Insurance agents and financial advisors have been investing their clients’ retirement money in annuities for decades. That practice has its detractors, with the criticism usually focusing on the high commissions paid to annuity salespeople and stiff fees charged to annuity owners year after year. Here's a rundown of the pros and cons of annuities, compared with other ways to invest for retirement.
- Annuities can provide a reliable income stream in retirement, but if you die too soon you may not get your money's worth.
- Annuities often have high fees, compared with mutual funds and other investments.
- You can customize an annuity to fit your needs, but you'll usually have to pay more or accept a lower monthly income.
How Annuities Work
An annuity is a contract between an individual and an insurance company. The investor contributes a sum of money—either all upfront or in payments over time—and the insurer promises to pay them a regular stream of income in return.
With an immediate annuity, that income begins almost right away. With a deferred annuity, it starts at some point in the future, typically during retirement. The dollar amount of the income payments is determined by such factors as the balance in the account and the age of the investor.
Annuities can be structured to pay income for a set number of years, such as 10 or 20, or for the life of the annuity owner. When the owner dies, any money remaining in the account typically belongs to the insurance company. But if they live happily to, say, 135 years old, the insurance company still has to keep those regular payments coming.
Annuities can also be fixed or variable. In a fixed annuity, the insurance company pays a specified rate of return on the investor's money. In a variable annuity, the insurer invests the money in a portfolio of mutual funds, or "sub-accounts," chosen by the investor, and the return will fluctuate based on their performance.
The Pros of Annuities
Despite the criticisms, annuities do offer some advantages for investors who are looking toward retirement.
The insurance company is responsible for paying the income it has promised, regardless of how long the annuity owner lives. However, that promise is only as good as the insurance company behind it. This is one reason investors should only do business with insurers that receive high ratings for financial strength from the major independent ratings agencies.
Annuity contracts can often be adapted to match the buyer's needs. For example, a death benefit provision can ensure that the annuity owner's heirs will receive at least something when the owner dies. A guaranteed minimum income benefit rider promises a certain payout regardless of how well the mutual funds in a variable annuity perform. A joint and survivor annuity can provide continued income for a surviving spouse. All of these features come at an additional price, however.
Variable annuities may offer a number of professional money-management features, such as periodic portfolio rebalancing, for investors who'd rather leave that work to someone else.
The Cons of Annuities
The commissions for selling annuities are almost always higher than those for selling mutual funds. Say an investor rolls a $500,000 balance in a 401(k) into an IRA. If the money is invested in mutual funds, the financial advisor might make a commission of about 2%. If it is invested in an annuity that holds the same or similar mutual funds, the advisor could make a commission of 5% to 7%, or even higher. Therefore, a $500,000 rollover into mutual funds would pay the advisor a $10,000 commission at most, while the same rollover into an annuity could easily pay the advisor $25,000 to $35,000 in commission. Not surprisingly, many advisors will direct their clients into the annuity.
Most annuities do not assess sales charges upfront. That may make them look like no-load investments, but it doesn't mean they don't have plenty of fees and expenses. Annuity contracts impose annual maintenance and operational charges that often cost considerably more than the expenses on comparable mutual funds. This has been changing somewhat in recent years, and some insurers are now offering annuities with comparatively low annual expense ratios. But, as always, investors should scrutinize the fine print before they sign.
If an annuity owner needs to get money out of the annuity before a certain period of time has elapsed (often seven or eight years, but sometimes as many as 15), they may be subject to hefty surrender fees charged by the insurer.
If the annuity owner is under age 59½, they may also have to pay a 10% early withdrawal penalty on any money they take out.
No Added Tax Benefits in IRAs
Annuities are already tax-sheltered. The investment earnings grow tax-free until the owner begins to draw income. If the annuity is a qualified annuity, they're also eligible for a tax deduction for the money they contribute to it each year.
A traditional IRA or 401(k) has the same tax benefits, however, and typically at a much lower cost if it's invested in conventional mutual funds. So putting an annuity in an IRA, as investors may be urged to do by some eager salespeople, is redundant and needlessly expensive.
If you're planning to buy an annuity, make sure you're dealing with a financially solid insurance company that's likely to be around—and able to make good on its promises—when you start drawing income.
A Compromise Solution
One practical option for investors is to stick with mutual funds until retirement and then move some of their money into an annuity, especially one with a downside protection rider. That keeps the fees to a minimum during the investor's working years but guarantees a steady income in retirement.