If you’re looking for guaranteed income during retirement, one obvious option is an annuity. The problem is that while this product can provide you with a guaranteed income stream, it's a considerably more expensive strategy than managing your retirement portfolio yourself.
Here's a look at the different types of annuities, their pros and cons, and the lowest-cost options to help you decide whether an annuity makes sense for your retirement.
- There are two ways to purchase annuities: with a lump sum that give you immediate payments, or with periodic deposits over time, which provide deferred payments.
- Both immediate payment and deferred payment annuities come in three varieties: fixed, variable, and equity-index.
- Fixed annuities are the least expensive in terms of fees, and variable annuities are the most expensive.
Buying an Annuity
There are two different ways to purchase an annuity. One option is an immediate payment annuity, a product you buy with a lump-sum payment, such as the funds you'll rollover from a 401(k) when you retire. In this case, the payments start immediately. Or you can choose a deferred payment annuity, which is funded using periodic deposits over time and starts paying out at a specified future date.
Both types of annuities come in three different varieties: fixed, variable, and equity-index. Each offers its own combination of certainty, risk, and fees.
These annuities have a guaranteed rate of return that is fixed at the time of purchase. When you buy a fixed annuity, you will be told the guaranteed income stream. The risk is that the rate of return is fixed and your income stream may not be enough to meet your needs as inflation increases the cost of living.
These annuities provide investment accounts called "sub-accounts," which are similar to mutual funds and let you take some advantage of any growth in the market. Variable annuities have become the most popular type of annuity because there is less risk of your income stream being eroded by a fixed rate of return. That stream will rise and fall depending on the success of the investments in your sub-accounts.
Many financial advisors dislike variable annuities due to their high management fees. Notably, Suze Orman believes that “variable annuities were created for one reason and one reason only—to make the advisor selling those variable annuities money.”
A relatively recent creation of the insurance industry, an equity-index annuity is a fixed annuity with a portion tied to a stock index that supposedly offsets some of the risk of inflation. Insurance companies use something called a “participation rate” to figure how much of your stock market gain they will keep to offset their risk—they need to keep paying you if the market turns bad. The one advantage of an equity-index annuity over a variable annuity is that there is less downward risk to you.
Annuities are best suited for people who don’t think they are capable of successfully managing their retirement portfolio.
The Benefit of Retirement Annuities
The primary reason people choose annuities is to get a guaranteed income stream. With an annuity—especially a fixed annuity—they know what their monthly income will be (and can budget accordingly). This saves them the task of managing their retirement portfolio, a plus for those who worry they aren't capable of managing their own portfolio.
In addition, a guaranteed income protects you if the economy turns bad and other investments tank. That’s really the only benefit of choosing an annuity.
The Cons of Retirement Annuities
Here are the top four reasons to avoid an annuity:
1. Not Liquid
If you need money more quickly for an emergency, you will pay stiff penalties—generally 5% to 7%. Surrender charges are reduced the longer you own the annuity but can be a factor for as long as 15 years. Always ask about surrender charges before you buy an annuity.
2. May Pay More In Taxes
Earnings from an annuity are taxed as ordinary income. That’s very different from what you’d pay on gains from the sale of a long-term stock or mutual fund. Long-term capital gains are taxed at 0% to 15% depending on your tax bracket under current tax laws.
3. Higher Taxes for Heirs
Their tax bill will be based on the cost of the initial purchase of the annuity. All the gains will be taxed at ordinary income rates and they will need to pay them immediately after taking possession. If your portfolio had been in stocks or mutual funds, the tax basis would be “stepped up,” which means that the taxes they will need to pay upon sale of these assets will be the market value at the time of your death. They will not have to pay taxes on the years of gains prior to your death.
4. High Fees
A “mortality and expense" fee, for example, can be as high as 1% to 2% per year. You can hire a professional portfolio manager for the same cost and not have to pay the other fees tacked on to an annuity. These additional costs can include administrative fees and subaccount expenses (unique to variable annuities). Some annuities have rider fees, depending on the options you select.
Lowest Cost Options for Variable Annuities
If you value the security of a guaranteed payout and think that security is worth paying some fees, consider low-cost options available through mutual-fund groups rather than an insurance company. Two excellent options you should explore include the mutual fund companies Vanguard and Fidelity. The Teachers, Insurance, and Annuity Association (TIAA), a nonprofit financial service organization that specializes in the needs of nonprofit employees, also sells its annuities to the general public.
Vanguard’s expense ratios average 0.10% as of Dec. 2019, depending on the investment allocation. Fidelity’s fees start at 0.10% for a $1 million initial purchase, plus fees based on the mutual funds chosen, and can go as high as 1.90%. TIAA’s fees range from 0.45% to 0.80%, depending on the options chosen.
All three of these companies offer annuities below the 1% (or more) you would likely pay for an investment advisor through a brokerage house. The additional income guarantees make all three options a good alternative for people who want to roll their retirement savings into one place and let someone else worry about providing them with a lifetime income stream.
The Bottom Line
Annuities are an option if you are not sure you have the skills to manage your retirement portfolio and want to be certain you won’t run out of funds during your lifetime. Make sure to do your research and be certain you understand all the fees and taxes you will have to pay for the income-stream guarantee.
Compare what the annuity salespeople would provide with the services that are offered by other financial advisors. Think about a one-time consultation with a fee-based financial advisor who does not make money based on the option you choose. A fee-based financial advisor can help you understand the annuity contracts you are considering and show you other options to help you decide what makes the most financial sense.
Annuities are sold by insurance companies, financial services companies, and through some charitable organizations. (These are called charitable gift annuities.) Be sure you purchase an annuity from a financially-stable company and ask what would happen to your money if the issuer goes out of business.
You can research certified financial planners on the CFP website. Commission-based financial advisors tend to steer you to companies from which they will make a commission, so always ask how your financial advisor will be compensated before you meet.