Does it Work?
At its most basic level, an annuity is an agreement between a person and an insurance company. You pay the insurance company an initial investment that can either be a lump sum or series of payments. In return, the insurance company makes monthly annuity payments to you for a set amount of time—often the rest of your life—that’s established based on the terms of your contract.
You have two options for receiving monthly annuity payments. When you buy an immediate annuity, you begin receiving monthly payments right away, usually within 1-12 months. With deferred annuities, the insurance company won’t begin making annuity payments until later, usually within a couple of years.
Types of Annuities
There are three main types of annuities. They are:
- Fixed. Much like a CD, a fixed annuity accrues a guaranteed interest rate over the life of the contract. Because you know what to expect, fixed annuities make it easy to plan and budget for the future.
- Indexed. An indexed annuity is a type of fixed annuity. But instead of earning a guaranteed rate, it earns interest based on a specific stock market index, such as the S&P. You won’t lose money if the market declines. But your potential earnings are capped, limiting the return you can earn.
- Variable. Variable annuities are invested in the stock market and earn (or lose) value based on market performance. With a variable annuity, you have the potential to earn a greater return on your investment than you do with a fixed annuity, but your initial investment could lose value. To help protect you from the downside of the market, most variable annuities have an income guarantee that allows you to receive monthly payments based on the amount you originally invested even if the market declines.
Pros and Cons of Annuities
Like other investment options you might consider, there are pros and cons of annuities. Here are a few to consider, to help you decide whether an annuity should be a part of your overall retirement strategy.
- You can receive a guaranteed retirement income. Most annuities, regardless of the type you choose, offer the option to receive a guaranteed stream of income for life, no matter how long you live. There are currently no other investment options that guarantee income for your life no matter how long you live.
- The interest is tax-deferred. The interest you earn on your investment grows tax-deferred until you withdraw money from your account. This is especially attractive to those with large amounts of taxable assets.
- You may pay more fees. The guarantees that are offered by annuity companies are not free. While the best annuities have reasonable fee structures, one of the reasons annuities get such a bad rap is because the salespeople who offer them are often compensated with commissions that get rolled into the cost of the annuity. Plus, if you choose to purchase riders that offer additional benefits the cost of the annuity will increase. Depending on the type of annuity you buy, you might also be on the hook for operating costs, surrender charges and more. However, there are companies that offer a no-commission annuity also known as direct-sold. This reduces the overall costs for the purchaser.
- Consider Credit Quality. It is critical to evaluate the credit rating of any company you plan on purchasing an annuity from. Unlike savings, CDs or money market accounts you can open at your local bank or credit union, annuities are not FDIC-insured. Instead, annuities are regulated by your state’s insurance commission. And if the insurance company that sells you the annuity becomes insolvent after you purchase it, you may lose your earnings as well as your initial investment. However, there is protection for purchasers through various State Guaranty Associations. Most states offer $300,000 in protection per customer.
- Your money is illiquid. To provide a guaranteed return, most insurance companies include a surrender period to a contract. This can limit your ability to withdraw 100% of your investment without a penalty. This penalty declines over time and most contracts allow you to remove a certain amount of income penalty-free each year. They also can offer special withdrawal provisions for illness or long term care. And while an annuity can help provide a steady stream of retirement income, once you annuitize it, you no longer have access to your initial investment. So, it’s important to make sure you have other sources of cash on hand to pay for large expenses if necessary.
Is an Annuity Right for Me?
When it’s part of a comprehensive retirement income strategy, an annuity can be a good choice, especially if you’re concerned about outliving your savings in retirement. While most annuities, regardless of the type, offer an option that provides retirement income for life, a fixed annuity is probably your best bet if your reason for purchasing one is to receive monthly income payments. They often have fewer fees than variable annuities, and unlike variable annuities, they offer a stated rate of return that allows its value to be easily predicted. That makes it easy to plan and budget for retirement, providing security and peace of mind for the future.
When deciding whether an annuity is right for you, it’s important to take a holistic approach and look at your overall financial picture. By understanding your entire financial picture, including all your income options in retirement, it will help ensure you make the decision that’s best for you.