First, it’s important to understand what exactly happens when you purchase an annuity. In general, an annuity is a contract sold by an insurance company that will pay you periodic payments at some point in the future.
The word annuity has many definitions and there are multiple varieties of annuities in the marketplace. The most common types of annuities are: immediate annuities, fixed annuities and indexed annuities.
Immediate annuities are a financial product in which the buyer pays a lump sum and then receives a stream of income from the insurance company. The mechanics behind this are that the insurance company uses the lump sum payment to invest and generate long terms returns that both support your cash stream and turn a profit for them.
A fixed annuity is a contract that once purchased by the buyer commits the insurance company to making fixed dollar payments for the term of the contract, typically until the buyer dies. When you buy a fixed annuity, you’re betting that you will live longer than the average person who also buys a fixed annuity. Obviously, the insurance company and their actuarial charts believe otherwise.
A variable annuity involves a stock portfolio. The insurance company will guarantee a minimum payment, but the rest of your income depends on the portfolio’s performance.
Now that we’ve reviewed the nature and types of annuities, let me explain the ideas behind them before we jump into the pros and cons of annuities for retirement. The theoretical idea behind the annuities is a very simple financial concept called the Time Value of Money. Basically, a dollar today is worth more than a dollar at some date in the future, because with a dollar today, you can invest it. Simply, if you have $1 today and someone asks for your dollar and says they will return $1 to you tomorrow, you are losing money. If you had kept your dollar today and invested in, you could have $1.10 tomorrow. What makes annuities, so attractive for insurance companies is that they get the $1.10!
Annuities, like all investment vehicles, have their downsides, but there are certain characteristics of annuities that simply cannot be replicated by anything else in the marketplace.
- If you won’t be retiring with a stream of income, such as a pension, annuities offer that potential.
- The interest earned in annuities are deferred until you take distributions.
- Most annuities will give you some level of principal protection, where it is guaranteed by the insurance company.
- You can lock in interest rates. This is good when interest rates are high, but not so much now. When interest rates rise from unusually low rates to high, then it is a wise time to consider a fixed annuity.
Unfortunately, many face the significant cons that are associated with annuities.
- Interest rates are used to calculate the immediate annuity payments, so if someone were to commit money to an immediate annuity payment, low interest rates could expose them to inflation risk. By not protecting from inflation, you could lose significant purchasing power when rates do increase.
- The tax deferral of annuities is definitely a benefit, but all of your gains will eventually be taxed at your ordinary income rate.
- Illiquidity. You are required to be 59 1/2 years of age in order to withdraw gains from some annuities and can be subject to a percent early withdrawal penalty. Other than that, the only way to get your money is by receiving periodic payments.
- No growth potential. Once you’re locked in to receive payments, that’s it. You are essentially transferring risk to the insurance company, which is why an annuity should only be considered as a pension type payment.
- If you choose a variable annuity, the investment options are severely limited and frequently have high expense ratios.
Overall, annuities are a comforting idea for retirement but have many negative attributes that detract from their appeal for retirees. If you choose to purchase annuity for retirement, it is hugely important that you find one with the option to put away more on an annual basis. It is likely best to find a low commission product, and no surrender charges.
There is probably a less expensive way to achieve the same outcome with another investment vehicle. As always, discuss your individual situation with an investment advisor who knows your circumstances.