Retirement planning is all about making sure you are saving enough money today so that when you stop working you have enough money to cover your expenses for the rest of your life. While regularly investing in your retirement accounts — your 401(k) and IRA — is a smart way to help ensure you’re not cash-strapped in retirement, those investment accounts are tied to the health of the stock market. As a result, there are no guarantees those funds will provide a steady payout over the course of your lifetime.
With this in mind, many retirees like to have a passive income stream to get them through their golden years. The more passive income you have in retirement, the less you need to put into your retirement savings today.
Perhaps the most well-known type of passive retirement income in the U.S. is Social Security. In 2018, Social Security benefits represented 33% of the elderly’s income. However, for millennials, Social Security is not guaranteed. The Social Security Administration predicts that the trust fund will run out of reserves in 2034.
As such, you might wonder what other options are available to you to continue receiving a steady monthly income even once you’ve decided to bid adieu to the working world. This is where annuities come in.
Annuities can provide a guaranteed monthly income for life. They give you limited access to your funds through annual income streams, and can last for a set period of time, or for the remainder of your life. An annuity also shifts the risk from you, the annuitant, to the insurance company.
Sounds pretty great, right?
While that might sound like an extremely attractive proposition, there’s more to an annuity than meets the eye. In fact, annuities are some of the most complicated and misunderstood financial products on the market.
If you’re not approaching or in retirement, they’re probably not something you should consider buying right now. Rather, annuities are an investment vehicle that are good to have on your radar for the future.
Here, we’ll clarify just what an annuity is, how it works, and if it’s right for you.
What Is an Annuity?
First of all, it’s important to point out that an annuity is not an investment — it is an insurance product. With an annuity, you sign a contract with an insurance company to cover specific investment objectives, such as the protection of your principal or the guarantee of a lifetime income.
That’s where the simplicity ends.
Annuities and the rules that govern their operation are complicated and highly customizable. However, while the fine print may vary depending on the specific annuity — as with most contracts — when you sign on the dotted line you’re locking yourself into certain terms and conditions with the insurance company. It’s important to keep in mind that breaking them can come with steep costs.
How Do Annuities Work?
As with most insurance products, an annuity works by transferring risk from you to the insurance company. For instance, with car insurance, you pay a premium every month to your auto insurer, and in return they agree to cover the costs of any damage to your vehicle in case of an accident or emergency.
In the case of an annuity, you — the annuitant — transfer the risk of not having a steady income stream to the insurance company. However, unlike with auto insurance and other common insurance policies, you do not pay a premium indefinitely. Instead, there is a premium paying period, also known as the accumulation phase, where you pay the insurance company a set amount. You can pay these premiums in a lump-sum payment, or through a series of payments over time.
When the accumulation phase ends and the annuity starts paying you, the contract is said to have entered the payout phase. Now, this is where annuities really start to get complicated, as there is great variation in how these payouts can be handled.
Depending on the annuity, you could potentially receive income payments for a fixed number of years, the rest of your life, or until you and your spouse have both passed away. You can also select annuities that combine lifetime income with a certain payout for your heirs. In such a case — known as a death benefit — if you were to pass away during a specified time frame, your beneficiary would continue to receive the remainder of your annuity payments for the time period agreed upon when you initially signed your contract.
What Kinds of Annuities Are Available?
As mentioned above, annuities are highly customizable and can be very complex. While there is no one-size-fits-all annuity available on the market, there are two primary types of annuities to consider: immediate annuities and deferred annuities.
As the name would suggest, with an immediate annuity, you begin to receive payments soon after your initial investment. Annuitants make a single lump-sum payment to the insurance company, and begin receiving payments one annuity period after purchase — usually ranging from 30 days to one year later. Due to the quick turnaround, these types of annuities are extremely popular with individuals approaching retirement age.
In contrast to an immediate annuity, deferred annuities are just that — deferred. With this type of annuity, you don’t begin receiving annuity payments for years or decades after you sign the contract.
The primary advantage to this type of annuity is that the premiums you pay into it are allowed to grow tax-deferred. Unlike 401(k) or IRAs, there is no limit to the amount of money you can place in the annuity — although many insurance companies cap the contribution amount at $1 to $2 million — and as a result some high wealth individuals use deferred annuities as a supplement to their other retirement accounts.
