Read This Before Purchasing an Annuity

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Wouldn’t it be great if you knew exactly how much income you could rely on for the rest of your life? If you’re worried about stretching those retirement savings through the golden years, you might consider giving a portion away in exchange for guaranteed payments in perpetuity. Annuities are a type of product offered by insurance companies that do just that. Part investment vehicle and part insurance policy, they can be a valuable supplement to your plan for leaving the workforce.

Annuities are complex, and many have a wealth of perplexing features. To figure out if they are right for you, it helps to understand more about this type of product. Unlike immediate annuities, which begin paying out immediately, you can contribute to deferred annuities over time rather than in a lump sum and begin collecting payments at a set point in the future. With deferred annuities, your investment grows tax-free, which usually means payments get larger the longer you delay collecting. With either the immediate or deferred option, you can decide whether to receive payments for life or over a set period. Keep in mind that like other retirement vehicles, you will suffer a 10% penalty tax on anything you cash out before the age of 59 ½.

The rate of return from an annuity can also be fixed or variable. Fixed annuities are generally straightforward. Your contract outlines the amount of your future payments and when they begin. You will have no control over how the money is invested, but that doesn’t matter. The rate of return on your principal is predetermined and guaranteed. The danger with this type of investment is that inflation may erode the value of your payout. This can be risky if you are relying on your annuity to pay the bills in retirement.

With a variable annuity, you can distribute your investment among portfolios called subaccounts which combat inflation risk with market exposure. What the markets do during the accumulation period form the base for determining your payout during the distribution phase. The rate of return therefore depends on the performance of the underlying assets.

Variable annuities are often compared unfavorably to mutual funds. After all, why lock up your cash until old age when you can simply invest in tax-efficient funds? When you invest in capital markets directly however, you risk losing what you start out with. With a variable annuity, you are always entitled to your principal—even if you die. Some variable annuities also come with a floor that caps your loss if the underlying investments take a nosedive.

On the flip side, variable annuities often come with steep levies, including sales commissions and management fees that are far higher than most actively-managed mutual funds. Many deferred variable annuities also incorporate surrender charges that penalize you for withdrawing within the first couple years. Since payouts go up and down with market performance, you lose the reliable return people often look for in an annuity. Gains from asset appreciation will also be taxed as ordinary income when you withdraw, rather than at the typically (far) lower capital gains rate.

A hybrid of fixed and variable is the equity-indexed annuity, which seeks to track the return of the overall market. Combining the best of both worlds, indexed annuities come with a guaranteed minimum “floor” on your return while preserving the upside of market exposure. Returns will typically be between that of fixed and variable. However, it’s important to look at participation rate which decides how closely your payments will mimic market performance.

If you expect to live to a ripe old age, you may also want to look at longevity annuities, which are a type of deferred income annuity that does not pay out until you have reached an advanced age, typically around 80. It makes more sense to purchase this type of annuity early so your investment has time to grow. Buying deferred annuities in advance typically costs less than buying an immediate annuity for the same monthly payout when you reach the same withdrawal age.

With annuities, you should decide whether the potential gain is worth sacrificing liquidity or other opportunity costs in the present. Annuities can be a reasonable choice if you have already maxed out other tax-deferred vehicles such as IRAs. If you are approaching or near retirement, an immediate annuity can also be a great option for making sure you have a reliable source of income for the future.

Fixed lifetime annuities are an investment product you can’t outlive. If you expect your Social Security benefits to fall short of your monthly expenses in retirement, you can purchase a lifetime annuity to make up the difference. With your basic overhead taken care of, you could then invest the rest of your retirement savings for growth rather than security.

Insurance companies are regularly coming up with annuity products that change the equation for comparison. For example, some insurers are offering inflation-indexed annuities. However, the payouts typically start lower and may take decades to catch up to traditional fixed annuities. If you find an annuity with more attractive benefits, you may be able to trade without triggering a tax event using what is called a 1035 exchange. Make sure the new annuity contract really is better, however. Given their complexity, it can be difficult to assess marginal benefits between two annuity options. In fact, companies have been known to take advantage of their apples-and-oranges nature to trick consumers into trades against their best interest.

Annuities are not cheap. Some of them are also needlessly complex, and come with an assortment of fees that could make this type of investment less attractive. Deciding whether to invest in an annuity is not an easy decision, and it’s important to understand what you’re buying. In addition to reading the fine print, consult a financial planner who can help you understand where annuities fit into your overall retirement plan.