An annuity is a contract between the account holder and the insurance company. You pay a lump sum or make a series of payments to the insurance company in exchange for regular payments, in many cases for the rest of your life.
Annuities have both pros and cons for those planning for retirement.
Annuity pros everyone should consider
There are a number of pros to annuities including:
- Guaranteed income. Annuities offer contract holders guaranteed income for life or another defined period depending upon the terms of the contract.
- Money grows tax deferred. Annuity contributions grow tax-deferred and compound inside of the annuity.
- Downside protection. Fixed annuities offer a guaranteed rate of return. Indexed annuities offer performance tied to an index like the S&P 500 or others, these annuities generally have a guaranteed floor to protect in the event of a market downturn.
- Riders allow customization. Riders are annuity “extras” that can be added to most contracts to customize things like inflation protection, long-term care coverage and death benefits for surviving spouses and other beneficiaries among other contract features.
- No IRS contribution limits. Unlike retirement accounts like an IRA, 401(k), or others, there are no IRS-mandated annual contribution limits. You can generally invest any amount that you’d like.
Note that as far as the guaranteed income feature, these guarantees are provided by the insurance company. Though very rare, if the insurance company suffers financial difficulties, this could put these guarantees at risk. Your state’s insurance guarantee entity, but note that there are likely limits on the benefit amount guaranteed.
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Before buying an annuity, consider the cons too
Annuities can have several cons that potential investors should be aware of.
- Potentially high fees. Many annuity contracts of various types come with high fees, mortality expenses and investment management fees. These are often a product of the significant commissions that many annuities carry to compensate agents and advisors selling these contracts.
- Surrender periods. Most contracts have a surrender period that might range from 3 to 10 years during which if you surrender the contract you will be assessed a fee. These surrender charges often start as high as 7% of the value of the contract and decline over time.
- Taxation of gains. Once the contract is annuitized, a portion of each distribution attributable to gains in the value of the contract over time will be taxed at ordinary income versus preferential long-term capital gains rates.
- Lack of inflation protection. Annuities with a fixed payout and without inflation protection can lose a great deal of purchasing power for the contract holder over time. Many contracts offer inflation protection riders, but these can be costly and will also erode the amount of the benefit over time.
- Lack of liquidity. Most annuities will charge significant penalties if you need access to the money in the account early. Money invested into an annuity should be considered to be illiquid.
Common types of annuities
There are a number of different types of annuities. Here are some common variations.
- Fixed annuity. These annuities pay fixed, guaranteed interest rates for a set period of time. Fixed annuities are considered to be very safe and offer predictable growth to contract holders.
- Variable annuity. These annuities offer a number of mutual fund like subaccounts. Money invested can gain or lose value based on the sub-account performance.
- Fixed-index annuity. Growth in the value of the annuity is tied to a market index like the S&P 500. There is often an upside cap for gains and a downside limit, often 0% gain or loss.
- Immediate annuity (SPIA). Single premium immediate annuities entail a single premium with annuity payments generally starting within 12 months. This is essentially converting a cash deposit into an immediate income stream.
Creating a tax-efficient income stream in retirement should be a priority. Annuities may or may not play a role here.
Considerations before purchasing an annuity
As with any other investment or retirement-planning vehicle, it’s important to understand how any annuity you might be considering works.
- When and how can you access the money?
- What does annuitization look like?
- How much will the person selling the annuity earn when you purchase the annuity? Are they recommending the annuity because they feel it is a good option for you or due to the high commission they stand to make?
- What are the tax implications?
- Is the annuity a good fit with your overall retirement and financial planning?
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