Individuals have a number of different vehicles to save for retirement, from 401(k)s to individual retirement accounts (IRAs). These options help individuals build a nest egg, but they do not necessarily guarantee income in retirement the same way that a pension would. For many people, the only guaranteed income in retirement comes from Social Security, but this payment is rarely enough to make ends meet.
Another option to consider is an annuity. This unique investment has its own distinct advantages and disadvantages. Annuities offer a fixed income, but they are not necessarily right for every situation. Individuals should understand the advantages and disadvantages of these investments before purchasing them, just as they should do with all investments.
What Exactly Is an Annuity?
Annuities are a foundational component of the retirement income planning process, as they offer an income stream that cannot be outlived. They are therefore most often used to create another stream of guaranteed income to be layered on top of Social Security benefits, to provide a larger base for recurring budget items. Unlike most other retirement products, an annuity is actually purchased from an insurance company. The investment is a contract between the investor and the insurance company.
The investor pays a lump sum or agrees to make payments over time. In turn, the insurance company invests the money and makes regular income payments back to the investor after a specified time. These income payments are usually installments over time, but they can also take the form of lump sums.
Importantly, three primary types of annuities exist and the payment structure of each can vary. Plus, each annuity has its own terms, so it is important to read the fine print before signing any agreement.
The first is a fixed annuity, which guarantees a minimum rate of interest on the money paid into it. These annuities also come with a fixed number of payments from the insurance company. These annuities have no annual fees and are similar to CDs, with the exception that the annuity interest earned is not taxed until it is withdrawn. Annuities offer tax deferral, and hence a measure of tax control to the owner that CDs, bonds, or stocks paying dividends do not, because the earnings on the latter investment vehicles are taxable every year.
A variable annuity, on the other hand, lets people invest in various securities of their choice. However, the eventual income payments received may depend on the performance of the underlying investments selected. The money invested in a variable annuity can rise or fall with the markets.
The third option is an indexed annuity, which is a variation of the fixed annuity. The returns from this type of annuity are based on the performance of various market indexes, such as the S&P 500, but the funds invested cannot fall in value when the markets are negative, as they can with a variable annuity. The variable annuity owner usually has more upside potential than the fixed indexed annuity owner. However, the fixed indexed annuity offers principal protection, and the invested funds will not fall in value in a negative market environment as they will with the variable annuity.
With each type of annuity, the payment phase can begin immediately or be deferred. A deferred payment can come years or decades later.
The Benefits of Annuities
Investing in annuities during retirement has several distinct advantages. First, as already mentioned, annuities can provide a guaranteed source of income for life. This reliable and safe supplemental income can help ensure that people will have enough to pay their bills as long as they live. Of course, the value and number of payments depends on the type of annuity purchased, but individuals can create plans that provide at least a base level of lifetime income, often with opportunities for increases over time .
Also, as with many retirement accounts, the money contributed to an annuity grows tax deferred. Taxes are not due until people start to receive payments as part of the plan. In the interim, the money could grow significantly without any tax implications for the investor. Note, however, that payouts are taxed as ordinary income rather than at a potentially lower capital gains rate, if the annuity is held outside of an IRA or qualified retirement account.
Annuities generally have lower risk than other investments. Any contract for a fixed annuity should come with guarantees that prevent individuals from losing money. Fixed annuities also guarantee a certain return on the principal. While the guaranteed percentage may be lower, it does not mean people cannot earn more if the underlying investments do well.
With a variable annuity, there is the possibility of losing money, but these investments come with a guaranteed death benefit. In other words, the insurance company will make a payment to a beneficiary in the event of the investor’s death. This payment is usually the amount of the initial annuity contribution plus any growth, even if the annuity owner dies in the middle of a market crash.
One last thing to keep in mind with annuities is that there is no other investment that can provide a guaranteed income stream for as long as people live. If interest rates on CDs or bonds decline, that prior higher interest income is lost—it was not guaranteed for life. Similarly, stock dividends or rental income are never guaranteed, and are often reduced or lost in recessionary periods. Social Security and pensions are types of annuities—they also provide lifetime income streams.
The Drawbacks of Annuities
While the pros of annuities sound enticing, people need to know these investments have drawbacks as well. The biggest issue that comes up with variable annuities is high fees. Fixed annuities generally have no annual fees, and fixed index annuities generally have fees in the neighborhood of 0 percent to 1 percent per year. Variable annuities, however, can be expensive, so it is important to pay close attention. Variable annuities generally have administrative, mortality, and expense fees.
Both variable and fixed annuities tend to have surrender charges, also known as early withdrawal fees. These fees can apply when people take more than the annual free withdrawal amount, which is usually 10 percent per year, during the surrender charge period. Surrender charges that apply in the early years of the contract generally decline over time. While they need to be considered, they are often significantly less than what a mutual fund owner could face when redeeming or selling off their mutual fund in a declining market environment.
In variable annuities, investment management fees depend on the assets chosen and tend to be comparable to investing independently, but they can still add up quickly. Some annuities can have riders, which are additional guarantees or benefits provided for a fee, such as a lifetime income benefit.
The other issue that investors need to consider is that annuity growth does not always mirror that of the stock market. The difference in growth can be due to annuity fees, but insurance companies will also sometimes cap gains through something called a participation rate. This rate dictates how much of the gains made by investments get applied to an investor’s account.
For example, if an annuity has a participation rate of 80 percent and the investments increase in value by 10 percent, the account will only reflect a gain of 8 percent. This cap is the tradeoff for having no downside risk in negative market environments. For example, in a fixed indexed annuity, if the markets fell 20 percent, or 35 percent or even 50 percent, annuity owners simply receive a 0 percent interest credit that year. They do not have to overcome the 20 to 50 percent decline as they would with mutual funds or stocks.
One last thing to keep in mind is that getting out of an annuity early, if an emergency arises, can be expensive due to the early withdrawal charges. This situation can be similar to someone needing to sell a stock or mutual fund in an emergency, and the markets are down in value at the time. Also, immediate annuities cannot generally be cashed out or transferred to another person other than upon death.
With fixed, fixed indexed, or variable annuities, individuals can generally transfer the money on a tax-free basis to a different annuity, but they may be charged fees for doing so if there are still early withdrawal charges in place. Also, in rare circumstances, if the annuity does not come with a death benefit, any money left in the account is lost upon the investor’s death, as happens with some pensions.