Annuities are one of the more complex and unique retirement savings vehicles on the market today. These versatile instruments can provide buyers with tax deferral, exemption from probate, protection from creditors in many cases and also principal and income guarantees in many cases. But they are not all things to all people. There is a right and wrong way to use these products, and their complexity has rendered them as one of the most misunderstood and misused instruments in the financial marketplace. The correct way to use these products generally begins by asking when they should be purchased, and the following scenarios often fit the bill.
When You Don’t Need Liquidity
One of the biggest disadvantages of annuities is that they are not liquid instruments. Many of them come with deferred sales charge schedules that can stretch out for 15 or even 20 years in some cases. While those that do also typically allow for limited withdrawals, such as 10% of the contract value every year, those who will have no need to make any withdrawals until after the sales charge schedule expires may be good candidates for these vehicles. (For more, see: Annuities and Baby Boomers: The Pros and Cons.)
When You Want a Guarantee of Principal
Fixed and indexed annuities can offer a direct guarantee of principal as long as certain rules are followed and no early withdrawals are made. Annuity carriers are required by state law to carry cash reserves that equal the amount of outstanding premiums that are issued in these contracts. If a carrier becomes insolvent, then state reinsurance companies step in and cover each contract up to a certain amount, such as $300,000. Your money is typically very safe inside an annuity, especially if you are using a highly-rated carrier.
When You Want Guaranteed Income
Many indexed and variable annuities come with optional income riders that you can purchase using the proceeds in the contract. These riders will offer those who annuitize their contracts a guaranteed payout based upon a guaranteed hypothetical rate of growth, such as 6%. If the actual value of the contract grows to the point that a payout based on the actual value exceeds the guarantee, then you will get that instead (but this rarely happens). This allows you to essentially convert your annuity contract into a private stream of pension income. The other major advantage that comes when you annuitize your contract (meaning that you begin receiving a payout that’s based on your single or joint life expectancy) is that you will continue to be paid as long as you live, even if you have exhausted the entire value of the contract plus its composite earnings. (For more, see: How Fixed Index Annuities Yield Retirement Income.)
When You Want a Better Return than CDs or Government Bonds
Although annuities are not the most efficient growth instruments available, they can usually provide a rate of return that exceeds that of other guaranteed instruments such as certificates of deposit (CDs). Fixed-rate annuities usually have slightly higher yields than CDs, and indexed annuities often provide a better return than fixed contracts as long as they are held until the surrender charge expires. Variable contracts come with market risk, but those who invest in them for long periods of time will usually come out ahead of other guaranteed offerings.
When You Want to Avoid Creditors and Probate
If you have a large balance of cash lying around that you want to protect from creditors and probate costs without having to draw up a living trust, then an annuity may be the vehicle you’re looking for. All annuity contracts pass directly to their beneficiaries without going through probate, and most contracts also offer at least partial protection from creditors. The specific rules and exemptions for this vary from one state to another. (For more, see: Establishing a Revocable Living Trust.)
When You Want Active, Tax-Deferred Management
Although many financial planners will tell clients who want to defer nonqualified money until retirement to invest it in low-cost index funds that will be eligible for capital gains treatment, a variable annuity can provide many money management services such as dollar-cost averaging and portfolio rebalancing within its tax-deferred umbrella. Just remember that you will pay ordinary income tax on all of the earnings when you withdraw money from the contract at retirement.
When You Want Protection for Long-Term Care Expenses
Some annuity contracts will double or triple their monthly payout if you have annuitized your contract and become unable to perform at least two out of the six activities of daily living. Medical underwriting may be necessary at the time of purchase.
The Bottom Line
Annuities are complex instruments that can do great things for consumers who want to protect their money from taxes, probate and creditors. However, they are not always appropriate for every situation, and those who seek total liquidity from their investments are probably better off putting their money elsewhere. But annuities can be ideal instruments for those seeking guaranteed income and principal as long as they understand the limitations that come with these products. (For more, see: Should You Wait for Rates to Rise Before Buying an Annuity?)