Annuity Benefits and Drawbacks: Essential Insights before Deciding
Insurance agents and financial advisors have been advocating for their clients to invest their retirement savings in annuities for decades. This practice, however, has its critics, with the major issues usually focusing on the high commissions paid to annuity salespeople and the many fees charged to annuity owners. Compared to a mutual fund, an annuity is considerably more expensive. So, it's crucial to understand the details about annuities before investing.
Here's a brief rundown of the pros and cons of annuities and how they compare to other methods of retirement savings.
Highlights
- Annuities can offer a dependable income stream in retirement. But if you pass away too soon, you might not get your investment's full worth.
- Annuities are often more expensive than mutual funds, ETFs, and other investments regarding costs.
- You can personalize an annuity to match your needs, but you might have to pay more or settle for a lower monthly income.
- If the insurance company behind your annuity goes bankrupt, you might lose your investment.
How Annuities Function
An annuity is a contract between an investor and an insurance company. An investor contributes a lump sum of money, either all at once or through multiple payments, and the insurance firm promises to pay them a constant stream of income in return.
Immediate or Deferred
You can opt for immediate or deferred annuities. With an immediate annuity, the income starts almost immediately. A deferred annuity, on the other hand, starts providing income at a later date, typically during retirement.
The amount of the income payments depends on factors like the balance in the account and the investor's age. Annuities can be designed to pay income for a set number of years, e.g., 10 or 20, or for the annuity owner's lifetime. When the owner dies, the remaining money usually goes to the insurance company. However, if the owner lives for an unusually long time, e.g., 120 years, the insurance company must continue making payments.
Fixed or Variable
Annuities can also be fixed or variable. With a fixed annuity, the insurance company provides a predetermined rate of return on the investor's money. A variable annuity, on the other hand, has the insurance firm invest the money in a portfolio of mutual funds or "subaccounts" chosen by the investor. The return fluctuates depending on the funds' performance.
- Guaranteed income
- Customizable features
- Money-management assistance
- High commissions
- High fees
- Surrender charges
- No additional tax benefits compared to IRAs
The Benefits of Annuities
Despite the criticisms, annuities can offer some advantages for retirement-focused investors.
Guaranteed Income
The insurance company is responsible for paying the promised income, either for a specific timeframe or for however long a person lives. However, this promise is only as good as the insurance company behind it. This is one reason investors should only work with insurers that receive high ratings for financial strength from major independent ratings agencies.
Customizable Features
Annuity contracts can often be tailored to suit the buyer's needs. For instance, a death benefit provision can ensure that the annuity owner's heirs receive something when the owner passes away. A guaranteed minimum income benefit rider guarantees a specific payout, regardless of how well the mutual funds in a variable annuity perform. A joint and survivor annuity can provide continued income for a surviving spouse. All these features come at an additional cost, though.
Money-Management Assistance
Variable annuities might come with professional money-management features such as periodic portfolio rebalancing, which some investors prefer to delegate.
The Drawbacks of Annuities
High Commissions
Commissions for selling annuities are typically higher than those for mutual funds. For example, if an investor rolls their $500,000 balance from a 401(k) into an individual retirement account (IRA), a financial advisor might make a commission of around 2%. If the money is instead invested in an annuity that holds the same or comparable mutual funds, the advisor could make a commission of 6% to 8%, or even more. Consequently, a $500,000 rollover into mutual funds would pay the advisor a maximum of $10,000 in commission, whereas the same rollover into an annuity could easily pay the advisor $30,000 to $40,000 in commission. Naturally, certain advisors may direct their clients into the annuity.
High Fees
Most annuities do not charge upfront sales fees, making them appear like no-load investments. However, they do have plenty of ongoing fees and expenses. Annuity contracts impose annual maintenance and operational charges that often cost significantly more than the expenses associated with comparable mutual funds. This has been changing in recent years, and some insurers now offer annuities with comparatively low annual expense ratios, but investors should carefully review the fine print before signing up.
Surrender Charges
If an annuity owner needs to withdraw their money before a certain period has elapsed (usually six to eight years, but sometimes longer), they might be subject to high surrender fees charged by the insurance company.
No Additional Tax Benefits Over IRAs
Annuities are tax-sheltered. The investment earnings grow tax-free until the owner begins receiving income. If the annuity is a qualified annuity, the owner is also eligible for a tax deduction for the money contributed each year. A traditional IRA or 401(k) offers the same tax benefits, plus if invested in conventional mutual funds or ETFs, it usually costs much less than an annuity. Importantly, investing in an annuity through your 401(k), as some salespeople might advise, is unnecessary (since both are tax-advantaged) and redundantly costly. In other words, why use your retirement plan contribution to buy an already tax-sheltered product when you can invest in higher-yielding taxable securities that will then grow tax-deferred?
Important
If you're considering buying an annuity, make sure that you're dealing with a financially strong insurance company that's likely to be able to meet its obligations when you start receiving income.
A Balanced Solution
If you like the idea of an annuity but aren't willing to pay the long-term cost, there's a practical solution. You can invest in mutual funds, ETFs, and other investments until retirement. Then, move some of your money into an annuity, preferably one with a downside protection rider. This approach can keep fees low during your working years while guaranteeing a stable income in retirement. Consider consulting with a tax advisor about the tax implications of this strategy.
Can You Lose Money With Annuities?
With certain annuities, such as an immediate annuity, a deferred income annuity, or a fixed annuity, it's impossible to lose money in the way that one can lose money on investments tied to the market. However, you can lose money with a variable annuity whose underlying funds fluctuate in value. You can also lose money if the insurance company that issued the annuity goes out of business and defaults on its obligations. In this scenario, there's a degree of regulatory protection for investors.
Why Are Annuities a Poor Investment Choice?
Annuities can be viewed as poor investments due to a variety of reasons such as high fees, little to no interest earned, inability to keep up with inflation, and limited liquidity.
What Is Better Than an Annuity for Retirement?
There are a variety of options that might be better for retirement savings instead of an annuity, depending on your financial situation and goals. These alternatives include deferred compensation plans like a 401(k), IRAs, dividend-paying stocks, variable life insurance, and retirement income funds.
The Final Word
Though annuities are amongst the most established retirement savings options, they might not be suitable for everyone.
Annuities work for individuals who are looking for simple, fixed payments, and who don't mind the downsides like high fees.
When considering an annuity, pay close attention to the details in the contract. Evaluate the pros and cons, and consult with a reputable financial advisor if you have any questions.
- Some investors may find the high commissions and fees associated with annuities a deterrent when compared to more affordable alternatives like mutual funds, ETFs, or IRA investments.
- Annuities can provide a customizable approach to retirement savings, offering features such as death benefits and guaranteed minimum income, but these customizations often come with additional costs.
- Personal finance experts often recommend a balanced strategy for retirement savings, suggesting that investors initially invest in mutual funds, ETFs, and other low-cost investments before transitioning to an annuity—particularly one with a downside protection rider—upon retirement, to ensure a stable income while minimizing long-term costs.
