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Pros and Cons of Annuities

Putting away money for retirement isn’t always easy. Once you figure out how much you need to save for retirement, then you need to actually save that money. Consistently putting money into savings is a difficult habit to build. There are also a number of retirement options. Maybe your employer offers a 401(k). Maybe you save money on your own through an individual retirement account (IRA). Here’s one more option to consider: annuities. Annuities are a way to supplement your retirement income but they aren’t right for everyone. Consider these pros and cons of annuities to see whether an annuity could work for you.

What Is an Annuity?

Annuities can be complex and confusing sometimes. Before we look at some pros and cons of annuities, here is a quick refresh on what exactly an annuity is.

An annuity is a contract between you and an insurance company. You pay for the annuity (through a lump sum or through payments over time) and the insurance company invests your money. The most common way to invest is through mutual funds. Then the insurance company will make regular payments to you (again through a lump sum or through payments over time). There are multiple types of annuities and the exact payment structure will vary based on the terms that you agree to with the insurance company.

There are two main types of annuities – fixed and variable. A fixed annuity guarantees a minimum rate of interest on your money and you receive a fixed number of payments from the insurance company. A variable annuity allows you to invest your money in different ways (e.g. in different mutual funds) and the payments you receive will depend on how much your investments make.

Pro 1: You Can Receive Regular Payments

The most basic feature of an annuity is that you receive regular payments from the insurance company. This is also the biggest pro of an annuity. Those 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 and the terms of your contract.

Pro 2: Your Contributions Grow Tax-Deferred

The money that you contribute to an annuity is tax-deferred. That means you can contribute money before you pay taxes and you do not have to pay taxes on the money until you withdraw it (i.e. until start receiving payments). In the time between when you contribute the money and when you withdraw it, it’s possible that your money grew significantly. This type of growth is similar to how 401(k) contributions grow.

Pro 3: A Fixed Annuity Offers Guaranteed Returns

The insurance company will invest any money that you put into an annuity. There is 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: A Variable Annuity Offers a Death Benefit

Variable annuities carry risk because they have the potential to actually lose you money. They also carry an extra benefit: a death benefit. A death benefit is a payment that the insurance company will make to your 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 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 to decline in value for the rest of your life.

Note that an annuity likely 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.

Con 1: High Fees

Pros and Cons of Annuities

Annuities can get very expensive. Any time you consider an annuity contract, you need to understand all the fees in that to be sure that you can pick the best annuity for your 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 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 should. Your insurance company could particularly limit withdrawals during the early years of your contract. Surrender fees are often high and can also apply for an extended amount 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 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 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 rider but some are very expensive. A death benefit rider can cost up to 50% of the value of your account value.

Con 2: Annuity Growth Might Not Match Stock Market Growth

As a second part to the first con, it’s important to understand how the cost of an annuity is impacting your 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 fees. However, 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 great gains. If your goal is to invest in the stock market, then you should consider investing in an index fund on your own (outside of an annuity). That might seem daunting if you don’t have investing experience, so consider using a robo-advisor. A robo-advisor will manage your investments without the crazy fees.

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 Impossible

This con is a concern for immediate annuities. Once you contribute the money to fund an immediate annuity, you cannot get that money back or 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

Con 4: An Annuity and a 401(k) May Be Redundant

Some employers provide the option of investing in annuities through a 401(k). This option is actually growing in popularity because people view it as a safe way to invest 401(k) money. The trouble is that you don’t really get the full benefits of an annuity is you have it through a 401(k).

One of the biggest benefits of an annuity is that your contributions are tax-deferred. But 401(k) contributions are also tax-deferred. So if you already get the tax benefits from investing in a 401(k), then you aren’t getting additional tax benefits by investing in an annuity. The same is true if you invest in a traditional IRA versus a 401(k).

If you’re thinking about investing in an annuity, consider making the maximum allowable contribution to any 401(k) or traditional IRA plans first.

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 con is simply the cost. Annuities can come with many different fees. Some fees will cost as much as 50% of the value of the annuity! So the bottom line is that you shouldn’t get an annuity (or any other investment option) until you know it is the right move for you.

Things to Consider When Looking for an Annuity

  • If you aren’t sure whether an annuity is the best option for you, consider talking with a financial advisor – an expert who can help you invest according to your goals and overall financial picture. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you answer a series of questions about your situation and your goals. Then the program narrows down thousands of advisors to three fiduciaries who meet your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while doing much of the hard work for you.
  • An annuity is best for people who think that they haven’t saved enough to cover their expenses 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. And if you’re still young but you want to make sure that you have enough for retirement, then you should absolutely check out these essential retirement planning moves for 20-somethings.
  • It can be very difficult to get your money out of an immediate annuity. That means you won’t really be able to get your money back if an emergency comes up and you need money in a hurry. So if you are considering an immediate annuity, make sure that you choose a plan that meets your goals.
  • Low- and moderate-income individuals might hear that it’s a good idea to invest after-tax dollars in an annuity. The idea is that you pay tax now because you expect to be in a higher income bracket when you retire. There’s nothing wrong with this thinking. (This is actually the same reason that investing in a Roth IRA is a good idea for many people.) The trouble is that you might not get the best returns if you fund an annuity with after-tax dollars. So if you’re looking to invest after-tax money for retirement, consider other options.

Photo credit: ©iStock.com/Ridofranz, ©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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