Pros And Cons Of Annuities – Forbes Advisor

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Annuities are a great way to secure guaranteed income as part of your retirement plan. Like any other retirement savings tool, annuities come with advantages and disadvantages.

“Annuities are the only product in the entire financial universe able to provide guaranteed income for a set period of time,” says Ryan Brown, a partner at financial planning firm CR Myers & Associates in Southfield, Michigan.

Let’s take a closer look at the pros and cons of annuities, and how they can help your retirement savings last for the long haul.

What Is An Annuity?

An annuity is a contract between you and an insurance company. Annuity investors hand over a single premium payment or several premium payments in exchange for a single payout or several payouts.

There are a variety of different types of annuities available, but three of the most common are:

An annuity is not a life insurance policy or a savings account. Rather, it’s a contract that’s designed to provide a stream of income, most often for retirement. In short, an annuity is supposed to be a long-term investment vehicle.

“The annuity contract is often described as being the opposite of life insurance. It pays while you live; life insurance pays when you die,” the Indiana Department of Insurance points out.

In 2021, total US annuity sales were $254.8 billion, according to the Security Retirement Institute.

How Does An Annuity Work?

Under your contract with an insurance company, your annuity is supposed to make either immediate or future payouts.

You pay for an annuity all at once or through a series of payments. Your payout can be in the form of a lump sum of money or a series of separate payments.

Advantages of Annuities

Regular Income Payments

Depending on the type of annuity, you can receive a lump-sum income payment, or income payments on a monthly, quarterly or annual basis.

Guaranteed Income

An annuity can provide guaranteed income, either right away or over a period of time. This guaranteed income can supplement a retiree’s overall income from sources such as Social Security or an individual retirement account (IRA).

Fixed Interest Rate

With a fixed annuity, you’re able to lock in an interest rate—like 3% a year. With a fixed interest rate, you can get a better handle on how much income will be coming in.

Tax-Deferred Contributions

Many annuities let you make tax-deferred contributions. With a tax-deferred annuity, the money you add isn’t taxed until after you retire. Taxes aren’t due until you start receiving annuity payouts.

So, if you don’t touch the money while it’s in an annuity, you aren’t required to pay taxes on any capital gains that you accumulate. Payments from a tax-deferred annuity can start as soon as one year after you’ve set up the annuity.

Contribution Limits

As opposed to a 401(k) or an IRA, an annuity does not impose annual contribution limits. Therefore, you can put as much money as you’d like into an annuity.

Protection Against Market Ups And Downs

Annuities, particularly fixed annuities, protect your principal against losses, according to Lamar Brabham, founder and CEO of Noel Taylor Agency in North Myrtle Beach, South Carolina. Over time, the principal in an annuity will go up or stay the same, but it will never go down, Brabham says.

“The old investor adage ‘zero is your hero’ comes from the fact that during a down market when many investors are losing money, investors with these annuities are credited with ‘zero’ interest and retain their original investment, plus any previously credited growth, ” says Brabham.

This feature can prove to be a comfort during a challenging market. In the current environment, where financial markets are at best volatile and at worst disastrous, many investors are more interested in the return of their investment, as opposed to a return on their investment.

Death Benefits

Some annuities pay a death benefit to beneficiaries, either as a lump-sum payment or a percentage of regular income payments.

However, the death benefit might not be all that generous or might not even be issued at all. An annuity holder can boost the death benefit at an additional cost.

Disadvantages of Annuities

Fees and Commissions

Some annuities charge fees, Brabham says, while others don’t. But for those who do, the fees might be 2% to 3% per year. That fee range is higher than the range for some other investment types. Investors and financial advisors might find annuity fees “troubling,” Brabham says.

Other annuity fees someone might run across include:

  • Surrender charges. An annuity seller subtracts this charge from the cash value of your annuity when you sell or withdraw money from a variable annuity during what’s known as the surrender period. This period typically lasts six to eight years.
  • Mortality and expense risk charges. This type of charge applies to variable annuities and can be around 1.25%. The seller tacks on this charge, usually every month, to make up for lost income in case an annuity holder dies before the seller had estimated the person would die.
  • Administrative fees. The seller of an annuity might charge fees for maintaining your account. These fees can cover costs such as recordkeeping and accounting.

In addition to these and other fees, some annuities may come with sales commissions of 7% or more.

Costly Riders

In many cases, some of the most appealing benefits of an annuity come in the form of optional riders. So, you might wind up paying more for add-on features such as minimum guaranteed income or lifetime payouts.

Coupled with fees and commissions, a rider could further water down your investment.

Tied-Up Money

Ron Tallow, founder and owner of Tallow Financial Services in Troy, Michigan, notes that annuities may restrict access to your money.

Most annuities let an owner take out a designated portion of their money, frequently 10% each year, without paying a surrender charge during the surrender period (usually six to eight years). If the withdrawal happens before age 59½, you’ll be slapped with a tax on “ordinary” income and potentially a 10% federal income tax penalty.

Furthermore, you might not be able to get a refund on an annuity that provides guaranteed income for life. In other words, you wouldn’t be able to pull out all of your money at once after buying this type of annuity.

Scams

Some buyers of annuities are susceptible to annuity scams. One common annuity scam targets older people. In this scam, an agent sells an annuity to a senior and hypes the benefits but fails to mention the drawbacks, such as the fees and commissions.

“In exchange for a promise of future rewards, the elderly individual ties up his or her life savings. Meanwhile, the agent pockets a handsome commission,” states the Center for Life Insurance Disputes, a firm that handles life insurance complaints on behalf of paying clients.

Fluctuating Returns

If you have a variable annuity, the cash value goes up or down based on how the market performs. This can lend uncertainty to your income stream during retirement.

A variable annuity typically invests in mutual funds whose holdings include stocks, bonds and money market instruments, such as treasury bills. Therefore, the rate of return on a variable annuity is not fixed.

Who Can Benefit From Annuities?

Annuities aren’t for everyone. But they might be a good choice for people who are nearing retirement or are already in retirement, thanks to the ability to receive regular income payments that can help replace regular paychecks, experts say.

“A very popular strategy with annuities is to structure the account to provide a lifetime income, much like a pension, for the annuity owner and as well as a lifetime income for a surviving spouse,” Brabham says. “Once a person reaches that certain age, safety for one’s nest egg becomes paramount and annuities are a natural choice. Remember that safety, growth and liquidity should be your goal, and annuities just may be the answer.”

Ron Tallow, founder and owner of Tallow Financial Services in Troy, Michigan, suggests digging into the details, such as payouts and structures, to find out whether an annuity is right for you.

“The biggest advice I can give to someone who is thinking about whether an annuity is right for them is to ask questions, because annuities can be structured in many ways,” Tallow says.

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