What are the Pros and Cons of an Annuity?
Although the details will vary based on the different types of annuity, in general all annuities more or less share the same pros and cons. While many investors seek them out as a key retirement-savings option due to their guaranteed income stream and other advantages, there are some important drawbacks to consider before deciding to buy an annuity.
Perhaps the most obvious and most attractive feature of any annuity is its guarantee of lifelong income.
As mentioned above, deferred annuities are the only investment option available that allows you to invest an (almost) unlimited amount tax-deferred. While 401(k)s and IRAs also allow your money to grow tax-free, they have maximum yearly contribution limits. An annuity, on the other hand, allows you to set aside as much money as you like watch it grow tax-free. As such, annuities are often an attractive vehicle for extremely wealthy individuals.
Protected from creditors
In addition to their tax-sheltered status, any funds tied up in an annuity cannot be accessed by creditors. That said, this exemption can vary from state to state, so you should check with your state insurance commissioner to pin down the specifics for your situation.
High costs and fees
Commissions on annuities are extremely high — typically 7% or more. So, if you buy a $200,000 annuity, the financial advisor or broker who sold it to you would likely receive a commission of $14,000 when you sign up. Additionally, it’s common for annuities to charge up to 3% to 4% in annual fees on top of that commission. Compare that to the usual 1.5% to 2% operating fee of an actively managed mutual fund or 0.25% to 0.50% of an ETF or index fund.
Given that an annuity is a binding contract, it can be costly to retrieve your money if your circumstances were to change. Most annuities will charge what is called a surrender fee if you withdraw your money during the surrender period, which can be anywhere from 2 to 10 years after you sign the initial contract. However, these fees typically decline with time. For instance, if an annuity has a 10-year surrender period, you would be charged 10% on money taken out in the first year, 9% the second year, and so on.
If you’ve read this far, this one should come as no surprise. In addition to the decision between an immediate or deferred annuity, there is a quagmire of other options that potential annuitants must wade through to pick the annuity that’s right for them. Even the most seasoned investors often find the terms and conditions of annuities highly confusing, so it might be better to stick to simpler investment options if you don’t feel comfortable navigating these choppy waters.
While the money sitting in an annuity can grow tax-deferred, that advantage disappears when the money is withdrawn. Any withdrawals from the annuity that are not considered as a return of your principal investment are taxed as ordinary income, and there is no chance for them to qualify for capital gains treatment. Additionally, if you withdraw money from your annuity before age 59 1/2, those earnings may be subject to a federal income tax penalty of up to 10%.
While the primary selling point for an annuity is its promise of guaranteed income for life, know that your investment is only as sound as the insurance company. If the insurance company holding your money becomes insolvent, there’s little you can do to recoup your investment. Unlike savings accounts, annuities are not FDIC insured.
Is an Annuity Right for Me?
As you may have gleaned, annuities are not right for everyone. If you’re not worried about running out of income in retirement, you probably don’t need an annuity. Typically, you’ll be better off maxing out your other tax-advantaged retirement accounts, such as your 401(k) and IRA, before even considering an annuity.
If you’re under 50 and have extra cash available to invest after maxing out those tax-deferred accounts, a good alternative investment might be rental properties. By purchasing a property with a mortgage, you can keep your cash flow neutral or even positive during the term of the loan by using the rental income to pay the mortgage and other property-related expenses. Essentially, your renters pay off your loan, and when it’s paid off, you get a steady stream of income to help you in retirement.
This option is better than an annuity for most investors, as the average national return on investment from residential real estate is between 3% and 5%. With most annuities, you won’t see such a high return due to fees and commissions eating away at your principal.
Additionally, with real estate, you’re in control of your money. When you purchase an annuity, you essentially lock your money away with the insurance company, and can only access it through the agreed upon yearly or monthly payments. With real estate, you can sell it, leave it to your kids, or even sell it to buy a more expensive home in your climb up the property ladder — all while avoiding any tax penalties.
Plan Ahead for a Relaxing Retirement
While annuities are not right for everyone — especially not for young investors many decades away from leaving the working world — planning for your retirement is still an excellent idea. Saving now can save you headaches in the future, whether you decide to put that money into your 401(k), IRA, real estate, or an annuity. No matter what you decide, educating yourself on the options available for retirement income is a firm step toward a stress-free, relaxing retirement.