What Are Annuities?
After diligently working and tucking away savings, you are thinking about retiring. However, are you sure you have enough money to last for the rest of your life?
If you are in good health and longevity runs in your family, then outliving your savings is a very real possibility. Imagine having to move in with your children or grandchildren, or having to work well into your retirement years.
If you are concerned about outliving your savings, you may want to consider investing in an annuity, sometimes considered as being “longevity insurance”.
While there is a lot of excitement around annuities, it’s best not to get caught up in the hype and to examine all the angles before making a decision. In this article, we’ll see the benefits and drawbacks of annuities and determine if an annuity is right for you.
What Is an Annuity?
An annuity receives funds from an investor, who then receives a steady stream of payments during what is called annuitization.
The period before payouts begin is called the accumulation phase. This is when the investor is adding funds to the account.
The purpose of an annuity is to provide a steady amount of cash for an investor, and to reduce the risk of an investor outliving his assets, called longevity risk. You can think of an annuity in much the same way as Social Security or a pension.
While typically used for retirement, annuities can be used for other purposes as well.
For example, those who receive a windfall of cash through the lottery sometimes use an annuity. This prevents them from spending all their money very quickly, like lottery winners often do. It can protect you against yourself.
Types of Annuities
Annuities come with many options that can be elected by the investor. While there are too many options to list here, we will cover some of the main types.
Fixed annuities pay out a fixed amount to the investor. The amount of these payouts is determined by the value of the account and the investor’s life expectancy. Many investors choose annuities because of their simplicity, and predictability of stable income.
Variable annuities are more complex than the straightforward fixed annuity. In exchange for greater risk to the investor, they allow for a potentially higher rate of return. The investor will receive greater pay outs if the annuity fund does well, and smaller ones if it does poorly.
Immediate annuities are funded by a lump sum payment, after which the pay outs begin immediately. This option is good for those who have won a windfall of money, or for retirees who are concerned about outliving their savings.
Deferred annuities are the way most people use annuities. With a deferred annuity, the investor funds the account during the accumulation phase, and later draws payments out during the annuitization phase.
In addition to these main types there are also others such as the lifetime annuity and the fixed period annuity.
Benefits of Annuities
One of the biggest advantages of an annuity is that they are tax deferred and there is no contribution limit, you can put in as much as you want as quickly as you want. This makes it a great option for those who are close to retirement but still need to catch up.
The money invested in an annuity is tax deferred. When making withdrawals, the money that was contributed to the annuity is not taxed, but the earnings are.
During payout, annuities provide investors with a steady and reliable income stream, which is how most people use it. However, it is also possible to receive a lump sum payout if that is what you need.
Drawbacks of Annuities
Annuities are illiquid, meaning that the funds invested in an annuity are locked for a period of time.
The length of time that the funds are unavailable is known as the surrender period. During the surrender period, the investor would be penalized if the funds were touched.
Surrender periods are different from product to product, but they can last from 2 years on the low end and over 10 years on the high end.
The fees for touching the funds prematurely start out around at least 10%. However, the fees usually become less severe over the length of the surrender period.
Another drawback is that your money may be permanently tied up in an annuity. Some annuities can’t be undone, once they are in an annuity they remain there.
If you don’t like your particular annuity, you can roll it over into a different annuity, but the annuity structure itself can’t be terminated.
Annuities are generally sold by sale people who collect a commission. They don’t necessarily have your best interest in mind when selling you an annuity. That’s not to say an annuity is a bad choice, you just have to be careful and do your research first.
Variable annuities also charge several annual fees. When added up, these fees can be around 3% per year, which takes a significant chunk out of your savings.
Who Should Use an Annuity
Those who use annuities should be investors who want to earn guaranteed, stable retirement income. Due to the illiquid nature of annuities, they are not recommended for younger investors or for others who have a need for liquid capital.
Annuities might also be a good idea if you are in a high tax bracket and expect to be in a lower tax bracket when retired, particularly if your 401k and IRA deferrals are already maxed out.
Those who are concerned about outliving their savings are a good match for annuities. With an annuity, the investor receives payments until death, and some annuities even continue until the death of the spouse as well.
Finally, those who are interested in annuities should be willing to do extensive research on their own. Luckily, we have don’t a lot of that for you!
Annuities will differ not only by type, but also by which company is selling it. In order to get the best deal and avoid any unpleasant surprises, doing diligent research will help you get the best return on your investment.