Smart Retirement Strategy?: The Pro And Cons Of Annuities
Annuities are financial products that are commonly used in retirement planning. They are popular among retirees because they can offer a steady stream of income with relatively little risk. However, they might not always be the best investment choice. In this article, we’ll look at what an annuity is and then we’ll examine the pros and cons of buying annuities.
What Is An Annuity?
An annuity is a contract with an insurance company. The investor agrees to pay the insurance company a set amount of money. In return, the insurance company guarantees the investor a certain number of payments, comprised of principal and interest, which will be received for a specific period of time or for the rest of an individual's lifetime.
Immediate Vs. Deferred
An immediate annuity is an annuity in which payments begin immediately after the contract is signed. Because the payments begin immediately, the investor does not have the option to make a series of scheduled payments to the insurance company. Instead, a lump-sum payment must be made.
A deferred annuity is an annuity in which payments from the insurance company are delayed for an agreed upon period of time. This deferment allows interest to build up before the payments start. During the pre-payment phase, the money paid to the insurance company earns interest and grows tax-deferred. This allows the investor to receive larger payments than he would have received had he bought an immediate annuity. Once the pre-payment phase is over, dispersal of the funds begins and any interest earned is taxed by the IRS. The funds can be dispersed with either a single payment or through a series of payments.
Because payments do not start immediately, deferred annuities can be purchased with a lump-sum payment or a series of scheduled payments.
Fixed-Rate Vs. Variable-Rate
A fixed annuity provides a guaranteed rate of return on the investment. Therefore, the amount of money the annuity investor will receive is locked-in. For example, if you purchase a fixed annuity with a three percent interest rate, you will be guaranteed to receive your money back plus three percent interest. Sometimes insurance companies will sell additional and expensive coverage that increases the fixed payments by a few percent each year as a hedge against inflation.
Most fixed annuities that do not make lifetime payments offer the option to purchase a lifetime conversion, which makes payments for the rest of the annuity holder's life.
Variable annuities allow the investor to invest in stocks and bonds through investment vehicles that act like mutual funds. Because variable annuities are tied to the performance of stocks and bonds, their value can rise and fall with the performance of the stock and bond markets. Therefore variable rate annuities do not have guaranteed payouts and the investor can experience gains and losses on the investment.
Variable annuities can usually be purchased with a lump-sum payment or payments that are stretched out over time.
One type of annuity that has been gaining in popularity is the equity-indexed annuity. These types of annuities earn interest based on the movement of a particular stock index, often the S&P 500. There is typically a cap on the gains and losses written into the contract of an equity-index annuity. Therefore, gains will be tempered but so will losses.
Taxation And Annuities
The interest or gains earned on an annuity is tax-deferred before the regular payouts begin. Once the regular payments begin, you will be taxed on a portion of each payment. Part of each annuity payment is considered the original investment, which is assumed to be money that was already taxed. The other part is considered the earnings. The earnings are viewed as ordinary income and not capital gains so you will be taxed at your normal tax rate instead of the capital gains tax rate. (For more information about the capital gains tax, see Understanding The Rules Of The Federal Capital Gains Tax.)
Why Buy An Annuity?
Consider the following pros of buying an annuity:
- Annuities can provide a steady stream of income to retirees.
- Fixed annuities can provide a guaranteed return.
- Annuities are relatively low-risk investments which can be comforting to those who do not want their retirement savings subjected to the volatile swings of the markets.
- Annuities allow your money to grow tax-free until you begin receiving your payments.
- Annuities do not have contributions limits like other retirement investment products such as IRAs and 401(k)s.
Why Skip an Annuity?
The cons of buying an annuity include:
- Annuities come with high commissions and management fees.
- Withdrawals made from annuities before the policy holder is 59 1/2 years old are subject to interest penalties.
- Annuity owners do not generally have a lot of say or choices about the investment options for their annuities.
- You can experience losses on a variable or equity-indexed annuity.
- Annuities are often purchased on the assumption that the owner will live out the term of the deal. If the holder dies before the annuity expires, the balance could be swept into a pool to make other annuity payments.
- You may be able to get a better return from other investment products like mutual funds.
What Are Other Investment Options?
While few investments are free from risk, there are alternative investment strategies that mimic some of the features of an annuity and might be more attractive to someone planning retirement. These include:
- Mutual funds. They are generally conservative mixes of stocks, bonds and cash that are designed to be low-risk. (To learn more about mutual funds, see Helpful Tips On Investing In Good Mutual Funds.)
- Conservative municipal bonds that mature at different times and offer a steady income. (For more information on municipal bonds, see An Investor’s Guide To Municipal Bonds.)
- Blue chip stocks with a track record of paying stable dividends.
- Treasury securities, money market accounts, certificates of deposit.
Before purchasing an annuity, it is always a good idea to speak with a financial adviser. The adviser will help you to determine whether the annuity would be a good fit for your overall retirement strategy. (For help choosing a financial adviser, see A Helpful Guide For How To Choose A Financial Adviser.)