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Pros and Cons of Annuities

Putting away money for retirement isn’t easy. 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 payments over time. The insurance company will then invest your money. The most common way to invest is through mutual funds.

From these earnings, the insurance company will make regular payments to you, again in the form of a lump sum or payments over time. There are multiple types of annuities and the exact payment structure of each will vary based on the terms that you agree to with the insurance company.

Here’s a few of the most popular companies that offer annuities:

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, as well as a fixed number of payments from the insurance company. On the other hand, a variable annuity allows you to invest your money in different securities, such as mutual funds. The payments you receive will depend on how well your investments perform.

While an indexed annuity is technically a version of a fixed 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.

For each of these annuity types, you can choose an immediate annuity or a deferred annuity. With the former, you supply the insurance company with a lump sum, then you immediately begin receiving payouts, hence the name. 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, or even decades, later. This gives your money the opportunity to earn interest or appreciate (in the case of a variable annuity).

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.

Pro #1: 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.

Pro #2: 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.

Pro #3: 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.

Pro #4: 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.

Con #1: Annuities Can Be Pricey

Pros and Cons of Annuities

Annuities can get very expensive. Any time you consider an annuity contract, you need to understand all the fees that come with it to be sure that you pick the best annuity for your personal goals and situation.

Variable annuities have administrative fees, as well as mortality and expense fees. Insurance companies charge these, which often run about 1.25% of your account’s value, to cover the costs and risks of insuring your money.

Surrender charges are common for both variable and fixed annuities. A surrender charge applies when you make more withdrawals than you’re allotted. Your insurance company could limit withdrawals particularly during the early years of your contract. Surrender fees are often high and can also apply for an extended period of time.

Investment management fees will 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.

Some annuities will also have additional riders that come at a fee. A rider is an optional guarantee. A good example of this is the enhanced death benefit option that we mentioned above. Adding better death benefits to your contract will require a death benefit rider. Rider fees will vary by the individual benefit, but they can cost up to 50% of the value of your account.

Con #2: 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.

Con #3: 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.

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. Annuities can come with many different fees, some of which will cost as much as half of the value of your contract.

So the bottom line is that you shouldn’t get an annuity until you know it is the right move for you. Don’t be afraid to reach out to an expert if you have any specific questions.

Retirement Planning Tips

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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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