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Pros and Cons of Annuities

Putting away money for retirement can be an arduous process. Once you figure out how much you need to save to retire, the real planning begins. There are a number of retirement savings options available, though, such as a 401(k) through your employer, an individual retirement account (IRA) or an annuity. Annuities can help you supplement your retirement income, but they aren’t necessarily right for everyone. Speak with a financial advisor in your area to determine if an annuity is right for you.

What Is an Annuity?

An annuity is a contract between you and an insurance company. You pay for the annuity through a lump sum or multiple payments, and the company uses a strategy to grow your assets. A variable annuity invests your money in certain types funds, a fixed annuity grows via a set interest rate and an indexed annuity earns returns based on the performance of an associated index.

However, growth only occurs during the accumulation phase of your annuity. This is the time when you make payments and the insurance company attributes returns to your account based on the type of annuity you have. Once you’re ready to begin receiving payments, your annuity contract will enter the annuitization phase. Payments can come in a variety of ways, including as a lump sum or monthly, semi-annually or annually. How you receive your money is completely up to you.

In order to protect against an early death during the accumulation phase, most annuity contracts come with some form of death benefit. Should this happen, the annuity company will send your funds to a pre-chosen beneficiary. If you pass away during the annuitization phase, payouts are determined by the type of payments you chose. For example, you can set up joint survivor payments where your spouse will take over after you die. You can also choose lifetime payments, which may allow you to outlive your deposit, though they cease at the time of your death.

For an extra fee, many annuity companies will offer you the chance to customize your contract with benefit riders. For instance, let’s say you want to protect against an early death during the accumulation phase. You could purchase a death benefit rider that entitles your beneficiaries to more money than they would’ve received from the standard death benefit.

Here are a few of the most popular annuity companies today:

Explaining the Different Types of Annuities

Pros and Cons of Annuities

There are three main types of annuities: fixed, variable and indexed. A fixed annuity guarantees a minimum rate of interest on your money, though these rates can reset annually or every few years. On the other hand, a variable annuity allows you to invest your money in different investment funds, such as mutual funds. The size of your payments will therefore depend on how well your investments perform rather than a fixed rate.

While an indexed annuity is technically a version of a variable annuity, it really combines the benefits of both fixed and variable products. The returns you earn from an indexed annuity aren’t based on investment decisions you make. Instead, your money will follow the performance of a stock market index, like the S&P 500. Note that in this case, your money isn’t actually invested in the index. Instead, the annuity company will attribute your account with the returns that the index produces.

As a way to limit returns, annuity companies often use participation rates or rate caps with indexed contracts. Here’s how they work:

  • Participation rate: Let’s say the S&P 500 grows by 10% in a year and your contract has a 60% participation rate. The annuity company will then take that 10% growth and give you 60% of it, which would equal 6%.
  • Rate cap: In this scenario, let’s assume the S&P 500 grows by 8% over a year, and your contract has a 5% rate cap. The result would be that your contract receives a 5% return, since the rate cap limits how much your contract can earn.

You can also choose an immediate annuity or a deferred annuity. With the former, you supply the insurance company with a lump sum and begin immediately receiving payouts. With a deferred annuity, you have the option to pay a lump sum or a series of payments, but you won’t begin receiving payouts until years later. This gives your money the opportunity to earn interest or appreciate.

What Are the Pros of Annuities?

An annuity offers a unique way to grow your retirement savings portfolio. In its most basic form, an annuity is essentially an insurance and retirement account hybrid that offers various ways to grow your funds. As a result, annuities have become increasingly popular in light of their advantages.

You Will Receive Regular Payments

The most basic feature (and biggest pro) of an annuity is that you receive regular payments from an insurance company. These payments provide supplemental income during your retirement, and can help if you’re afraid that you haven’t saved enough to cover your regular expenses. Keep in mind that the value and number of your annuity payments will vary depending on the type of annuity you have and the terms of your contract.

Your Contributions Can Grow Tax-Deferred

The money that you contribute to an annuity is tax-deferred. That means you can contribute money before you pay taxes. In fact, you won’t owe taxes on the money until you start receiving payments. During the time between when you contribute funds and when you withdraw them, it’s possible that your money could grow significantly. This type of growth is similar to how 401(k) contributions grow.

Fixed Annuities Offer Guaranteed Rates of Return

The insurance company will invest any money that you put into an annuity. There’s always a certain level of risk involved when you invest money. However, any contract you sign for a fixed annuity should include certain guarantees to prevent you from losing money. Fixed annuities guarantee that you make a certain percentage of your principal investment. That percentage is usually quite low, but it does mean that you’ll earn more than the amount of your original investment.

Death Benefits Are Typically Available

Variable annuities carry risk because they have the potential for you to actually lose money. But they also provide an extra perk: a death benefit. A death benefit is a payment that the insurance company will make to a beneficiary if you die.

For a basic variable annuity, the death benefit is usually equal to the amount that you contributed to the annuity. If you get an annuity contract worth $100,000, then the death benefit payout will likely be $100,000. It does not matter how your annuity’s investments perform.

Alternatively, you can find variable annuities with enhanced death benefits. With an enhanced benefit, the insurance company will record the value of your annuity’s investments on each anniversary of your annuity’s start date. If you die, the insurance company will pay a death benefit equal to the highest recorded value of your annuity.

For example, let’s say you have an annuity contract worth $100,000. You aggressively invest your money and on the anniversary of your annuity’s start date, your investments are worth $125,000. Your death benefit would then be $125,000, even if your investments decline in value for the rest of your life.

Note that an annuity probably isn’t your best choice if you’re just looking for a death benefit. In that case, you can help your beneficiaries defer funeral and burial costs with a life insurance policy.

What Are the Cons of Annuities?

