What's An Annuity And Does It Fit Into Your Retirement Plan?
The financial world doesn’t always paint annuities in the most flattering light.
The reason is that many annuity contracts have historically been very expensive and very difficult to understand. Even worse, there are countless horror stories of financial advisors pocketing big commissions by selling annuities to their clients, even when another investment strategy could have made a lot more sense.
But, when used appropriately, specific types of annuities can be a strategic addition to your retirement income stream.
It’s always important to keep in mind that no annuity is great for everyone and many investors may not benefit from an annuity at all.
Should an annuity be part of your retirement plan?
Let’s take a look at how an annuity works and the reasons why one may or may not be good for you.
1. What's An Annuity?
We explore several types of annuities next, but for our purposes, think of an annuity as a financial product that provides a guaranteed stream of income over a set period of time.
It's a contract between you and the insurance company. You pay the insurance company premiums in exchange for a specified amount of income. Those incomes can be regular monthly or annual payments over time, or all at once in a single lump-sum payment.
2. Types Of Annuities
You must understand the different types of annuities before deciding if one may be a good fit for you. Each annuity differs from insurer to insurer depending on the terms of the contract, but there are some basic categories that all annuities fall into.
Fixed vs. Variable. Fixed annuities offer guaranteed income at a fixed interest rate over a period. Variable annuities have an investment component to them. You can select how you want your annuity invested from a set of options, from conservative to more aggressive, and your account grows accordingly. The payments you receive will fluctuate depending on investment performance. Sales of variable annuities are regulated by the SEC and FINRA.
Immediate vs. Deferred. This distinction describes when your payments start. With an immediate annuity, your payments begin right away. Of course, that means you need to fund it in one lump sum. Immediate annuities are the simplest to understand, and a deferred annuity will start paying you later. You can fund a deferred annuity with a single lump sum, but you can also make gradual payments over time until the payouts start.
3. What Annuities Can Bring To The Table
The most noteworthy benefit of annuities is that they can provide you with a stable source of guaranteed income, which can be helpful for a portion of your retirement income.
Exactly how your annuity works will depend on what’s in the contract, so make sure you shop around for the features you want (and want to pay for!). Many products can be adjusted for inflation, which means the value of your payments won’t decline over time.
They can also provide long-term financial security since most provide an income “for life,” meaning you reduce the financial risk of outliving your retirement savings. They can even offer death benefits to beneficiaries.
Deferred annuities grow tax-deferred, but the IRS considers them as ordinary income tax once you start taking withdrawals.
4. Why You Should Be Careful With Annuities
While lifetime income is a compelling story, perhaps the most significant piece of advice about annuities is,
Read the fine print!
A large part of why annuities get bad press is that aggressive salespeople often promote them to people who don’t fully understand what they are buying. Don't buy insurance products you don't understand. It's important to work with financial professionals whose recommendations have your best interests at heart.
Variable annuities can have complex formulas to determine how much growth the insurance carrier credits to your account and what your future payments end up being, aka the annuitization process. Then there are the fees. The fees you pay directly cut into the returns you receive, which the company often buries in long, confusing paragraphs.
Additionally, annuities are a rather illiquid investment—at least until you start receiving annuity payments. If you need access to the principal investment via an early withdrawal or selling it during the "surrender" period, you'll likely get stuck with hefty surrender charges. Quite often the surrender period is substantial, around 6-10 years depending on the product, so you have to be okay tying your money up for a decade or so.
However, all annuities aren’t the same, and some can be great solutions to the right problem.
5. Why Immediate Annuities Could Be Worth It
While most annuity products are expensive, complex, and frankly don't yield the type of returns you could if invested elsewhere—that isn’t the case for all annuities. When applied to the right situation, an immediate annuity, also known as an income annuity, could be an excellent addition to your retirement income plan.
What makes an immediate annuity different?
For starters, they are simple. That makes immediate annuities pretty easy to understand. You buy an annuity for a flat amount and immediately receive a specified payment for the rest of your life. Here, there’s very little chance of confusion. That’s good because it lets you make a well-informed decision about whether the trade-off is good for you.
They also provide you with a way of establishing a fixed income floor that never runs out. Since they pay for life, you don’t have to worry about what the stock market will do or how long you will live. It can be very comforting to know that you will receive at least a certain amount of income regardless of what happens.
Pro tip: Don’t confuse the payout rate on an immediate annuity with a rate of return on investment. They are not the same thing. Our free guide details several opportunities for pre-retirees to build their nest eggs.
Curious if an annuity makes sense for you or are you wondering how it compares to other investment options? We’d love to help you figure it out.
Annuities require a lot of financial planning considerations, like your cash flow, current investments, financial goals, and more. Call us today to get personalized guidance on your own retirement.
About Broderick Mullins, MBA
Broderick is a personal financial advisor and fee-only financial planner with Covenant Wealth Advisors. He manages investment portfolios for individuals age 50 plus with over $1 million in investments.
Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. We provide investment management, financial planning, and tax planning services to individuals age 50 plus with over $1 million in investments. Investments involve risk and does not guarantee that investments will appreciate. Past performance is not indicative of future results.
The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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