One question we get asked frequently is whether or not to buy an annuity. Since there are many factors to consider when answering this question, this article isn’t intended to provide you with a “yes” or “no” answer, but instead serves as a way to provide you with additional information. If you have a better understanding of annuities, it will help you make a more informed decision.
Let’s start with what an annuity is and is not. An annuity is a contract issued by an insurance company. It is not an investment like a stock or a mutual fund. Since they are insurance company-issued contracts, many of them can be sold by insurance agents and not just financial advisors. Because they are insurance company-issued contracts, they provide certain guarantees (backed by the financial strength of the insurance company) as opposed to a pure investment, which does not provide any guarantees. An annuity is designed to provide you with income, whether it be immediate or in the future, for your lifetime, or a specific period of time. This is the main reason to buy an annuity, income, period. An annuity can provide income once you turn on the income from it, and it can provide that income to you regardless of how long you live. Much like a pension or social security pays you for as long as you live, an annuity can be designed to do the same thing. No other vehicle can provide this, which is why annuities should never be compared to traditional investments. The comparison is flawed as soon as it is made. Comparing annuities and traditional investments is like comparing apples and oranges.
What are the typical features of an annuity? They typically do not have a sales charge to buy them, but rather they impose a surrender charge for a designated period of time should you take your money elsewhere. The benefit is that all of your deposit is working for you from day one. The surrender charge is imposed because the company has obvious expenses in setting up the contract, as well as commissions (if not fee-based) to the person who sold you the contract. This is similar to how a permanent life insurance policy works. The annuity can contain riders that may guarantee returns for future income purposes, death benefits, or principal protection. Often, these riders come with an additional fee. Unlike non-IRA investments, annuities have named beneficiaries, which bypass your will. unless you name your estate as the beneficiary, which is not frequently recommended.
What are the pros of an annuity?
- Lifetime income. Only an annuity will typically provide you with income for life, regardless of whether or not you run out of principal. This is clearly the primary selling point of an annuity.
- Principal protection. Some annuities will provide protection against a loss of principal, which many retirees favor.
- Tax deferral. Interest earned in annuities, unlike other non-IRA investments, is not taxable until withdrawn. Be careful, however, when the withdrawals are made, the interest comes out first and is taxed as ordinary income, which can be less favorable than traditional investments, which are taxed as a capital gain.
- Beneficiary designations. Naming a beneficiary can allow the death benefit proceeds to avoid probate.
What are the disadvantages of an annuity?
- Annuities are complex. They are poorly understood by most people, often due to their complexity and multitude of moving parts.
- Taxation. While the tax deferral of an annuity is a selling point, as mentioned earlier, income coming out of an annuity may not be as favorable as traditional investments.
- Potentially muted returns. While we all love guarantees, sometimes those guarantees come at a price, and one of the possible costs is that an annuity may not earn as much as traditional investments. Retirees may not care as much about this as younger investors may because they may be more concerned with the protection of principal, but it is worth noting.
- Fees. Some annuities, typically variable annuities, can become very expensive if you add multiple riders, etc., to the contracts. Remember, all those bells and whistles can be great, but they come at a price, and it can be a very high price, so be careful what you add onto your annuity contract.
Seeing annuities through this lens can hopefully help you decide if an annuity is a suitable product for you to consider purchasing.
Frequently Asked Questions About Annuities
1.What is the main reason someone would buy an annuity?
The primary reason to purchase an annuity is to create a reliable stream of income. Depending on the contract, an annuity can provide income for a specific period of time or potentially for the rest of your life, helping reduce the risk of outliving your savings.
2. Are annuities the same as stocks, mutual funds, or other investments?
No. An annuity is an insurance contract issued by an insurance company, not a traditional investment. While investments focus primarily on growth, annuities are designed to provide income and may offer guarantees that traditional investments cannot.
3. How do I know if an annuity is right for me?
The answer depends on your financial goals, income needs, risk tolerance, and overall retirement strategy. An annuity may be worth considering if guaranteed income or principal protection is important to you, but it should be evaluated as part of a comprehensive financial plan.