Nothing in the financial sphere is immune to disadvantages, and annuities are no exception. For example, the fees charged in conjunction with some annuities can be rather overbearing. In addition, the safety of an annuity is enticing, but their returns can sometimes be weaker than what you might earn through traditional investing.

Variable Annuities Can Be Pricey

Pros and Cons of Annuities

Variable annuities can get very expensive. Any time you consider one, you need to understand all the fees that come with it to be sure that you pick the best option for your goals and situation.

Variable annuities have administrative fees, as well as mortality and expense risk fees. Insurance companies charge these, which often run about 1-1.25% of your account’s value, to cover the costs and risks of insuring your money. Investment fees and expense ratios vary depending on how you invest with a variable annuity. These fees are similar to what you would pay if you invested independently in any mutual fund.

Fixed and indexed annuities, on the other hand, are actually fairly cheap. Many of these contracts don’t come with any annual fees and have limited other expenses. But in an effort to let you customize your contract, companies will often offer additional benefit riders for these. Riders come with an additional fee, but they are completely optional. Rider fees typically vary up to 1% of your contract value annually, and variable annuities may offer them too.

Surrender charges are common for both variable and fixed annuities. A surrender charge applies when you make more in withdrawals than you’re allowed to. Insurance companies usually limit withdrawal fees during the early years of your contract. Surrender fees are often high and can also apply for an extended period of time, so beware of these.

Returns of an Annuity Might Not Match Investment Returns

The stock market will make gains in a good year. That could mean more money for your investments. At the same time, your investments will not grow by the same amount that the stock market grew. One reason for that difference in growth is annuity fees.

Let’s say you invest in an indexed annuity. With an indexed annuity, the insurance company will invest your money to mirror a specific index fund. But your insurer will likely cap your gains through something called a “participation rate.” If you have a participation rate of 80%, then your investments will only grow by 80% of the amount that the index fund grew. You could still make great gains if the index fund performs well, but you could also be missing out on returns.

If your goal is to invest in the stock market, then you should consider investing in an index fund on your own. That might seem daunting if you don’t have investing experience, so consider using a robo-advisor. A robo-advisor will manage your investments with much lower fees than an annuity.

Another thing to keep in mind is that you will likely pay lower taxes if you invest on your own. Contributions to a variable annuity are tax-deferred, but any withdrawals you make will be taxed at your regular income tax rate, not the long-term capital gains tax rate. The capital gains tax rates are lower than the income tax rates in many places. So you’re more likely to save on taxes if you invest your after-tax dollars instead of investing in an annuity.

Getting Out of an Annuity May Be Difficult or Impossible

This is a major concern relating to immediate annuities. Once you contribute the money to fund an immediate annuity, you cannot get it back or even pass it on to a beneficiary. It may be possible for you to move your money into another annuity plan, but doing so could also leave you subject to fees.

On top of the fact that you can’t get your money back, your benefits will disappear when you die. You cannot pass that money to a beneficiary, even if you have a lot of funds left when you die.

Which Type of Annuity Is Best for You?

The answer to which annuity is optimal for you is entirely dependent on your situation. For example, if you’re a ways away from retirement, the higher potential returns of a variable annuity could be enticing. On the other hand, those closer to retirement may want to go with a shorter-term fixed annuity that safely grows based on a set interest rate.

More specifically, because variable annuities earn returns through investments, they offer the most opportunity for growth. Annuity companies typically provide hundreds of potential investments with their variable contracts. The vast majority of these are investment funds, with each focusing on specific pools of securities. These can include bond funds, large-cap stock funds, small-cap stock funds and more.

As we state above, the tradeoff with variable annuities is the hefty fees they incur. This makes them even riskier products than just their investments. If this is a turn-off for you, an indexed annuity might be more preferable. These contracts offer a handful of indexes you can have your assets follow without actually investing in the index, which means you can’t lose money. However, participation rates and rate caps can limit your overall growth.

If you want to completely avoid the chance that you don’t lose money, but also don’t earn returns, you can open a fixed annuity. Annuity companies constantly update the fixed rates they offer, as they’re dependent on market conditions. Most fixed annuities feature a rate floor of 1%, and in some of the best rate environments of the past, companies were offering around 3%. In general, fixed annuities offer better fixed rates than certificates of deposit (CDs).

Bottom Line

Pros and Cons of Annuities

An annuity is a way to supplement your income in retirement. For some people, an annuity is a good option because it can provide regular payments, tax benefits and a potential death benefit.

However, there are potential cons for you to keep in mind. The biggest of these is simply the cost of an annuity. While some of the safer options, like fixed and indexed annuities, have very low fees, variable annuities can cost you quite a bit due to their improved return possibilities.

So the bottom line is that you shouldn’t get an annuity until you know it’s the right move for you. Don’t be afraid to meet with a financial advisor if you have any specific questions.

Retirement Planning Tips

  • Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • An annuity is best for those who worry their savings won’t last them in retirement. Even if that sounds like you, an annuity might not necessarily be the best option. Before signing any contracts, consider some of these retirement planning moves for late starters.

Photo credit: ©iStock.com/Ridofranz, ©iStock.com/Casper1774Studio, ©iStock.com/Zerbor, ©iStock.com/monkeybusinessimages

Derek Silva, CEPF® Derek Silva is determined to make personal finance accessible to everyone. He writes on a variety of personal finance topics for SmartAsset, serving as a retirement and credit card expert. Derek is a member of the Society for Advancing Business Editing and Writing and a Certified Educator in Personal Finance® (CEPF®). He has a degree from the University of Massachusetts Amherst and has spent time as an English language teacher in the Portuguese autonomous region of the Azores. The message Derek hopes people take away from his writing is, “Don’t forget that money is just a tool to help you reach your goals and live the lifestyle you want.”
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