 | ||
| © Ridofranz/Getty Images | A middle age Black couple hugs each other. |
By James Royal, Bankrate
Annuities are a popular approach to securing a retirement income, and millions of Americans invest in them. Annuities are designed to provide a steady stream of income during your retirement years, though they do have some notable drawbacks and can be notoriously complex.
Here's what annuities can do for your retirement as well as what you need to watch out for.
What is an annuity?
An
annuity is a contract that provides someone a stream of income,
typically in retirement, in exchange for money paid into the annuity.
Annuities are most often offered by insurance companies, which construct
the annuity and guarantee that it’s paid as scheduled. You may purchase
an annuity by depositing a lump sum or by paying into the annuity
contract over time.
The annuity will pay out over whatever period
is specified in the contract, perhaps that's a fixed period such as 20
years or perhaps it's for the remainder of the client's life. So the
annuity can offer the certainty of income and the possibility of never
exhausting that income.
Types of annuities
Annuities can be broadly lumped together into three different types:
- Fixed - A fixed annuity guarantees you a minimum rate of return on your investment and will pay out over a fixed term.
- Variable - A variable annuity allows you to put your money into various investments, often mutual funds. What the annuity returns and pays out to you depends on how the investments perform as well as the expense ratios on any funds you invest in.
- Indexed - An indexed annuity offers a rate of return that tracks an index such as the Standard & Poor's 500 Index, which holds hundreds of America's largest companies.
In addition to those three types, annuities can also be classified by when they pay out:
- Deferred annuities pay out at some specified time in the future, perhaps at some specific age in retirement.
- Immediate payment annuities begin paying out as soon as you deposit a lump sum.
An
annuity has two broad periods in its life - the accumulation phase and
the annuitization, or payout, phase. In the accumulation phase you're
putting money into the annuity, either as a lump sum or over time. In
the annuitization phase, you're taking payouts from the annuity.
Money deposited into an annuity is locked up for a period of time
called the surrender period. If you decide you want out of the annuity,
you'll pay a hefty fee called a surrender charge.
Features of an annuity
Annuities
can be structured in many different ways, depending on a customer's
needs. Some may guarantee that you'll receive a certain dollar amount of
payments from the account over some period. Many offer a death benefit,
which may pay out on your passing, like life insurance.
One
popular option is to have a longer surrender period, giving you more
time to cancel. Some annuities may offer survivor's benefits, where a
spouse may continue to receive the annuity's benefits over some period
of time, and most annuities can be structured with other "riders" that
offer some insurance-like benefit. Generally the more features your
annuity has, the pricier it is.
So while the company issuing the
contract has many different ways to create the annuity based on what you
need, you'll pay extra for all the benefits.
Tax advantages
Annuities
offer tax-deferred growth on your investment until you withdraw the
money. So if you pay into the annuity with after-tax money, you'll be
taxed at withdrawal only on the earnings of the account, not any
principal that you take out. This feature can be valuable for those
looking for a tax-advantaged way to invest.
Unlike other tax-deferred retirement accounts such as a traditional 401(k),
annuities have no annual contribution maximum, allowing savers to pile
away as much cash as they can. That's a particular benefit for
higher-income savers, who may otherwise want to contribute more to their
retirement but have maxed out their ability to do so in a
tax-advantaged way.
You can also buy an annuity inside a Roth IRA or Roth 401(k),
making those payouts fully tax-free, though many experts frown on
putting a complex tax-advantaged account inside another such as a Roth
IRA.
The downside of annuities
An annuity can solve the
challenge of finding a guaranteed stream of income in retirement, and
may offer some other benefits such as a death benefit. However, it comes
with quite a few downsides, and many financial advisers are suspicious
of annuities for the following reasons.
1. Complexity
Annuity
contracts are tremendously complex, often running to dozens of pages.
