How to Know if Annuities Are the Right Investment for You

Because annuities are often used to supplement retirement income, they remain a popular choice for many investors. In fact, according to the Secure Retirement Institute, total annuity sales (based on dollar value) in 2021 were the highest since 2008. However, while annuities remain an attractive investment for many, they aren’t for everyone.

In this post, we’ll share our thoughts on when you should (and shouldn’t) buy an annuity.

An overview of annuities

An annuity is a type of insurance product that provides investors with a guaranteed stream of income. You pay money up front (via a lump sum or series of payments), which is then invested and later paid out per an agreed-upon time, amount, and timeframe.

All annuities have two components: the principal you pay into it and returns on the same. Depending on the type of annuity you set up, you can fund it with either pre-tax (qualified annuities) or post-tax (non-qualified annuities) dollars. Regardless of which option you choose, annuity account investments can grow tax-free.

Annuities are not insured by the FDIC or any federal government agency. Instead, state guaranty associations (nonprofit organizations regulated at the state level) provide a safety net to protect policyholders. The amount of coverage varies by state but is generally up to $250,000 (per http://www.annuity.org).

Types of annuities

There are two basic annuity categories: immediate and deferred.

An immediate annuity provides a guaranteed income stream (often within a year) for the exchange of a lump sum today.

With deferred annuities, you can contribute a series of payments (or a lump sum) and begin collecting income at a set point in the future. Your investments grow tax-free, which usually means payments continue to grow as you delay collecting.

With either the immediate or deferred option, you can decide whether to receive payments for life or over a set period of time. Moreover, like many other retirement vehicles, you will face a 10% penalty on any funds you cash out before age 591/2.

Immediate and deferred annuity options

Within these two categories, there are three main types of annuities: fixed, variable, and indexed.

Fixed annuities are generally straightforward, with your contract outlining the amount of your future payments and when they commence. You’ll have no control over how the money is invested, which in fact doesn’t matter as the rate of return is predetermined and guaranteed (akin to a CD).

The drawback of fixed annuities is that inflation may erode the value of your payout, which is sometimes risky if you plan to rely on your annuity to pay the bills during retirement.

The objective of variable annuities is to combat inflation risk with market exposure and provide you with higher returns. The money in these accounts is therefore often invested in various stocks, bonds, and mutual funds (called “subaccounts”). This makes variable annuities inherently riskier than their fixed counterpart as your account balance and future payouts can vary based on financial market performance. Moreover, unlike fixed annuities, variable annuities are not entirely guaranteed.

These features explain why variable annuities are considered securities rather than insurance products, as brokers or financial advisors who sell you a variable annuity must be registered with the U.S. Securities and Exchange Commission.

It’s important to note that variable annuities offer optional—though sometimes costly—add-on features (called riders) to help minimize some of your risk. For example, floor caps can minimize losses should your underlying investments take a nosedive, while the guaranteed minimum accumulation benefit (GMAB) can guarantee your account value will equal some fixed percentage of your premiums.

Indexed annuities—also known as “equity-indexed” or “fixed index” annuities—represent a hybrid of fixed and variable options and offer a minimum guaranteed interest rate combined with an interest rate linked to a market index such as the S&P 500 or various market segments.

As a result, returns typically fall between those of fixed and variable options.

With hybrid annuities, it’s important to consider participation rates that are a percentage of an index’s return credited to your annuity. For example, if your annuity has a participation rate of 70%, this means index-linked returns would only amount to 70% of gains associated with the index.

Death and living benefit riders

Death and living benefit riders have also grown to become popular add-ons, especially with respect to variable annuity contracts whereby they are designed to protect your account value for a fee.

A living benefit rider generally guarantees some sort of defined guaranteed payout during the account owner’s lifetime—regardless of stock market performance—while a death benefit rider protects beneficiaries against declines in annuity value due to market conditions.

You can also add on an enhanced death benefit wherein the highest monthly (or annual, depending on the contract) recorded value of your account becomes the benefit upon your death.

When to consider buying an annuity

The goal of an annuity is to provide you with a steady stream of income, typically during retirement. Therefore, these are often appropriate investments if you’re:

·      A conservative investor who wants to create a guaranteed source of income for the rest of your life

·      Worried about running out of money during retirement

·      Looking to protect your legacy (because if you include a death rider, you can pass your annuity to one or more named beneficiaries)

·      Already maxed out on all other retirement vehicles but want to continue funding your retirement

When you shouldn’t purchase an annuity

Annuities aren’t for everyone, and there are many disadvantages to owning one.

For starters, annuities are sometimes complex (some needlessly) and come with a wealth of perplexing features. Annuities are also expensive and often feature a variety of fees that can make this type of investment even less attractive.

For example, many annuities include a “surrender period”: the period of time you must keep your funds in the annuity to avoid paying fees. If you need to access these funds sooner than anticipated, you could get hit with surrender charges.

Another reason to avoid purchasing an annuity is that the investment may not provide the level of returns you might be able to achieve elsewhere. This is a critical consideration, especially if you haven’t yet maxed out other retirement vehicles such as your 401(k) and IRA. It’s also possible to lose more than just your returns, depending on the type of annuity you decide to purchase.

Finally, if the insurance company that sold your annuity goes bankrupt, this can adversely impact your payouts given limited coverage with state guaranty associations. It’s therefore important to select a reputable insurance company with a long track record of financial strength.

In sum: how to determine if annuities are right for you

Determining whether or not an annuity is right for you isn’t an easy decision. That’s why seeking advice from an independent financial advisor is so important: providing the clarity and guidance you need to make the right decision.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual. 

Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59 1⁄2 are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.  Riders are additional guarantee options that are available to an annuity or life insurance contract holder. While some riders are part of an existing contract, many others may carry additional fees, charges and restrictions, and the policy holder should review their contract carefully before purchasing.  All guarantees are based on the claims paying ability of the issuing insurance company.