Retirement annuities: Pros and cons of annuity investing
An annuity is a contract issued by an insurance company that pays a stream of income for a specified period or, often, for the remaining life of the contract holder.
Insurance agents and registered representatives often sell annuities as a way to provide a steady stream of income for their clients’ retirement needs. But you should consider several pros and cons before investing your retirement funds in an annuity.
How an annuity works
When you purchase an annuity, you hand over a lump sum of money or a series of premium payments to an insurance company, for which the insurer promises to pay you a series of payments now or in the future. Those payments can last for a specific number of years or for the rest of your life — no matter how long you live. Money invested in an annuity grows tax-deferred, meaning you’re taxed when you withdraw it or when payments begin.
Annuity contracts are highly customizable, which is part of what makes annuities so confusing. You can choose among numerous riders — optional features that you can add to an annuity contract to enhance its benefits or provide additional protections.
The main types of annuities are:
- Variable annuities: Premium payments into a variable annuity are invested in one or more subaccounts, which are similar to mutual funds. The performance of investments in those accounts determines how much you can earn from a variable annuity.
- Fixed annuities: A fixed annuity guarantees a minimum rate of return that can be reset periodically or increase annually.
- Indexed annuities: An indexed annuity tracks an index like the S&P 500 and offers a capped, or maximum, return based on the total returns of the index. Some indexed annuities offer a minimum level of return as well.
With an immediate annuity, payments can begin within a year or less after you pay the premium. With deferred annuities, payments begin at some point in the future, as stipulated in the annuity contract.
Pros and cons of annuities
Like any source of retirement income, annuities have their pros and cons. Understanding them can help you make an informed decision about whether an annuity is right for you.
Advantages of annuities
1. Regular payments
In an era in which employer pensions have become all but extinct in the private sector, annuities can offer you the opportunity to receive guaranteed monthly payments. This can provide regular, dependable income during retirement or a bridge to Social Security if you choose to retire early. Here’s how an annuity compares to an IRA.
2. Lifetime income
Annuities can be structured to provide regular payments for the rest of your life — no matter how long you live. The fear of running out of money in old age is a real concern for many Americans, so not outliving your savings is a huge advantage annuity providers tout. Just keep in mind that to secure a lifetime of guaranteed income, you’ll likely need to purchase a rider.
3. Tax-deferred growth
Money inside an annuity grows tax-deferred. This means gains on the amount of premium invested in the contract grow with no taxes due until you withdraw the money. That’s assuming the annuity is nonqualified, meaning that it’s not held inside an IRA or other retirement account.
If you withdraw money in lump sums, it’s considered ordinary income, making regular payouts fully taxable at your ordinary tax rate. You might also be subject to a 10 percent penalty on withdrawals you make before age 59 ½.
4. Guaranteed rates of return
Some annuity contracts, typically fixed annuities and indexed annuities, offer guaranteed rates of return. While your rate of return on these annuities can be higher than the minimum, it’s nice to know there is a floor — a figure beneath which it won’t fall further. However, sometimes, this floor can be a loss instead of a gain.
5. Survivor benefits
Annuity contracts offer several options for what happens to an annuity after you die. They vary by annuity and insurer and will typically offer an option to designate beneficiaries in the event of the account holder’s death.
Annuities might also offer options that allow survivors to continue to receive payments upon the annuitant’s death. This might be a joint and survivor option for a spouse or a “period certain” option for a nonspousal beneficiary.
Disadvantages of annuities
1. High expenses and commissions
Cost is one of the biggest drawbacks of annuities. Expenses erode the owner’s payouts, especially on a variable annuity in which the value depends on the investment returns. Some annuity contracts are so complex that the full rate of the internal expenses is hard for the average person to understand.
Annuities are typically sold by insurance agents, not financial advisors. That means they earn a commission on the products they sell you. While the commission is usually baked into the annuity contract, it can amount to anywhere from 1 to 10 percent of the total value of your contract.
2. Difficult to exit
While it may be possible to get out of an annuity contract, doing so comes at a cost. Some insurers make it difficult to exit an annuity by imposing high surrender charges that can amount to 10 percent or more of the value of the contract. Typically, the surrender charge will decline over time.
And you can’t get out of the contract whenever you want, since annuities typically have a limited surrender period. These periods usually last six to eight years after you purchase the annuity, depending on the contract.
3. Possibility of an insurer defaulting
The insurance company that issues the contract guarantees the annuity. While there have not been a lot of defaults on annuities, they can still occur. The backup to the insurance company is your state’s guaranty association. It is a good practice to check on the insurer’s financial solvency before purchasing an annuity contract.
4. Highly complex
The language in an annuity contract is complex, making it difficult for the average person to understand their rights and responsibilities and what they’re getting for their money. Annuities can differ markedly from one another, making it difficult to compare them. Worse, because salespeople earn a commission by selling annuities, they have little incentive to explain all the fine print or risks to potential buyers.
Bottom line
Annuities come in many varieties and offer a way to provide a guaranteed stream of income for a specified period or for life. For those who have maxed out other retirement plan options, they are another way to invest on a tax-deferred basis. However, despite offering some advantages, many annuities carry very high expenses and surrender charges in addition to being complex and tricky to understand.
FAQs
— Bankrate’s Rachel Christian contributed to an update of this story.