In this fine print, you'll find all the many conditions of the annuity
spelled out, such as when you can get paid, how much it will cost you to
cancel the contract, how much you're guaranteed to be paid, what rate
of return the annuity is based on, and all the other details that govern
the agreement.
On top of this complexity, annuity contracts may
differ markedly from one to the next. Annuities have some broad
similarities, but the details are where annuities really stand apart.
The benefits of each annuity contract may differ - allowing insurance
companies to offer a specific kind of coverage that you're looking for
as well as hide some of the less flattering details of the contract.
It
ought to go without saying, you'll need to read the contract very
closely to see just what your rights and responsibilities are. But even
spending hours on the contract may not be enough.
2. Huge sales commissions
One
of the biggest drawbacks of an annuity are the large sales commissions
bundled in with the product. The commission is money that comes straight
off the top of your payment and won't go into the pot of money that's
funding your income stream years later.
Unfortunately, it's not
unusual to spot a commission at 6 or 7 percent, though they may go up to
10 percent. If you put $100,000 into an annuity, a salesperson may take
$6,000 or more before the money starts working for you, though the
industry may obscure how you're charged.
In general, complex
annuities with more features have higher commissions than simple
annuities. An annuity with a long surrender charge period means higher
commissions, too.
With that kind of incentive, it's little wonder
that insurance agents are eager to sign up clients in a complex product.
It's also a reason why you need an independent fee-only financial adviser who's looking out for your interest, not their own personal financial interest.
3. Can be hard to cancel
Amid
all the complexity of the contract, you may find how to cancel your
annuity, a process that may come with substantial fees - called
surrender charges - or other lost income. While there may be ways for
you to wiggle out of the contract, don't expect them to be easy or
pain-free.
4. Illiquid money
Once you put your money into
an annuity, it's generally tied up for a long period of time. You'll
receive your stream of income and you may be able to withdraw some of
the principal, but for the most part your money is locked into the
annuity and you have relatively little access to it.
That can be problematic if you need money for an emergency and your income or other savings doesn't suffice.
5. Variable annuities are risky
Because
they may rely fully on the markets for any gain, variable annuities can
potentially be quite risky, leaving you with few gains and maybe even
losses after years of saving. You'll want to invest any money for the
long term so that you can ride through the dips in the market, and avoid
fees that may come with an early redemption of the annuity, if you
decide to go that way.
Variable annuities can also be full of fees
- a mortality and expense risk charge, the expense ratios of any funds
you invest in, administrative fees and any additional fees for special
features that you've added to the account (for example, a death benefit
or guaranteed minimum payout.)
And if you withdraw your money
early, before age 59 1/2, you can get hit with a 10 percent bonus
penalty in addition to taxes you'll owe on any investment gains, much
like the penalties for early withdrawal on traditional IRA and 401(k) accounts.
Alternatives to annuities
So
many kinds of annuities exist because consumers have varying needs. But
a good financial adviser can recreate many of an annuity's benefits
without as many of the drawbacks.
For example, while an annuity
may promise you a 4 percent return on your money, an adviser may be able
to construct a portfolio that earns you 5 percent today and offers a
growing stream of dividends in future years. Such a portfolio may also
offer you flexibility, too.
On the other hand, many retirees like
the security of a monthly income, and an adviser can set up your
portfolio to pay you cash on a regular basis just like an annuity. You
may even be able to set up a life insurance contract that mimics the
death benefit that is typical of many annuities.
Perhaps best of
all, you can get these benefits without the same cost that you'd pay in
sales commissions and still retain a much more flexible portfolio. An adviser who looks out for your best interest can find low-cost mutual funds that generate strong returns over time.
Bottom line
Annuities
can solve a specific kind of problem for a specific kind of person -
steady retirement income for people with little experience in financial
matters - but they're not the cure-all that they're often pitched as. A
good financial adviser can construct a plan that avoids many of the
downsides of an annuity while offering many of the upsides, including a
potentially higher return.
See more at Bankrate
