Retirement Annuities: The Basics
Perhaps no investment product in existence generates a wider spectrum of reactions than retirement annuities. The basic idea behind these insurance products—a guaranteed stream of income, often for a lifetime—sounds pretty appealing. But critics are quick to point out that they have a lot of drawbacks too, not least of which is their cost compared to other investment options. Before signing a contract, make sure you understand both the pros and cons.
Before discussing the advantages and disadvantages of annuities, it's important to understand that they're not all the same. These days they seem to come in an almost limitless number of varieties, but below are just the four basic types.
- Retirement annuities promise lifetime guaranteed monthly or annual income for a retiree until their death.
- These annuities are often funded years in advance, either in a lump sum or through a series of regular payments, and they may return fixed or variable cash flows later on.
- While annuities are perceived as having large up-front costs and early withdrawal penalties that make them somewhat illiquid, they are great for those who need extra income in retirement.
Fixed vs. Variable Retirement Annuities
Individuals can typically buy into an annuity with either a lump-sum payment or a series of payments. With a fixed product, you know ahead of time how much you'll receive once the "annuitization" phase begins—that is, when the insurer starts making payments back to you. That's because the rate of return is fixed for a predetermined number of years. Generally, that rate is in the ballpark of what a certificate of deposit (CD) would pay, so they tend to be pretty conservative.
Variable annuities work differently. Your return is based on the performance of a basket of stock and bond products, called sub-accounts, that you select. There's a bigger opportunity for growth compared to a fixed annuity, but there's also more risk. However, the insurer may allow you to purchase a rider that offers a guaranteed minimum withdrawal, even when the market does poorly.
Immediate vs. Deferred Retirement Annuities
With an immediate annuity, you pay the insurer a lump sum and start collecting regular payments right away. Some older adults, for example, may choose to put some of their nest egg into an annuity once they hit retirement to ensure a regular income stream.
A deferred product, by contrast, is more of a long-term tool. After paying in, you don't collect until a specified date—before you get to that date, your money has the opportunity to either accrue interest (fixed annuities) or benefit from market gains (variable annuities).
Annuities can provide lifelong income.
Taxes on deferred annuities are only due upon the withdrawal of funds.
Fixed annuities guarantee a rate of return, which translates into a steady income stream.
They're complex and hard to understand.
Fees make annuities more expensive than other retirement investments.
Net returns on withdrawals are taxed as ordinary income.
Annuities can be attractive for a variety of reasons, including the following:
Income for life. Perhaps the most compelling case for an annuity is that it generally provides income that you can't outlive (though some only pay out for a certain period of time). That's not necessarily the case with traditional investments, unless your nest egg is particularly large. For folks with more modest means, an annuity ensures you'll have something to supplement Social Security, even if you reach a ripe old age.
Deferred distributions. Another nice perk of annuities is their tax-deferred status. With other popular retirement investments, such as CDs, you'll have to pay Uncle Sam when they reach the maturity date. But with annuities, you don't owe a penny to the government until you withdraw the funds. That aspect gives owners some control over when they pay taxes. Leaving money in a deferred annuity can also help reduce your Social Security taxes, as you have less taxable income when you delay withdrawals.
Guaranteed rates. The payout from variable annuities depends on how the market performs. But with the fixed type, you know what your rate of return will be for a certain period of time. For seniors looking for a predictable income stream, that may be a better alternative than putting money into equities or even corporate bonds.
Critics cite the following problems with annuities:
Hefty fees. The biggest concern with annuities is their hefty cost compared to mutual funds and CDs. Many are sold through agents, whose commission you pay through a considerable upfront sales charge. Direct-sold products, which you buy straight from the insurer, can help you get around that big upfront fee.
But even then you could be faced with sizable annual expenses, often in excess of 2%. That would be high even for an actively managed mutual fund. And if you take out special riders to increase your coverage, you'll be paying even more.
Lack of liquidity. Another concern is the lack of liquidity. Many annuities come with a surrender fee, which you incur if you try to take a withdrawal within the first few years of your contract. Typically, the surrender period lasts between six to eight years, although they're sometimes even longer. These fees can be on the large side, so it's hard to back out of a contract once you sign on the dotted line.
The typical cost of annual expenses on an annuity—and they can go even higher.
Higher tax rates. Issuers often cite the tax-deferred status of your interest and investment gains as a main selling point. But when you do take withdrawals, any net returns you received are taxed as ordinary income. Depending on your tax bracket, that could be a lot higher than the capital gains tax rate.
Complexity. One of the cardinal rules of investing is not to buy a product you don't understand. Annuities are no exception. The insurance market has exploded over the past few years with a slew of new, often exotic variations on the annuity. Some, like the equity-indexed annuity, come with fees and limitations so complex that few investors fully understand what they're getting into.
The Bottom Line
For some people, especially those uncomfortable with managing an investment portfolio, a retirement annuity can be a secure way to make sure they don't outlive their assets. If you go for one, just make sure you pay close attention to the fees, avoid the more exotic variations, and don't take out a bigger contract than you really need.